UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
 
(Mark One)
 
 
þ     QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended June 30, 2014
 
o    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: 001-32421
 
FUSION TELECOMMUNICATIONS INTERNATIONAL, INC.
(Exact name of registrant as specified in its charter)
 
 
Delaware
58-2342021
(State or other jurisdiction of incorporation or organization)
(IRS Employer Identification No.)
 
420 Lexington Avenue, Suite 1718, New York, New York   10170
  (Address of principal executive offices)    (Zip Code)
 
(212) 201-2400
(Registrants telephone number, including area code)
 
Indicate by check mark whether the issuer (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
 
Yes þ  No o
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  
 
Yes þ  No o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
       
Large accelerated filer
o
Accelerated filer
o
Non-accelerated filer 
 (Do not check if smaller reporting company)
o
Smaller reporting company
þ
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b—2 of the Exchange Act).      Yes o No  þ
 
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: August 12, 2014.
 
   
Title Of Each Class
Number of Shares Outstanding
Common Stock, $0.01 par value
6,331,895




 
 
 
 
 
FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES
 
TABLE OF CONTENTS
 
Part 1     Financial Information.
3
Item 1.   Financial Statements.
3
Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations.
21
Item 3.   Quantitative and Qualitative Disclosures About Market Risk.
31
Item 4.   Controls and Procedures.
31
Part II     Other Information.
32
Item 1.    Legal Proceedings.
32
Item 1A. Risk Factors.
32
Item 2.    Unregistered Sales of Equity Securities and Use of Proceeds.
32
Item 3.    Defaults Upon Senior Securities.
32
Item 4.    Mine Safety Disclosures.
32
Item 5.    Other Information.
32
Item 6.    Exhibits.
32
Signatures.
33
Index to Exhibits.
34
   
 
 
 
2

 
 
 
FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES
 
PART 1 FINANCIAL INFORMATION
 
Item 1. Financial Statements.
Condensed Consolidated Balance Sheets
 
   
June 30,
2014
   
December 31,
2013
 
ASSETS
 
(unaudited)
       
Current assets:
           
Cash and cash equivalents
  $ 9,786,329     $ 6,176,575  
Accounts receivable, net of allowance for doubtful accounts of
               
approximately $187,000 and $381,000, respectively
    7,361,697       5,828,389  
Prepaid expenses and other current assets
    1,336,097       2,704,787  
Total current assets
    18,484,123       14,709,751  
Property and equipment, net
    11,793,189       11,193,355  
Other assets:
               
Security deposits
    596,073       585,083  
Restricted cash
    1,164,007       1,163,872  
Goodwill
    5,222,088       5,124,130  
Intangible assets, net
    31,705,263       35,048,818  
Other assets
    1,089,404       1,125,652  
Total other assets
    39,776,835       43,047,555  
TOTAL ASSETS
  $ 70,054,147     $ 68,950,661  
                 
LIABILITIES AND STOCKHOLDERS' EQUITY
               
Current liabilities:
               
Notes payable - non-related parties
  $ 2,027,724     $ 625,000  
Notes payable - related parties
    125,000       310,714  
Equipment financing obligations
    202,805       245,138  
Escrow payable
    -       295,000  
Accounts payable and accrued expenses
    10,496,322       11,161,550  
Related party payable
    -       226,148  
Current liabilities from discontinued operations
    55,000       55,000  
Total current liabilities
    12,906,851       12,918,550  
Long-term liabilities:
               
Notes payable - non-related parties, net of discount
    36,511,327       36,788,987  
Notes payable - related parties, net of discount
    1,267,114       1,478,081  
Equipment financing obligations
    123,711       167,614  
Derivative liability
    7,082,401       10,515,472  
Deferred tax liabilities
    147,341       -  
Other long-term liabilities
    57,442       131,627  
Total liabilities
    58,096,187       62,000,331  
Commitments and contingencies
               
Stockholders' deficit:
               
Preferred stock, $0.01 par value, 10,000,000 shares authorized,
               
27,883 and 23,525 shares issued and outstanding
    279       235  
Common stock, $0.01 par value, 18,000,000 shares authorized,
               
6,204,169 and 6,077,071 shares issued and outstanding
    62,041       60,770  
Capital in excess of par value
    172,659,066       166,625,595  
Accumulated deficit
    (160,763,426 )     (159,736,270 )
Total stockholders' equity
    11,957,960       6,950,330  
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY
  $ 70,054,147     $ 68,950,661  
 
 
See accompanying notes to the Condensed Consolidated Interim Financial Statements.
 
 
3

 
 
FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES
 
Condensed Consolidated Interim Statements of Operations
(Unaudited)
 
   
Three Months Ended June 30,
   
Six Months Ended June 30,
 
   
2014
   
2013
   
2014
   
2013
 
Revenues
  $ 23,140,973     $ 14,230,178     $ 46,045,802     $ 30,398,599  
Cost of revenues, exclusive of depreciation and
                               
amortization, shown separately below
    12,747,441       9,605,534       24,976,473       21,357,130  
Gross profit
    10,393,532       4,624,644       21,069,329       9,041,469  
Depreciation and amortization
    2,597,978       872,584       5,165,469       1,722,499  
Selling general and administrative expenses (including
                               
stock-based compensation of approximately $73,000 and
                               
$28,000 for the three months ended June 30, 2014 and
                               
2013, respectively, and approximately $142,000 and $56,000
                               
for the six months ended June 30, 2014 and 2013, respectively
    7,825,494       4,433,848       15,644,891       8,701,446  
Total operating expenses
    10,423,472       5,306,432       20,810,360       10,423,945  
Operating (loss) income
    (29,940 )     (681,788 )     258,969       (1,382,476 )
Other (expenses) income:
                               
Interest expense
    (1,597,215 )     (669,731 )     (2,991,761 )     (1,329,250 )
Loss on extinguishment of debt
    -       (92,376 )     -       (150,579 )
Change in fair value of derivative liability
    (690,878 )     238,517       1,919,069       105,267  
Other income (expenses), net
    719       (17,731 )     (40,355 )     (62,351 )
Total other expenses
    (2,287,374 )     (541,321 )     (1,113,047 )     (1,436,913 )
Gain on extinguishment of accounts payable
    -       2,908,882       -       2,908,882  
(Loss) income before income taxes
    (2,317,314 )     1,685,773       (854,078 )     89,493  
Provision for income taxes
    151,583       -       173,078       -  
Net (loss) income
    (2,468,897 )     1,685,773       (1,027,156 )     89,493  
Preferred stock dividends in arrears
    (443,194 )     (100,349 )     (885,282 )     (199,595 )
Net (loss) income applicable to common stockholders:
  $ (2,912,091 )   $ 1,585,424     $ (1,912,438 )   $ (110,102 )
                                 
Basic (loss) earnings per common share:
  $ (0.42 )   $ 0.40     $ (0.28 )   $ (0.03 )
                                 
Diluted (loss) earnings per common share:
  $ (0.42 )   $ 0.30     $ (0.38 )   $ (0.03 )
Weighted average common shares outstanding:
                               
Basic
    6,876,617       3,917,341       6,842,532       3,746,326  
Diluted
    6,876,617       5,593,544       6,842,532       3,746,326  
 
 
See accompanying notes to the Condensed Consolidated Interim Financial Statements.
 
 
4

 
 
FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES
 
Condensed Consolidated Interim Statement of Stockholders' Equity
 
     
Preferred Stock
     
Common Stock
     
Capital in
   
Accumulated
   
Stockholders'
 
     
Shares
     $      
Shares
     $      
Excess of Par
   
Deficit
   
Equity (Deficit)
 
Balance at December 31, 2013
    23,525     $ 235         6,077,071     $ 60,770       $ 166,625,595     $ (159,736,270 )   $ 6,950,330  
                                                             
Discount on related party note payable, net of exchanges
      -       -         -       -         372,551       -       372,551  
                                                             
Proceeds from the sale of preferred stock and warrants, net of expenses
      4,358       44         -       -         3,984,382       -       3,984,426  
                                                               
Warrants issued in conunction with the issuance of preferred stock deemed not indexed to the Company's common stock
      -       -         -       -         (1,301,607 )     -       (1,301,607 )
                                                             
Issuance of common stock for services rendered
      -       -         4,265       43         21,624       -       21,667  
                                                             
Modification of previously issued warrants and reclassification to stockholders' equity
      -       -         -       -         2,815,609       -       2,815,609  
Net loss
      -       -         -       -         -       (1,027,156 )     (1,027,156 )
Dividends on preferred stock
    -       -         122,833       1,228         (1,228 )     -       -  
                                                             
Stock-based compensation associated
with stock incentive plans
      -       -         -       -         142,140       -       142,140  
Balance at June 30, 2014
    27,883     $ 279         6,204,169     $ 62,041       $ 172,659,066     $ (160,763,426 )   $ 11,957,960  
 
 
 
5

 
 
FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES
 
Condensed Consolidated Interim Statements of Cash Flows (Unaudited)
 
   
Six Months Ended June 30,
 
   
2014
   
2013
 
Cash flows from operating activities:
           
Net (loss) income
  $ (1,027,156 )   $ 89,493  
Adjustments to reconcile net (loss) income to net cash used in operating activities:
               
Depreciation and amortization
    5,165,469       1,722,499  
Loss on disposal of property and equipment
    84,373       -  
Loss on sale of accounts receivable
    94,037       128,769  
Deferred income tax provision
    147,341       -  
Bad debt expense
    222,856       1,251  
Stock-based compensation
    142,140       55,931  
Stock and warrants issued for services rendered or in settlement of liabilities
    37,542       83,564  
Amortization of debt discount and deferred financing fees
    579,541       209,011  
Change in fair value of derivative liability
    (1,919,069 )     (105,267 )
Loss on extinguishment of debt
    -       150,579  
Gain on extinguishment of accounts payable
    -       (2,908,882 )
Increase (decrease) in cash and cash equivalents attributable to changes in
               
operating assets and liabilities:
               
Accounts receivable
    (1,004,835 )     (992,929 )
Prepaid expenses and other current assets
    (862,851 )     (75,670 )
Other assets
    (46,870 )     25,894  
Replenishment of security deposits
    -       (144,141 )
Accounts payable and accrued expenses
    (1,446,993 )     1,430,459  
Other long-term liabilities
    (74,186 )     (67,645 )
Net cash provided by (used in) operating activities
    91,339       (397,084 )
Cash flows from investing activities:
               
Purchase of property and equipment
    (1,817,707 )     (628,607 )
Proceeds from the sale of property and equipment
    46,116       -  
Payment of obligations related to purchase price of acquisitions
    (226,148 )     (159,360 )
Returns of security deposits
    2,000,000       -  
Payments of security deposits
    (10,990 )     -  
Change in restricted cash
    (136 )     (197 )
Net cash used in investing activities
    (8,865 )     (788,164 )
Cash flows from financing activities:
               
Proceeds from the sale of common stock and warrants, net
    -       1,559,509  
Proceeds from the sale of preferred stock and warrants, net
    3,984,426       -  
Proceeds from notes payable - related parties
    -       100,000  
Proceeds from notes payable - non-related parties
    1,102,724       212,500  
Payments on equipment financing obligations
    (173,832 )     (5,352 )
Repayments of notes payable - related parties
    (185,714 )     (257,143 )
Repayments of notes payable - non-related parties
    (1,200,324 )     (180,577 )
Net cash provided by financing activities
    3,527,280       1,428,937  
Net change in cash and cash equivalents:
    3,609,754       243,689  
Cash and cash equivalents, beginning of period
    6,176,575       543,214  
Cash and cash equivalents, end of period
  $ 9,786,329     $ 786,903  
 
See accompanying notes to the Condensed Consolidated Interim Financial Statements.
 
 
6

 
 
FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES
 
NOTES TO THE CONDENSED CONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED)
 
1. Basis of Presentation, Consolidation, and Summary of Selected Significant Accounting Policies
The accompanying unaudited condensed consolidated interim financial statements and notes thereto should be read in conjunction with the audited consolidated financial statements included in the Annual Report on Form 10-K for the fiscal year ended December 31, 2013 for Fusion Telecommunications International, Inc. (“Fusion”) and its subsidiaries (collectively, the “Company”).  These condensed consolidated interim financial statements have been prepared in accordance with the instructions to Form 10-Q and Article 8 of Regulation S-X of the United States Securities and Exchange Commission (the “SEC”) and therefore omit or condense certain footnotes and other information normally included in consolidated interim financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”).  All material intercompany balances and transactions have been eliminated in consolidation.  In the opinion of the Company’s management, all adjustments (consisting of normal recurring accruals) considered necessary for the fair presentation of the condensed consolidated interim financial statements have been made. The results of operations for an interim period are not necessarily indicative of the results for the entire year.

During the three and six months ended June 30, 2014 and 2013, comprehensive loss was equal to the net loss amounts presented for the respective periods in the accompanying condensed consolidated interim statements of operations.  In addition, certain prior year balances have been reclassified to conform to the current presentation.

Reverse split of common stock
On April 9, 2014, the Company’s Board of Directors approved amendments to the Company’s Certificate of Incorporation to (a) effect a reverse stock split of all of the outstanding shares of the Company’s common stock at a ratio (the “Reverse Split Ratio”) of one for fifty (the “Reverse Stock Split”) and (b) a corresponding reduction in the number of shares of common stock that the Company is authorized to issue from 900,000,000 to 18,000,000.  The Certificate of Amendment, which was approved by the Company’s stockholders on March 28, 2014, became effective on May 13, 2014, and at that time the Reverse Stock Split took place and each 50 shares of outstanding common stock of the Company was combined and automatically converted into one share of the Company’s common stock, with a par value of $0.01 per share.  In addition, the conversion and exercise prices of all of the Company’s outstanding preferred stock, common stock purchase warrants and options to purchase common stock were proportionately adjusted at the Reverse Split Ratio consistent with the terms of such instruments.  No fractional shares were issued as a result of the Reverse Stock Split, and any fractional share to which a stockholder may have been entitled as a result of the Reverse Stock Split was rounded up to the nearest whole share.

As a result of the Reverse Stock Split, all share and per share amounts as of December 31, 2013, as well as for the three and six months ended June 30, 2013, have been restated at the Reverse Split Ratio to give effect to the Reverse Stock Split.

Income taxes
The Company complies with accounting and reporting requirements with respect to accounting for income taxes, which require an asset and liability approach to financial accounting and reporting for income taxes.  Deferred income tax assets and liabilities are computed for differences between the financial statement and tax bases of assets and liabilities that will result in future taxable or deductible amounts, based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income.  Valuation allowances are established, when necessary, to reduce deferred income tax assets to the amount expected to be realized.

In accordance with U.S. GAAP, the Company is required to determine whether a tax position of the Company is more likely than not to be sustained upon examination by the applicable taxing authority, including resolution of any related appeals or litigation processes, based on the technical merits of the position.  The tax benefit to be recognized is measured as the largest amount of benefit that is greater than fifty percent likely of being realized upon ultimate settlement.  Derecognition of a tax benefit previously recognized could result in the Company recording a tax liability that would reduce net assets.  Based on its analysis, the Company has determined that it has not incurred any liability for unrecognized tax benefits as of June 30, 2014 and December 31, 2013.  The Company is subject to income tax examinations by major taxing authorities for all tax years since 2010 and its tax returns may be subject to review and adjustment at a later date based on factors including, but not limited to, on-going analyses of and changes to tax laws, regulations and interpretations thereof.  No interest expense or penalties have been recognized as of June 30, 2014 and December 31, 2013.  During the three and six month periods ended June 30, 2014 and 2013, the Company recognized no adjustments for uncertain tax positions.

 
7

 
 
FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES

Earnings per share
Basic earnings per share excludes dilution and is computed by dividing earnings attributable to common stockholders by the weighted-average number of common shares outstanding during the period.  Diluted earnings per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock, or resulted in the issuance of common stock that then shared in the income of the Company.  For the six months ended June 30, 2014, the diluted loss per share computation reflects a decrease in the loss attributable to common stockholders of approximately $688,000 for the gain on fair value of the Company’s derivative liability that was attributable to outstanding in-the-money warrants (see note 6).

For the three months ended June 30, 2013, the computation of diluted earnings per share was as follows:

Numerator:
     
Income available to common stockholders
  $ 1,585,424  
   Dividends on Series A-1, A-2 and A-4 Convertible Preferred Stock
    100,349  
    $ 1,685,773  
         
Denominator:
       
Weighted-average shares outstanding - basic
    3,917,341  
Dilutive effect of employee stock options
    192  
Dilutive effect of common stock purchase warrants
    271,042  
Dilutive effect of Convertible Preferred Stock
    1,404,971  
Weighted-average shares outstanding - diluted
    5,593,546  
 
For the six months ended June 30, 2014 and 2013, the following securities were excluded in the calculation of diluted loss per share because their inclusion would be antidilutive:
 
   
2014
   
2013
 
Warrants
    3,565,583       1,980,542  
Stock options
    386,333       174,457  
Convertible preferred stock
    4,726,572       1,404,971  
      8,678,488       3,559,970  
 
The net loss per common share calculation includes a provision for preferred stock dividends on the Company’s outstanding Series A-1, A-2 and A-4 Preferred Stock (the “Series A Preferred Stock”) of approximately $100,000 for the three months ended June 30, 2014 and 2013, and approximately $200,000 for the six months ended June 30, 2014 and 2013.  As of June 30, 2014, the Board of Directors had not declared any dividends on the Company’s Series A Preferred Stock, and the Company had accumulated approximately $3,730,000 of preferred stock dividends.  The Board of Directors has declared dividends for the three and six months ended June 30, 2014 of $342,570 and $685,140, respectively, in connection with the Company’s Series B-2 Preferred Stock which, in accordance with the terms of the Series B-2 Preferred Stock, was paid in the form of 56,506 and 122,833 shares, respectively, of the Company’s common stock.

Sale of accounts receivable
The Company has an agreement to sell certain of its accounts receivable under an arrangement with a third party.  The Company records a loss on sale of accounts receivable at the time the receivables are sold for the difference between the book value of the receivables transferred and their respective purchase price.  During the year ended December 31, 2013, the Company accounted for the sales of its accounts receivable as sales of financial assets and derecognized them from its consolidated balance sheet as of the date of sale. In connection with the preparation of its June 30, 2014 consolidated financial statements, the Company determined that although the rights, title and interest of these receivables belong to the transferee, these transfers do not meet all of the criteria outlined in Accounting Standards Codification Topic (“ASC”) 860, Transfers and Servicing.  The Company had derecognized $0.9 million of such receivables as of December 31, 2013, and the Company believes this difference was not material to its consolidated balance sheet as of that date.  At June 30, 2014 the Company recorded accounts receivable and recognized a note payable to unrelated parties in the amount of $1.1 million (see note 6) for the amount of uncollected receivables that had been transferred.

The Company recognized losses on the sale of accounts receivable in the three and six months ended June 30, 2014 of approximately $53,000 and $94,000, respectively.  For the three and six months ended June 30, 2013, the Company recognized losses on the sale of accounts receivable of approximately $45,000 and $129,000, respectively.  These amounts are recorded in Other income (expenses) in the accompanying consolidated statements of operations.  The Company’s obligations to the purchaser of the receivables under the agreement are secured by a first priority lien on the accounts receivable of the Company’s Carrier Services business segment, and by a subordinated security interest on the other assets of the Company’s Carrier Services business segment.  Based on the Company’s evaluation of the creditworthiness of the customers whose receivables the Company sells under this arrangement, the Company does not believe that there is any significant credit risk related to those receivables.
 
 
8

 

FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES

Goodwill
Goodwill is the excess of the acquisition cost of businesses over the fair value of the identifiable net assets acquired, and consists of $2.6 million of goodwill recognized in the acquisition of Network Billing Systems, LLC (“NBS”) on October 29, 2012, with the remainder resulting from the Broadvox Transaction described more fully in note 2.  Goodwill at June 30, 2014 and December 31, 2013 was approximately $5.2 million and $5.1 million, respectively.  Goodwill is not amortized but is instead tested annually for impairment.  All of the Company’s goodwill is attributable to its Business Services business segment.  The following table presents the change in goodwill during the six months ended June 30, 2014.  There was no change in goodwill during the six months ended June 30, 2013:
 
Balance at
January 1, 2014
   
Additions
   
Other (a)
   
Balance at 
June 30, 2014
 
$ 5,124,130       -       97,958     $ 5,222,088  
 
(a) - Amount relates to adjustments to the preliminary purchase price for acquisitions completed on December 31, 2013.
 
Impairment of Long-Lived Assets
The Company reviews long-lived assets, including intangible assets, for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be fully recoverable.  If an impairment indicator is present, the Company evaluates recoverability by a comparison of the carrying amount of the assets to future undiscounted net cash flows expected to be generated by the assets.  If the carrying value of the asset exceeds the projected undiscounted cash flows, the Company is required to estimate the fair value of the asset and recognize an impairment charge to the extent that the carrying value of the asset exceeds its estimated fair value.  The Company did not record any impairment charges for the six months ended June 30, 2014 and 2013.
 
Impairment testing for goodwill is performed annually in the Company’s fourth fiscal quarter.  The impairment test for goodwill uses a two-step approach, which is performed at the reporting unit level.  The Company has determined that its reporting units are its operating segments since that is the lowest level at which discrete, reliable financial and cash flow information is available.  Step one compares the fair value of the reporting unit (calculated using a market approach and/or a discounted cash flow method) to its carrying value.  If the carrying value exceeds the fair value, there is a potential impairment and step two must be performed.  Step two compares the carrying value of the reporting unit’s goodwill to its implied fair value, which is the fair value of the reporting unit less the fair value of the unit’s assets and liabilities, including identifiable intangible assets.  If the implied fair value of goodwill is less than its carrying amount, an impairment is recognized.

Stockbased compensation
The Company accounts for stock-based compensation by recognizing the fair value of the compensation cost for all stock awards over their respective service periods, which are generally equal to the vesting period.  This compensation cost is determined using option pricing models intended to estimate the fair value of the awards at the date of grant using the Black-Scholes option-pricing model.  An offsetting increase to stockholders' equity is recorded equal to the amount of the compensation expense charge.

Stock-based compensation expense recognized in the condensed consolidated interim statements of operations for the three and six month ended June 30, 2014 and 2013 includes compensation expense for stock-based payment awards granted prior to June 30, 2014 but not yet vested, based on the estimated grant date fair value.  As stock-based compensation expense recognized in the condensed consolidated statements of operations is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. When estimating forfeitures, the Company considers historical forfeiture rates as well as ongoing trends for actual option forfeiture.

The impact of stock-based compensation expense on the Company’s results of operations for the three and six months ended June 30, 2014 was approximately $73,000 and $142,000, respectively.  Stock-based compensation expense for the three and six months ended June 30, 2013 was approximately $28,000 and $56,000, respectively.  These amounts are included in selling, general, and administrative expenses in the condensed consolidated interim statements of operations.

 
9

 
 
FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES

The following table summarizes the stock option activity for the six months ended June 30, 2014:
 
(unaudited)
 
   
Number of
Options
   
Weighted Average Exercise Price
 
Balance at December 31, 2013
    351,464     $ 16.29  
Shares granted during the period
    37,450     $ 6.67  
Shares exercised during the period
    -     $ -  
Shares forfeited during the period
    (1,996 )   $ 6.23  
Shares expired during the period
    (585 )   $ 9.72  
Shares outstanding at June 30, 2014
    386,333     $ 15.42  
Shares exercisable at June 30, 2014
    130,460     $ 36.31  
 
The Company calculated the fair value of each common stock option grant on the date of grant using the Black-Scholes option-pricing model method with the following assumptions:
 
   
(unaudited)
 
   
Six Months Ended June 30,
 
   
2014
   
2013
 
Dividend yield
    0 %     0 %
Stock volatility
    137.2 %     137.2 %
Average Risk-free interest rate
    2.34 %     0.52 %
Average option term (years)
    8.08       4  
 
As of June 30, 2014, there was approximately $647,000 of total unrecognized compensation cost, net of estimated forfeitures, related to stock options granted under the Company’s Stock Incentive Plans, which is expected to be recognized over a weighted-average period of 2.14 years.

Advertising and marketing
Advertising and marketing expense includes cost for promotional materials and trade show expenses for the marketing of the Company’s business products and services. Advertising and marketing expenses were approximately $33,000 and $6,000 for the three months ended June 30, 2014 and 2013, and approximately $77,000 and $15,000 for the six months ended June 30, 2014 and 2013, respectively.

Fair value of financial instruments
The carrying amounts of the Company’s assets and liabilities approximate the fair value presented in the accompanying Condensed Consolidated Balance Sheets, due to their short-term maturities.

Use of estimates
The preparation of condensed consolidated interim financial statements in conformity with U.S. 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 condensed consolidated interim financial statements and the reported amounts of revenues and expenses during the periods.  Actual results could be affected by the accuracy of those estimates.

Restricted cash
Restricted cash at June 30, 2014 and December 31, 2013 includes $1,000,000 of cash held in reserve as required by the terms of the Company’s senior lending agreement (see note 6), and certificates of deposit collateralizing a letter of credit in the aggregate amount of approximately $164,000.  The letter of credit is required as security for one of the Company’s non-cancelable operating leases for office facilities.
 
 
 
10

 
 
FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES
 
2.     Acquisition
On December 31, 2013, the Company, through its wholly-owned subsidiary Fusion BVX LLC (“FBVX”), completed the acquisition of substantially all of the cloud services assets used by BroadvoxGO!, LLC, and its affiliate Cypress Communications, LLC,  in the operation of their cloud services business (the “Broadvox Transaction”).   The purchase price for the assets acquired in the Broadvox Transaction was $32.1 million in cash, plus a working capital adjustment paid to the sellers in accordance with the terms of the purchase agreement of approximately $0.2 million.  Had the transaction taken place on January 1, 2013, the Company’s consolidated revenues and net loss for the six months ended June 30, 2013 would have been approximately $46.2 million and $3.0 million, respectively.

3.     Prepaid Expenses and Other Current Assets
Prepaid expenses and other current assets consist of the following at June 30, 2014 and December 31, 2013:

   
June 30,
2014
   
December 31,
2013
 
   
(unaudited)
       
Prepaid insurance
  $ 163,504     $ 63,737  
Due from purchaser of accounts receivable
    278,691       236,232  
Escrowed funds – senior lenders
    -       2,000,000  
Other prepaid expenses
    893,902       404,818  
Total
  $ 1,336,097     $ 2,704,787  
 
4.      Intangible Assets
Identifiable intangible assets as of June 30, 2014 and December 31, 2013 are comprised of: 
 
   
June 30, 2014
   
December 31, 2013
 
   
Gross Carrying
Amount
   
Accumulated Amortization
   
Total
   
Gross Carrying
Amount
   
Accumulated Amortization
   
Total
 
Intangibles associated with the acquisition of NBS:
                                   
Trademarks and tradename
  $ 563,000     $ (93,833 )   $ 469,167     $ 563,000     $ (65,683 )   $ 497,317  
Proprietary technology
    1,903,000       (634,333 )     1,268,667       1,903,000       (444,033 )     1,458,967  
Non-compete agreement
    3,257,000       (1,809,444 )     1,447,556       3,257,000       (1,266,611 )     1,990,389  
Customer relationships
    9,824,000       (1,078,487 )     8,745,513       9,824,000       (754,988 )     9,069,012  
Favorable lease intangible
    218,000       (72,667 )     145,333       218,000       (50,867 )     167,133  
Total acquired intangibles
    15,765,000       (3,688,764 )     12,076,236       15,765,000       (2,582,182 )     13,182,818  
                                                 
Intangibles associated with the Broadvox Transaction:
                                               
Proprietary technology
    3,878,000       (387,800 )     3,490,200       3,878,000       -       3,878,000  
Non-compete agreements
    5,471,000       (1,367,750 )     4,103,250       5,471,000       -       5,471,000  
Customer relationships
    12,517,000       (481,423 )     12,035,577       12,517,000       -       12,517,000  
Total acquired intangibles
    21,866,000       (2,236,973 )     19,629,027       21,866,000       -       21,866,000  
Total
  $ 37,631,000     $ (5,925,737 )   $ 31,705,263     $ 37,631,000     $ (2,582,182 )   $ 35,048,818  
 
  Amortization expense for the three and six months ended June 30, 2014 was $1.7 million and $3.3 million, respectively.  Amortization expense for the three and six months ended June 30, 2013 was $0.6 million and $1.1 million, respectively.  Estimated future aggregate amortization expense is as follows for the periods indicated:
 
 
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FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES
 
 
     
($000's)
 
Remainder of the year
2014
  $ 3,343  
Year ending December 31:
2015
    6,505  
 
2016
    2,865  
 
2017
    2,795  
 
2018
    2,441  
         
 
5.     Accounts Payable and Accrued Expenses
Accounts payable and accrued expenses conist of the following at June 30, 2014 and December 31, 2013:
 
   
June 30,
2014
   
December 31,
2013
 
   
(unaudited)
       
Trade accounts payable
  $ 4,621,081     $ 5,933,736  
Accrued expenses
    1,452,369       3,101,103  
Accrued payroll and vacation
    259,623       102,898  
Interest payable
    84,492       421,632  
Sales and communications taxes payable
    1,762,549       691,350  
Deferred revenue
    805,377       407,426  
Other
    1,510,831       503,405  
Total accounts payable and accrued expenses
  $ 10,496,322     $ 11,161,550  
 
   6.   Notes Payable – Non-Related Parties
   At June 30, 2014 and December 31, 2013, notes payable – non-related parties are comprised of the following: 
 
   
June 30,
2014
   
December 31,
2013
 
Senior Notes
  $ 41,479,167     $ 41,791,667  
Discount on Senior Notes
    (4,042,840 )     (4,377,680 )
Other notes payable
    1,102,724       -  
Total notes payable - non-related parties
    38,539,051       37,413,987  
Less:
               
Current portion
    (2,027,724 )     (625,000 )
Non-current portion notes payable - non-related parties
  $ 36,511,327     $ 36,788,987  
 
Senior Notes
On October 29, 2012, the Company and its wholly owned subsidiary, Fusion NBS Acquisition Corp. (“FNAC”) entered into a Securities Purchase Agreement and Security Agreement (the “Purchase Agreement”) with Praesidian Capital Opportunity Fund III, LP, Praesidian Capital Opportunity Fund III-A, LP and Plexus Fund II, LP (the “Lenders”).  Under the Purchase Agreement, the Company sold the Lenders (a) five-year Series A senior notes (the “Series A Notes”) in the aggregate principal amount of $6.5 million, bearing interest at the rate of 10.0% annually, and (b) five-year Series B senior notes (the “Series B Notes”) in the aggregate principal amount of $10.0 million bearing interest at the rate of 11.5% annually.  The proceeds from the sale of the Series A Notes and Series B Notes were used to finance the acquisition of NBS.
 
 
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FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES
 
On December 15, 2013, the Company sold to the Lenders Series C senior notes (the “Series C Notes”) in the aggregate principal amount of $0.5 million.  The proceeds were used to pay a deposit on the purchase price to the sellers in connection with the Broadvox Transaction (see note 2).  On December 31, 2013, the Purchase Agreement was amended and restated (the “SPA”) whereby the Company sold to Praesidian Capital Opportunity Fund III, LP, Praesidian Capital Opportunity Fund III-A, LP, Plexus Fund III, L.P., Plexus Fund QP III, L.P. and United Insurance Company of America (collectively with Plexus Fund II, L.P., the “Senior Lenders”) Series D Senior Notes (the “Series D Notes”) in the aggregate principal amount of $25.0 million (collectively with the Series A Notes, the Series B Notes and the Series C Notes, the “Senior Notes”).  The proceeds from the sale of the Series D Notes were used to finance the Broadvox Transaction.  Under the terms of the SPA:
 
  
Plexus Fund III, L.P., Plexus Fund QP III, L.P. and United Insurance Company of America became parties to the SPA and to certain ancillary agreements that were entered into with the Lenders at the time of the Purchase Agreement.
 
  
The interest rate on all of the Senior Notes was adjusted to 11.15% per annum.
 
  
The maturity date on all of the Senior Notes became December 31, 2018.
 
  
Interest on all of the Senior Notes is payable monthly, and monthly principal payments aggregating $52,083 are required from January 2014 through December 2014.
 
  
Monthly principal payments aggregating $102,083 are required from January 2015 through December 2018, with the outstanding principal balance on all of the Senior Notes payable at maturity.

The SPA contains a number of affirmative and negative covenants, including but not limited to, restrictions on paying indebtedness subordinate to the Senior Notes, incurring additional indebtedness, making capital expenditures, dividend payments and cash distributions by subsidiaries.  In addition, at all times while the Senior Notes are outstanding, the Company is required to maintain a minimum cash bank balance of no less than $1.0 million in excess of (i) any amounts outstanding under a permitted working capital line of credit, and (ii) any and all cash balances held by the Company’s Business Services business segment.  The SPA also requires on-going compliance with various financial covenants, including leverage ratio, fixed charge coverage ratio and minimum levels of earnings before interest, taxes, depreciation and amortization.  Failure to comply with any of the restrictive or financial covenants could result in an event of default and accelerated demand for repayment of the Senior Notes.  As of and for the six months ended June 30, 2014, the Company was in compliance with all of the financial covenants contained in the SPA.

The obligations to the Senior Lenders are secured by first priority security interests on all of the assets of FNAC, NBS and FBVX, as well as the capital stock of each of the Company’s subsidiaries, including NBS and FBVX, and by second priority security interests in the accounts receivable pertaining to the Company’s Carrier Services business segment and all of the other assets of the Company.  In addition, Fusion, FBVX and NBS guaranteed FNAC’s obligations under the SPA, including FNAC’s obligation to repay the Senior Notes.
 
In connection with the sale of the Senior Notes to the Senior Lenders, the Company issued nominal warrants to the Senior Lenders to purchase an aggregate of 728,333 shares of the Company’s common stock (the “Lenders’ Warrants”).  The Lenders’ Warrants are exercisable from the date of issuance at an exercise price of $0.50 per share, with 266,501 warrants expiring on October 29, 2022, and the remainder expiring on December 31, 2023.  The Company is required to pay the exercise price on behalf of the Senior Lenders at the time of exercise.  The Company has recorded a discount on the Senior Notes based on the fair value of the Lenders’ Warrants as of the date of issuance.  The discount is being accreted over the life of the Senior Notes, and was $4.0 million and $4.4 million as of June 30, 2014 and December 31, 2013, respectively.
 
Commencing upon the earlier of a change in control, the repayment of the Senior Notes in full or the five year anniversary of the issuance of the Lenders’ Warrants, in the event that the Company’s common stock does not meet certain liquidity thresholds with respect to trading volume and market price, then the Senior Lenders have the right to require the Company to repurchase the shares issued or issuable upon exercise of the Lenders’ Warrants at a repurchase price based upon the formulas set forth therein.  As a result, the Lenders’ Warrants do not meet the criteria for equity classification under ASC Topic 480, Distinguishing Liabilities From Equity (“ASC 480”), and are not considered to be indexed to the Company’s own stock under the guidance provided in ASC 815, and the Company recognized derivative liabilities aggregating $4.7 million upon the issuance of the Lenders' Warrants.  At June 30, 2014 and December 31, 2013, the fair value of these derivative liabilities was $3.9 million and $4.5 million, respectively.  The Company recognized a loss on the change in fair value of this derivative in the amount of $0.2 million for the three months ended June 30, 2014, and gain on the change in fair value of $0.7 million for the six months ending June 30, 2014.  For the three and six months ended June 30, 2013, the Company recognized a gain on the change in fair value this derivative in the amount of $0.2 million and $0.1 million, respectively.

Expenses incurred in connection with the Purchase Agreement and SPA and the sale of the Senior Notes are reflected in Other assets on the Company’s consolidated balance sheet in the amount of $1.0 million and $1.1 million at June 30, 2014 and December 31, 2013, respectively, and are being amortized as interest expense over the life of the Senior Notes.

Other Notes Payable
As more fully described in note 1, from time to time the Company sells certain of its accounts receivable to an unrelated party at a discount.  At June 30, 2014, $1.1 million of the receivables that were sold had yet to be collected by the transferee.  All of these receivables were collected by the transferee subsequent to June 30, 2014, satisfying this obligation.

 
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FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES
7. Notes Payable-Related Parties
At June 30, 2014 and December 31, 2013, notes payable – related parties are comprised of the following: 
 
   
June 30,
2014
   
December 31,
2013
 
NBS Sellers Notes
  $ -     $ 85,714  
Notes payable to Marvin Rosen
    1,478,081       1,578,081  
Discount on notes payable to Marvin Rosen
    (210,967 )        
Other notes payable - related parties
    125,000       125,000  
Total notes payable - related parties
    1,392,114       1,788,795  
Less:
               
Current portion of NBS Sellers Notes
    -       (85,714 )
Current portion of notes payable to Marvin Rosen
    -       (100,000 )
Current portion of other notes payable - related parties
    (125,000 )     (125,000 )
Non-current portion notes payable - related parties
  $ 1,267,114     $ 1,478,081  
 
Sellers Notes
As part of the purchase price of NBS, FNAC issued promissory notes (the “Sellers Notes”) to Jonathan Kaufman and entities affiliated with Mr. Kaufman, the sellers of NBS, in the aggregate principal amount of $600,000.  Upon the closing of the acquisition of NBS, Mr. Kaufman became President of the Company’s Business Services division and an executive officer of the Company.  The Sellers Notes were paid in full as of June 30, 2014.

Notes Payable to Marvin Rosen
In conjunction with the Company’s sale of the Series A Notes and Series B Notes to the Lenders, Marvin Rosen, the Company’s Chairman of the Board of Directors, entered into an Intercreditor and Subordination Agreement with the Company and the Lenders, as amended, whereby Mr. Rosen agreed, among other things, that the amounts owed to him by the Company would be subordinate to the Senior Notes and the Company’s other obligations to the Senior Lenders.  In connection with this agreement, on October 25, 2012 Mr. Rosen agreed to consolidate the principal amount of all his then outstanding promissory notes aggregating to $3.9 million into a new single note (the “New Rosen Note”).  The New Rosen Note is not secured, pays interest monthly at a rate of 7% per annum, and matures 60 days after the Senior Notes are paid in full.  Accrued interest on the outstanding promissory notes as of October 24, 2012 amounted to approximately $0.5 million, and the Company also agreed to pay Mr. Rosen 7% annual interest on this amount (collectively, with the New Rosen Note, the “Subordinated Obligations”). In connection with the preparation of the June 30, 2014 consolidated financial statements, the Company determined that the 7% interest rate on the Subordinated Obligations is less than market and requires the Company to impute additional interest expense.  As a result, effective January 1, 2014, the Company recognized a discount on the Subordinated Obligations in the approximate amount of $0.4 million as a capital contribution (net of exchanges). This adjustment reflects a 12% effective interest rate, and gives effect to the pro rata reductions to the discount resulting from Mr. Rosen’s partial exchanges of the New Rosen Note into shares of the Company’s common stock during the year ended December 31, 2013.  During the three and six months ended June 30, 2014, the Company recognized interest expense of approximately $0.2 million to amortize the discount on the Subordinated Obligations, and the net unamortized discount as of June 30, 2014 is $0.2 million.  The Company has determined that the forgoing items, including amortization of discount not previously recognized, were not material to the Company’s consolidated financial statements as of and for the years ended December 31, 2013 and 2012 and for the three and six months ended June 30, 2013.

On March 1, 2013, the Company received a short-term unsecured advance from Mr. Rosen in the amount of $100,000.  The Senior Lenders had approved the repayment of this advance from the proceeds from certain future sales of the Company’s equity securities. The advance was repaid during the six months ended June 30, 2014.

8.     Equity Transactions
On January 24, 2014, the Company accepted subscriptions from and issued to a total of 40 accredited investors (the “Investors”) an aggregate of 4,358 shares of its Series B-2 Preferred Stock and warrants (the “Investor Warrants”) to purchase 278,912 shares (the “Warrant Shares”) of the Company’s common stock and received gross cash proceeds of $4,358,000.  The proceeds, net of transaction expenses, are being used for general corporate purposes.   

Each share of Series B-2 Preferred Stock has a Stated Value of $1,000, and is convertible into shares of the Company’s common stock at a conversion price of $5.00 per share (the “Preferred Conversion Price”), subject to adjustment. Subject to the other terms of the Series B-2 Preferred Stock, the Series B-2 Preferred Stock, including the Series B-2 Preferred Stock issued on December 31, 2013, is convertible into an aggregate of 4,567,600 shares of the Company’s common stock (the “Conversion Shares”).

 
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FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES
 
The Investor Warrants became exercisable on March 28, 2014 and may be exercised at any time until January 24, 2019 for a number of Warrant Shares that is equal to 40% of the Stated Value divided by 125% of the Preferred Conversion Price, as adjusted for stock splits, combinations and reclassifications (the “Investor Warrant Exercise Price”).
 
The Company also agreed to register the resale of the Conversion Shares and the Investor Warrant Shares, and to use its reasonable commercial efforts to cause the registration statement to remain effective until the date that all of the Conversion Shares and Warrant Shares have been sold or may be sold pursuant to Rule 144 under the Securities Act of 1933, as determined by the Company. The Company may be required to pay the Investors, as liquidated damages and not as a penalty, an amount equal to one percent (1%) of the aggregate amount invested by such Investor for each 30-day period or pro rata portion thereof during which the registration statement is not available to permit re-sales by the Investors; provided, that the maximum payment to each Investor shall not exceed six percent (6%) of the aggregate amount invested by such Investor.  The Company filed the registration statement on May 2, 2014, and the registration statement became effective on July 21, 2014.
 
Commencing January 1, 2016, the Company has the right to force the conversion of the Series B-2 Preferred Stock into common stock at the Preferred Conversion Price; provided that the volume weighted average price for Fusion’s common stock is at least $12.50 for ten consecutive trading days.  In addition, shares of Series B-2 Preferred Stock bear a cumulative six percent (6%) annual dividend payable quarterly in arrears, in cash or shares of common stock, at the option of the Company (see note 1, “Earnings per Share”).

Holders of Series B-2 Preferred Stock have liquidation rights that are senior to that of holders of the Company’s outstanding Series A-1, A-2 and A-4 Preferred Stock, and holders of Series B-2 Preferred Stock are entitled to vote as one group with holders of common stock on all matters brought to a vote of holders of common stock (with each share of Series B-2 Preferred Stock being entitled to that number of votes into which the registered holder could have converted the Series B-2 Preferred Stock on the record date for the meeting at which the vote will be cast). However, holders of common stock will be entitled to vote as a class on all matters adversely affecting such class.
 
The Company sold the Series B-2 Preferred Stock and Investor Warrants through its officers and directors, in conjunction with the assistance of certain broker-dealers. The Company paid aggregate cash compensation to the broker-dealers of $0.4 million, and issued warrants to the broker-dealers or their respective designees to purchase 45,050 shares of the Company’s common stock.

The Investor Warrants provide for a downward adjustment of the exercise price if the Company were to issue common stock at an issuance price or issue convertible debt or equity securities with an exercise price that is less than the Investor Warrant Exercise Price.  As a result, the Investor Warrants are deemed not indexed to the Company’s common stock under the guidance provided by ASC Topic 815.  Accordingly, the Company recognized a derivative liability of approximately $1.3 million at the date of issuance for the fair value of the Investor Warrants based on a Black-Scholes valuation.  During the six months ended June 30, 2014, a portion of the holders of the Investor Warrants executed agreements to modify the terms of the Investor Warrants to remove the provisions related to the downward adjustment of the exercise price.  The Company concluded that the amended terms for these Investor Warrants were such that they qualified for equity treatment under ASC Topic 815.  As a result, the Company reclassified $2.8 million (the fair value of the derivative liability relative to the modified warrant at the date of the amendment) from the derivative liability related to the Investor Warrants into equity.  Including the Investor Warrants issued in connection with the issuance of Series B-2 Preferred Stock on December 31, 2013, the fair value of the derivative liability related to the Investor Warrants not qualifying for equity treatment was $3.2 million and $6.0 million at June 30, 2014 and December 31, 2013, respectively.  The Company recognized a loss on the change in fair value of this derivative liability of $0.5 million for the three months ended June 30, 2014, and a gain on the change in fair value of $1.2 million for the six months ended June 30, 2014.

On April 30, 2014, as more fully described in note 1, the Company filed an amendment to its Certificate of Incorporation to (a) effectuate the Reverse Stock Split and (b) reduce the number of shares of common stock that are authorized for issuance to 18,000,000.  The Reverse Stock Split became effective on May 13, 2014.

9.     Recently Adopted and Issued Accounting Pronouncements
During the six months ended June 30, 2014, there were no new accounting pronouncements adopted by the Company that had a material impact on the Company’s consolidated financial statements.  In May of 2014, the Financial Accounting Standards Board issued Accounting Standards Update No. 2014-09, “Revenue from Contracts with Customers,” (“ASU 2014-09”).  ASU 2014-09 outlines a comprehensive new revenue recognition model that requires a company to recognize revenue to depict the transfer of goods or services to a customer at an amount that reflects the consideration it expects to receive in exchange for those goods or services.  ASU 2014-09 is effective for annual and interim reporting periods beginning after December 15, 2016 and early adoption is not permitted.  Companies may either use a full retrospective or modified retrospective approach to adopt this new standard.  The Company is currently evaluating both adoption options and the impact that adoption of ASU 2014-09 will have on its consolidated financial statements.
 

 
15

 
 
FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES
 
10.    Commitments and Contingencies
 
Legal matters
The Company is from time to time involved in claims and legal actions arising in the ordinary course of business. Management does not expect that the outcome of any such claims or actions will have a material effect on the Company’s operations or financial condition.  In addition, due to the regulatory nature of the telecommunications industry, the Company periodically receives and responds to various inquiries from state and federal regulatory agencies.  Management does not expect the outcome of any such regulatory inquiries to have a material impact on the Company’s liquidity, results of operations or financial condition.

11.    Segment Information
The accounting and reporting requirements on Disclosures about Segments of an Enterprise and Related Information requires disclosures of segment information on the basis that is used internally for evaluating segment performance and for determining the allocation of resources to the operating segments.
 
The Company has two reportable segments that it operates and manages – Carrier Services and Business Services.  These segments are organized by the products and services that are sold and the customers that are served.  The Company measures and evaluates its reportable segments based on revenues and gross profit margins.  The Company’s measurement of segment profit exclude the Company’s executive, administrative and support costs.  The Company’s segments and their principal activities consist of the following:

Carrier Services
Carrier Services includes the termination of carrier traffic utilizing primarily Voice over Internet Protocol (“VoIP”) technology.  VoIP permits a less costly and more rapid interconnection between the Company and international telecommunications carriers, and generally provides better profit margins for the Company than other technologies.  The Company currently interconnects with over 270 carrier customers and vendors, and is working to expand its interconnection relationships, particularly with carriers in emerging markets.
 
Business Services
The Company provides a full portfolio of cloud communications, cloud connectivity, storage and security solutions to small, medium and large businesses. These services are sold through both the Company’s direct sales force and its partner sales program, which utilizes the efforts of independent third-party distributors to sell the Company’s products and services.  The Business Services segment includes the results of operations related to the assets acquired in the Broadvox Transaction effective as of January 1, 2014.
 
 
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FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES
 
Operating segment information for the three and six months ended June 30, 2014 and 2013 is summarized as follows:
 
Three months ended June 30, 2014
 
   
   
Carrier
Services
   
Business
Services
   
Corporate and Unallocated
   
Consolidated
 
 Revenues
  $ 7,510,875     $ 15,630,098     $ -     $ 23,140,973  
 Cost of revenues (exclusive of
                               
 depreciation and amortization)
    6,714,319       6,033,122       -       12,747,441  
 Gross profit
    796,556       9,596,976       -       10,393,532  
 Depreciation and amortization
    53,503       2,522,472       22,003       2,597,978  
 Selling, general and administrative expenses
    725,383       5,878,297       1,221,814       7,825,494  
 Interest expense
    -       (1,400,275 )     (196,940 )     (1,597,215 )
 Loss on change in fair value of derivative liability
                    (690,878 )     (690,878 )
 Other (expenses) income
    (52,997 )     (25,556 )     79,272       719  
 Provision for income taxes
    -       -       151,583       151,583  
 Net loss
  $ (35,327 )   $ (229,624 )   $ (2,203,946 )   $ (2,468,897 )
                                 
                                 
 Total assets
  $ 5,040,316     $ 58,293,657     $ 6,720,174     $ 70,054,147  

Six months ended June 30, 2014
 
   
   
Carrier
Services
   
Business
Services
   
Corporate and Unallocated
   
Consolidated
 
 Revenues
  $ 14,673,371     $ 31,372,431     $ -     $ 46,045,802  
 Cost of revenues (exclusive of
                               
 depreciation and amortization)
    13,033,057       11,943,416       -       24,976,473  
 Gross profit
    1,640,314       19,429,015       -       21,069,329  
 Depreciation and amortization
    116,198       5,005,102       44,169       5,165,469  
 Selling, general and administrative expenses
    1,441,232       11,840,301       2,363,358       15,644,891  
 Interest expense
    -       (2,754,067 )     (237,694 )     (2,991,761 )
 Gain on change in fair value of derivative liability
                    1,919,069       1,919,069  
 Other (expenses) income
    (94,037 )     (26,656 )     80,338       (40,355 )
 Provision for income taxes
    -       -       173,078       173,078  
 Net loss
  $ (11,153 )   $ (197,111 )   $ (818,892 )   $ (1,027,156 )
                                 
                                 
 Capital expenditures
  $ 56,995     $ 1,760,712     $ -     $ 1,817,707  
 

 
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FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES
 
Three Months Ending June 30, 2013
 
   
   
Carrier
Services
   
Business
Services
   
Corporate and Unallocated
   
Consolidated
 
 Revenues
  $ 6,738,527     $ 7,491,651     $ -     $ 14,230,178  
 Cost of revenues (exclusive of
                               
 depreciation and amortization)
    5,938,937       3,666,597       -       9,605,534  
 Gross profit
    799,590       3,825,054       -       4,624,644  
 Depreciation and amortization
    48,219       803,006       21,359       872,584  
 Selling, general and administrative expenses
    748,757       2,600,306       1,084,785       4,433,848  
 Interest expense
    -       (583,344 )     (86,387 )     (669,731 )
 Loss on extinguishment of debt
                    (92,376 )     (92,376 )
 Gain on change in fair value of derivative liability
                    238,517       238,517  
 Other (expenses) income
    (43,747 )     28,107       (2,091 )     (17,731 )
 Gain on extinguishment of accounts payable
            -       2,908,882       2,908,882  
 Provision for income taxes
    -                       -  
 Net (loss) income
  $ (41,133 )   $ (133,495 )   $ 1,860,401     $ 1,685,773  
                                 
 Total assets
  $ 3,332,067     $ 23,091,098     $ 897,682     $ 27,320,847  
 
Six Months Ended June 30, 2013
 
   
   
Carrier
Services
   
Business
Services
   
Corporate and Unallocated
   
Consolidated
 
 Revenues
  $ 15,431,815     $ 14,966,784     $ -     $ 30,398,599  
 Cost of revenues (exclusive of
                               
 depreciation and amortization)
    13,920,474       7,436,656       -       21,357,130  
 Gross profit
    1,511,341       7,530,128       -       9,041,469  
 Depreciation and amortization
    96,432       1,583,422       42,645       1,722,499  
 Selling, general and administrative expenses
    1,617,952       5,051,717       2,031,777       8,701,446  
 Interest expense
    -       (1,148,822 )     (180,428 )     (1,329,250 )
 Loss on extinguishment of debt
                    (150,579 )     (150,579 )
 Gain on change in fair value of derivative liability
                    105,267       105,267  
 Other (expenses) income
    (127,231 )     38,711       26,169       (62,351 )
 Gain on extinguishment of accounts payable
            -       2,908,882       2,908,882  
 Net (loss) income
  $ (330,274 )   $ (215,122 )   $ 634,889     $ 89,493  
                                 
                                 
 Capital expenditures
  $ 49,768     $ 561,342     $ 17,497     $ 628,607  
 
The Company employs executive, administrative, human resources, and finance resources that service both the Carrier Services and Business Services business segments.  The amounts reflected as Corporate & Unallocated represent those operating expenses, assets and capital expenditures that were not allocated to a business segment or product line.
 
 
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FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES
 
12.    Supplemental Disclosure of Cash Flow Information
 
   
Six months ended June 30,
 
   
2014
   
2013
 
Cash paid for interest
  $ 2,749,360     $ 931,380  
Cash paid for income taxes
  $ 21,495     $ -  
Supplemental schedule of non-cash financing and investing activities:
               
Conversion of notes and interest payable - related parties to common stock
  $ -     $ 345,000  
Conversion of accounts payable - related parties to common stock
  $ -     $ 2,500  
Assets acquired under capital leases
  $ 49,090     $ 121,834  
 
13.    Related Party Transactions
Upon the closing of the acquisition of NBS on October 29, 2012, the purchase price was adjusted for an additional amount payable to the sellers of NBS of approximately $1.1 million following the application of certain working capital adjustments as set forth in the purchase agreements.  Approximately $226,000 remained outstanding to the sellers of NBS as of December 31, 2013, which was repaid during the six months ended June 30, 2014.

14.    Fair Value Disclosures
Fair value of financial and non-financial assets and liabilities is defined as an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. The three-tier hierarchy for inputs used in measuring fair value, which prioritizes the inputs used in the methodologies of measuring fair value for assets and liabilities, is as follows:
 
Level 1—Quoted prices in active markets for identical assets or liabilities
Level 2—Observable inputs other than quoted prices in active markets for identical assets and liabilities
Level 3—No observable pricing inputs in the market

The following table represents the fair value of the liability measured at fair value on a recurring basis:
 
   
Level 1
   
Level 2
   
Level 3
   
Total
 
As of June 30, 2014
                       
Non-current liabilities:
                       
Derivative liability (see notes 6 and 8 )
  $ -     $ -     $ 7,082,401     $ 7,082,401  
                                 
As of December 31, 2013
                               
Non-current liabilities:
                               
Derivative liability
  $ -     $ 10,515,472     $ -     $ 10,515,472  
                                 
 
The following table reconciles the changes in the derivative liability categorized within Level 3 of the fair value hierarchy.
 
Balance at December 31, 2013
  $ -  
Transfer of Level 2 balance (a)
    10,515,472  
Issuance of additional warrants
    1,301,607  
Gains for the period:
       
Included in earnings (loss)
    (1,919,069 )
Included in other comprehensive income (loss)
    -  
Modification of warrant contracts (see note 8)
    (2,815,609 )
Balance at June 30, 2014
  $ 7,082,401  
 
(a) In the course of preparing its financial statements as of June 30, 2014, the Company determined that all of its derivative liabilities contained unobsoverable inputs and should therefore be reported in the Level 3 fair value hierarchy
 
 
 
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FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES
 
15.    Gain on Extinguishment of Accounts Payable
In June of  2013, pursuant to the advice of counsel and based on applicable laws, the Company determined that it no longer had any liability pertaining to an international trade payable in the amount $2,908,882.  As a result, the Company derecognized the payable from its consolidated balance sheet at June 30, 2013 and recorded a corresponding gain on the extinguishment of debt.
 
16.    Subsequent Events
In July of 2014, three holders of Series B-2 Preferred Stock, representing an aggregate stated value of $0.6 million, converted their shares of Series B-2 Preferred Stock into 120,000 shares of common stock.

 
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FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES
 
Item 2.  Managements Discussion and Analysis of Financial Condition and Results of Operations
The following discussion should be read in conjunction with the information contained in our unaudited consolidated financial statements and the notes thereto appearing elsewhere herein and in conjunction with the Management’s Discussion and Analysis set forth in our fiscal 2013 Annual Report on Form 10-K.
 
OVERVIEW
 
Our Business
We are a cloud services provider delivering value-added cloud-based solutions to businesses and carriers in the United States and throughout the world.  Through our Business Services business segment, we offer business products and services that consist primarily of cloud-based voice and cloud connectivity, as well as a complement of additional cloud solutions such as storage, security and disaster recovery.  Our advanced business services are flexible, scalable and rapidly deployed, lowering customers’ costs of ownership and increasing productivity.

Through our Carrier Services business segment, we offer domestic and international voice termination services to telecommunications carriers throughout the world, with a particular focus on providing services to and from emerging markets in Asia, the Middle East, Africa, Latin America, and the Caribbean.  These services primarily utilize VoIP termination.  We currently interconnect with over 270 carrier customers and vendors, which include U.S.-based carriers sending voice traffic to international destinations and foreign carriers sending voice traffic to the U.S. and internationally.  Our carrier-grade network, advanced switching systems and interconnections with global carriers on six continents also reduce the cost of global voice traffic termination and expand service delivery capabilities for our Business Services segment.

We manage our business segments based on gross profit and gross margin, which represents net revenue less the cost of revenue, and on net profitability after excluding certain non-cash and non-recurring items.  The majority of our operations, engineering, information systems and support personnel are assigned to either the Business Services or Carrier Services business segment for segment reporting purposes.

Although we believe that the Carrier Services business segment continues to be of significant value to our long term strategy, our growth strategy is focused primarily on the higher margin Business Services business segment and marketing to small and mid-sized businesses, as well as larger enterprises, using both our direct and partner distribution channels.  This strategy has resulted in an increasing percentage of the Company’s total revenues being contributed by the Business Services business segment, which we believe complements the Company’s Carrier Services business segment by providing higher margins and a more stable customer base.

Recent Acquisitions
On December 31, 2013, through our wholly owned subsidiary Fusion BVX LLC (“FBVX”), we completed the acquisition of substantially all of the cloud services assets used by BroadvoxGO!, LLC and its affiliate Cypress Communications, LLC (the “Broadvox Sellers”) in the operation of their cloud services business.  A definitive agreement to purchase these assets, including the assumption of substantially all of the related on-going liabilities incurred in the ordinary course of business (collectively, the “Broadvox Assets”) was entered into on August 30, 2013, and amended on November 15, 2013 and December 16, 2013 (the “BVX Purchase Agreement”).  For the year ended December 31, 2013, the business constituted by the Broadvox Assets generated unaudited revenues of approximately $32.7 million.

The purchase price of the Broadvox Assets was $32.1 million in cash, plus a working capital adjustment paid to the sellers in accordance with the terms of the BVX Purchase Agreement of approximately $0.2 million.  The Broadvox Assets are being integrated into our existing Business Services business segment, and the results of operations generated by the Broadvox Assets are reflected in our consolidated statement of operations effective January 1, 2014.  As provided in the BVX Purchase Agreement, we and the Broadvox Sellers entered into a Transitional Services Agreement (the “TSA”), under which we purchase a variety of services from the Broadvox Sellers that are necessary to provide certain services to the customers acquired until such time as those customers are fully transitioned to our own network infrastructure.  A failure by the Broadvox Sellers to provide the required services to us until such time as we have completed this transition would have a material adverse effect on our business, results of operations and financial condition.

On October 29, 2012, through our wholly owned subsidiary, Fusion NBS Acquisition Corp (“FNAC”), we completed the acquisition of Network Billing Systems, LLC and certain assets and liabilities of its affiliate, Interconnect Services Group II LLC (collectively, “NBS”).  NBS is a unified communications and cloud services provider offering a wide range of hosted voice and data products, as well as Internet, data networking and other cloud services solutions to small, medium and large businesses in the United States.  For the year ended December 31, 2013, the NBS customer base contributed approximately $28 million of revenue to our Business Services business segment.

 
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FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES
 
The aggregate purchase price for the outstanding membership interests of NBS and the assets of ISG, net of assumed liabilities, was $19.6 million, consisting of $17.75 million in cash, $0.6 million to be evidenced by promissory notes payable to the sellers of the NBS membership interests (the “Seller Notes”) and 11,363,636 shares of our restricted common stock valued at $1.25 million.  The purchase price has been adjusted for certain working capital measurements described in the purchase agreements.  As of June 30, 2014, the Seller Notes have been paid in full.

Effective as of the date of the acquisition, NBS became our wholly-owned subsidiary, and during 2013 we completed the integration of our pre-acquisition Business Services business segment into NBS’ existing business. In connection with our acquisition of NBS, we entered into an Employment and Restrictive Covenant Agreement with Jonathan Kaufman, the founder and principal operating officer of NBS, and Mr. Kaufman became the President of our combined Business Services business segment.

The purchase price of the Broadvox Assets and the cash portion of the NBS Purchase Price were primarily financed through the issuance of senior notes by FNAC in the principal amounts of $25.5 million and $16.5 million, respectively (see “Liquidity and Capital Resources”).  The acquisition of the Broadvox Assets (the “Broadvox Transaction”) and the acquisition of NBS added approximately 11,000 customer locations to our Business Services segment.  These transactions are a significant component of our strategy to increase the percentage of our total revenues contributed by the Business Services business segment, which operates at higher profit margins than does our Carrier Services business segment.

Our Performance
Revenues for the three months ended June 30, 2014 were $23.1 million, an increase of $8.9 million, or 62.6%, compared to the three months ended June 30, 2013.  Our operating loss for the three months ended June 30, 2014 was $30,000, as compared to $0.7 million in the same period of a year ago, mainly due to the operating income generated by the Broadvox Assets, which are not reflected in the 2013 results.  Our net loss for the three months ended June 30, 2014 was $2.5 million, compared to net income of $1.7 million the three months ended June 30, 2013, as we recognized a non-cash gain of $2.9 million on the extinguishment of a trade payable in June of 2013.

Revenues for the six months ended June 30, 2014 were $46.0 million, an increase of $15.6 million, or 51.5%, compared to the six months ended June 30, 2013.  Our operating income for the six months ended June 30, 2014 was $0.3 million, as compared to an operating loss of $1.4 million in the same period of a year ago, mainly due to the operating income generated by the Broadvox Assets, which are not reflected in the 2013 results, partially offset by increases in SG&A expenses.  Our net loss for the six months ended June 30, 2014 was $1.0 million, as compared to net income of $0.1 million for the six months ended June 30, 2013.

Our Outlook
We expect that the revenues and gross profit in our Business Services business segment will increase significantly in 2014 as a result of the Broadvox Transaction.  However, our ability to achieve positive cash flows from operations and net profitability is dependent upon our ability to grow our revenues and successfully integrate the operations associated with the Broadvox Assets into our existing business.  We believe that a successful integration will result in synergistic cost savings and operational efficiencies that would substantially improve our operating performance.

Revenues from our Carrier Services business have declined over the last few years due in large part to decreases in market rates for the termination of international traffic, and we have seen this trend continue into the first half of 2014.  We believe these declines in market rates resulted largely from increased competition, deregulation in many of the markets we serve and the use of lower cost, Internet-based technologies.  While the market demand for international voice termination has seen a corresponding increase over the last few years, we have been unable to increase our revenues accordingly due to capacity limitations on our network switching platform and liquidity constraints.  We are in the process of implementing new systems and equipment which,  subject to their successful implementation, will bring our network capacity to the levels necessary to compete in the current market and allow us to increase our traffic volumes.  In addition, we do not believe we will experience the same liquidity constraints that we have in the past.  As a result, while we may experience additional declines in revenue during the remainder of 2014, we expect to reverse this trend as we move into 2015 and see the results of the implementation of our new systems.

 
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FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES
 
Reverse Split of Common Stock
On May 13, 2014, a reverse split of the Company’s common stock became effective, whereby each 50 shares of outstanding common stock of the Company was combined and automatically converted into one share of the Company’s common stock (the “Reverse Stock Split”) and the conversion and exercise prices of all of the Company’s outstanding preferred stock, common stock purchase warrants and options to purchase common stock were proportionately adjusted to reflect the terms of the Reverse Stock Split consistent with the terms of such instruments.  As a result of the Reverse Stock Split, all share and per share amounts as of December 31, 2013, as well as for the three months and six months ended June 30, 2013, have been restated at a ratio of one for fifty to give effect to the reverse stock split.


CRITICAL ACCOUNTING POLICIES AND ESTIMATES
 
Our discussion and analysis of financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAPP”).  The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and the related disclosure of contingent liabilities.  We base these estimates on our historical experience and on various other assumptions that we believe to be reasonable under the circumstances, and these estimates form the basis for our judgments concerning the carrying values of assets and liabilities that are not readily apparent from other sources.  We periodically evaluate these estimates and judgments based on available information and experience. Actual results could differ from our estimates under different assumptions and conditions.  If actual results significantly differ from our estimates, our financial condition and results of operations could be materially impacted. 
 
We have identified the policies and significant estimation processes discussed below as critical to our business operations and to the understanding of our results of operations.  For a detailed discussion on the application of these and other accounting policies, see Note 2 to the Consolidated Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2013.
 
Revenue Recognition
We recognize revenue when persuasive evidence of a sale arrangement exists, delivery has occurred or services have been rendered, the sales price is fixed and determinable and collectability is reasonably assured.  We record provisions against revenue for billing adjustments, which are based upon estimates derived from factors that include, but are not limited to, historical results, analysis of credits issued and current economic trends.  The provisions for revenue adjustments are recorded as a reduction of revenue when incurred.
 
Our revenue is primarily derived from the monthly recurring and usage fees charged to customers that purchase our business products and services, and from usage fees charged to other telecommunications carriers that terminate voice traffic over the Company’s network.   Fixed revenue is earned from monthly recurring services provided to the customer, for which the charges are contracted for over a specified period of time.  Revenue recognition commences after the provisioning, testing and acceptance of the service by the customer.  The recurring customer charges continue until the expiration of the contract, or until cancellation of the service by the customer.  To the extent that payments received from a customer are related to a future period, the payment is recorded as deferred revenue until the service is provided or the usage occurs.

Variable revenue is earned based on the length of a call, as measured by the number of minutes of duration.  It is recognized upon completion of the call, and is adjusted to reflect the allowance for billing adjustments.  Revenue for each customer is calculated from information received through our network switches.  Our customized software tracks the information from the switches and analyzes the call detail records against stored detailed information about revenue rates.  This software provides us with the ability to complete a timely and accurate analysis of revenue earned in a period.  We believe that the nature of this process is such that recorded revenues are unlikely to be revised in future periods.

Cost of Revenues
Cost of revenues for our Carrier Services business segment is comprised primarily of costs incurred from other domestic and international communications carriers to originate, transport, and terminate voice calls for our carrier customers.  Thus the majority of our cost of revenues for this business segment is variable, based upon the number of minutes actually used by our customers and the destinations they are calling.  Call activity is tracked and analyzed with customized software that analyzes the traffic flowing through our network switch.  During each period, the call activity is analyzed and an accrual is recorded for the revenues associated with minutes not yet invoiced.  This cost accrual is calculated using minutes from the system and the variable cost of revenue based upon predetermined contractual rates.  Fixed expenses reflect the costs associated with connectivity between our network infrastructure, including our New York switching facility, and certain large carrier customers and vendors.

 
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FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES
 
For our Business Services business segment, fixed expenses include the monthly recurring charges associated with certain platform services purchased from other service providers, the monthly recurring costs associated with private line services and the cost of broadband Internet access used to provide service to business customers.

Accounts Receivable
Accounts receivable is recorded net of an allowance for doubtful accounts.  On a periodic basis, we evaluate our accounts receivable and adjust the allowance for doubtful accounts based on our history of past write-offs and collections and current credit conditions.  Specific customer accounts are written off as uncollectible if the probability of a future loss has been established, collection efforts have been exhausted and payment is not expected to be received.

Impairment of Long-Lived Assets
We periodically review long-lived assets, including intangible assets, for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be fully recoverable.  If an impairment indicator is present, we evaluate recoverability by a comparison of the carrying amount of the asset to future undiscounted net cash flows expected to be generated by the asset.  If the carrying value of the asset exceeds the projected undiscounted cash flows, we are required to estimate the fair value of the asset and recognize an impairment charge to the extent that the carrying value of the asset exceeds its estimated fair value.  We did not record any impairment charges for the six months ended June 30, 2014 and 2013.

Impairment testing for goodwill is performed annually in our fourth fiscal quarter.  The impairment test for goodwill uses a two-step approach, which is performed at the reporting unit level.  We have determined that our reporting units are our operating segments since that is the lowest level at which discrete, reliable financial and cash flow information is available.  The authoritative guidance provides entities with an option to perform a qualitative assessment to determine if the fair value of the reporting unit is less than its carrying value, and we utilize this option where appropriate.

Income Taxes
We account for income taxes in accordance with U.S. GAAP, which requires the recognition of deferred tax liabilities and assets for the expected future income tax consequences of events that have been recognized in our financial statements.  Deferred income tax assets and liabilities are computed for temporary differences between the financial statement and tax bases of assets and liabilities that will result in future taxable or deductible amounts, based on enacted tax laws and rates applicable to the periods in which the differences are expected to affect taxable income.  Valuation allowances are established to reduce deferred income tax assets when we determine that it is more like than not that we will fail to generate sufficient taxable income to be able to utilize the deferred tax assets.

Property and Equipment
In accordance with Accounting Standards Codification 350-40, Intangibles – Goodwill and Other – Internal-Use Software, we capitalize a portion of our payroll and related costs for the development of software for internal use and amortize these costs over three years. During the six months ended June 30, 2014 and 2013, we capitalized costs pertaining to the development of internally used software in the approximate amount of $0.4 million.

Recently Issued Accounting Pronouncements
During the six months ended June 30, 2014, there were no new accounting pronouncements adopted by the Company that had a material impact on the Company’s consolidated financial statements.  In May of 2014, the Financial Accounting Standards Board issued Accounting Standards Update No. 2014-09, “Revenue from Contracts with Customers,” (“ASU 2014-09”).  ASU 2014-09 outlines a comprehensive new revenue recognition model that requires a company to recognize revenue to depict the transfer of goods or services to a customer at an amount that reflects the consideration it expects to receive in exchange for those goods or services.  ASU 2014-09 is effective for annual and interim reporting periods beginning after December 15, 2016 and early adoption is not permitted.  Companies may either use a full retrospective or modified retrospective approach to adopt this new standard.  The Company is currently evaluating both adoption options and the impact that adoption of ASU 2014-09 will have on its consolidated financial statements.


 
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FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES

RESULTS OF OPERATIONS

 
As a result of the Broadvox Transaction on December 31, 2013, our results of operations for the three and six months ended June 30, 2014, particularly with respect to our Business Services business segment, are not comparable to the results of operations for the same period in 2013.  The following table summarizes our results of operations for the periods indicated
 
   
Three Months Ended June 30,
   
Six Months Ended June 30,
 
   
2014
   
2013
   
2014
   
2013
 
Revenues
  $ 23,140,973       100.0 %   $ 14,230,178       100.0 %   $ 46,045,802       100.0 %   $ 30,398,599       100.0 %
Cost of revenues, exclusive of
                                                               
depreciation and amortization
    12,747,441       55.1 %     9,605,534       67.5 %     24,976,473       54.2 %     21,357,130       70.3 %
Gross profit
    10,393,532       44.9 %     4,624,644       32.5 %     21,069,329       45.8 %     9,041,469       29.7 %
Operating expenses:
                                                               
Depreciation and amortization
    2,597,978       11.2 %     872,584       6.1 %     5,165,469       11.2 %     1,722,499       5.7 %
Selling general and administrative
    7,825,494       33.8 %     4,433,848       31.2 %     15,644,891       34.0 %     8,701,446       28.6 %
Total operating expenses
    10,423,472       45.0 %     5,306,432       37.3 %     20,810,360       45.2 %     10,423,945       34.3 %
Operating income (loss)
    (29,940 )     -0.1 %     (681,788 )     -4.8 %     258,969       0.6 %     (1,382,476 )     -4.5 %
Interest expense, net
    (1,597,215 )     -6.9 %     (669,731 )     -4.7 %     (2,991,761 )     -6.5 %     (1,329,250 )     -4.4 %
Loss on extinguishment of debt
    -       0.0 %     (92,376 )     -0.6 %     -       0.0 %     (150,579 )     -0.5 %
(Loss) gain on change in fair value of derivative liability
    (690,878 )             238,517               1,919,069               105,267          
Other income (expenses)
    719       0.0 %     (17,731 )     -0.1 %     (40,355 )     -0.1 %     (62,351 )     -0.2 %
Total other (expenses) income
    (2,287,374 )     -9.9 %     (541,321 )     -3.8 %     (1,113,047 )     -2.4 %     (1,436,913 )     -4.7 %
Gain on extinguishment of accounts payable
                    2,908,882                               2,908,882          
Income (loss) before taxes
    (2,317,314 )     -10.0 %     1,685,773       11.8 %     (854,078 )     -1.9 %     89,493       0.3 %
Provision for income taxes
    151,583               -               173,078               -          
Net (loss) income
  $ (2,468,897 )     -10.7 %   $ 1,685,773       11.8 %   $ (1,027,156 )     -2.2 %   $ 89,493       0.3 %
                                                                 
 
Three Months Ended June 30, 2014 Compared with Three Months Ended June 30, 2013

Revenues
Consolidated revenues were $23.1 million during the three months ended June 30, 2014, compared to $14.2 million during the three months ended June 30, 2014, an increase of $8.9 million, or 62.6%.  Revenues for the Business Services segment increased by $8.1 million in 2014 compared to 2013 due to completion of the Broadvox Transaction.  Carrier services revenue of $7.5 million represents an increase of $0.8 million, or 11.5%, from a year ago, as a 16% increase in the volume of traffic terminated over our network was partially offset by a 4% decrease in the blended rate per minute realized.

Cost of Revenues and Gross Margin
Consolidated cost of revenues was $12.7 million for the three months ended June 30, 2014, compared to $9.6 million for the three months ended June 30, 2013.  The increase is due to $2.4 million of costs attributed to revenues related to the Broadvox Assets not present in 2013, and to the increased traffic volume in the Carrier Services business segment.  Consolidated gross margin was 44.9% in the three months ended June 30, 2014, compared to 32.5% in 2013. The increase is due to the higher mix of Business Services revenue in 2014 as a result of the Broadvox Transaction.

Gross Margin for the Business Services segment was 61.4% in 2014, compared to 51.1%, in 2013, as a result of the Broadvox Transaction.  The Broadvox Assets have historically generated higher margins than our previously existing Business Services business, including NBS, due to a higher concentration of hosted VoIP and SIP Trunking services.  Gross margin for the Carrier Services segment was 10.6% for the three months ended June 30, 2014, compared to 11.9% in the three months ended June 30, 2013.  The decrease is mainly due to a 4% decrease in the blended rate realized per minute of traffic terminated.

 
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FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES

Depreciation and Amortization
Depreciation and amortization increased by $1.7 million to $2.6 million for the three months ended June 30, 2014 from $0.9 million during the same period of a year ago, mainly due to $1.1 million of amortization expense related to intangibles and $0.6 million of depreciation expense on property and equipment associated with the Broadvox Transaction in 2014 not present in 2013.
 
Selling, General and Administrative Expenses
Selling, general, and administrative expenses increased by $3.4 million for the three months ended June 30, 2014 compared to the three months ended June 30, 2013.  The increase is mainly due to SG&A expenses attributable to BVX and, to a lesser extent, higher employee related expenses.

Operating Loss
Our operating loss for the three months ended June 30, 2014 was $30,000, as compared to $0.7 million for the three months ended June 30, 2013.  The improvement is due to the increased sales and gross profit in 2014 resulting from the Broadvox Transaction, partially offset by the related increases in SG&A and depreciation and amortization expense.

Interest Expense
Interest expense increased by $0.9 million in the three months ended June 30, 2014 as compared to the three months ended June 30, 2013, mainly due to an additional $25.5 million of senior debt incurred in December of 2013 to finance the Broadvox Transaction.

Loss on Extinguishment of Debt
During the three months ended June 30, 2013, we recorded a loss on the extinguishment of debt of approximately $92,000 for the fair value of warrants to purchase shares of our common stock in connection with the conversion of debt into equity, with no comparable amount in the three months ended June 30, 2014.
 
Change in Fair Value of Derivative Liability
During the three months ended June 30, 2014, we recognized a loss on the change in fair value of our derivative liabilities in the amount of $0.7 million, as compared to a gain of $0.2 million for the three months ended June 30, 2013.  These gains and losses are related to the derivatives associated with the warrants that we issued to our senior lenders in 2012 and 2013 and with the warrants we issued to purchasers of our preferred stock, the terms of which require them to be treated as liabilities and not equity instruments.  The changes in their fair value are required to be recorded through the statement of operations at each accounting period.  The warrants are valued using a Black-Scholes pricing model, such that increases to our stock price result in a higher valuation of the derivative and a charge to our income statement, and decreases to our stock price result in a lower valuation and a gain being recorded in our income statement.  We expect that we will be subject to additional significant fluctuations in our income statement in 2014 and beyond based on changes in our stock price and the corresponding changes in fair value of our derivative liabilities.

Other Income (Expenses)
Other income, net for the three months ended June 30, 2014 reflects a net loss on the disposal of certain property and equipment in the amount of $84,000, which was offset by a refund granted to us by the Federal Communications Commission for an overpayment of certain regulatory fees.

Gain on Extinguishment of Accounts Payable
In June of 2013, pursuant to the advice of counsel and based on applicable laws, we determined that the Company no longer had any liability pertaining to a trade payable in the amount of $2,908,882.  As a result, we derecognized this payable from our balance sheet and recorded a corresponding one-time gain on the extinguishment of accounts payable.

Provision for Income Taxes
During the three months ended June 30, 2014, we recorded income tax expense of $0.2 million, which is mainly due to the recognition of a deferred tax liability related to the goodwill acquired in the NBS and Broadvox transactions.
 
Net (Loss) Income
Net loss was $2.5 million for the three months ended June 30, 2014, compared to net income of $1.7 million in the same period of a year ago, mainly due to the absence of the $2.9 million gain on the extinguishment of the trade payable in 2014, the difference in mark-to-market impact of the derivative liabilities and the increase in interest expense in 2014, partially offset by the decrease in operating loss in 2014.

 
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FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES
Six Months Ended June 30, 2014 Compared with Six Months Ended June 30, 2013

Revenues
Consolidated revenues were $46.0 million for the six months ended June 30, 2014, compared to $30.4 million for the six months ended June 30, 2013, an increase of $15.6 million, or 51.5%.  Revenues for the Business Services segment increased by $16.4 million in 2014 compared to 2013, substantially all of which was due to the Broadvox Transaction.  Carrier services revenue of $14.7 million represents a decrease of $0.8 million, or 4.9%, from a year ago, as a 14% increase in the volume of traffic terminated over our network was more than offset by a 17% decrease in the blended rate realized per minute of traffic terminated.

Cost of Revenues and Gross Margin
Consolidated cost of revenues was $25.0 million for the six months ended June 30, 2014, compared to $21.4 million for the six months ended June 30, 2013.  The increase is due to $4.8 million of costs attributable to the Broadvox Assets not present in 2013, partially offset by improved margins in both of our business segments.  Consolidated gross margin was 45.8% in the six months ended June 30, 2014, compared to 29.7% in 2013. The increase is due to the higher mix of Business Services revenue in 2014 resulting from the Broadvox Transaction.

Gross Margin for the Business Services segment was 61.4% in 2014, compared to 51.1%, in 2013, as the Broadvox Assets have historically generated higher margins than our previously existing Business Services business, due to a higher concentration of hosted VoIP and SIP Trunking services.  Gross margin for the Carrier Services business segment was 11.2% for the six months ended June 30, 2014, compared to 9.8% in the six months ended June 30, 2013, due to a 20% decrease in the cost of revenues blended rate.

Depreciation and Amortization
Depreciation and amortization increased by $3.4 million to $5.2 million for the six months ended June 30, 2014 from $1.7 million during the same period of a year ago, mainly due to $2.2 million of amortization expense related to intangible assets and $1.2 million of depreciation expense related to property and equipment acquired in the Broadvox Transaction.

Selling, General and Administrative Expenses
Selling, general, and administrative expenses increased by $6.9 million for the six months ended June 30, 2014 compared to the six months ended June 30, 2013.  The increase is mainly due to $6.1 million of expenses attributable to the Broadvox Assets and, to a lesser extent, post-acquisition integration expenses associated with the Broadvox Transaction, increased third party agent commissions and higher employee compensation and related expenses.

Operating Loss
Our operating income was $0.3 million for the six months ending June 30, 2014, as compared to an operating loss of $1.4 million for the same period of a year ago.  The Broadvox Assets generated approximately $2.0 million of operating income in 2014, which was partially offset by increases in selling general and administrative expenses.

Interest Expense
Interest expense increased by $1.7 million in the six months ended June 30, 2014 as compared to the six months ended June 30, 2013, mainly due to an additional $25.5 million of senior debt incurred in December of 2013 to finance the Broadvox Transaction.

Loss on Extinguishment of Debt
During the six months ended June 30, 2013, we recorded a loss on the extinguishment of debt of 0.2 million for the fair value of warrants to purchase shares of our common stock in connection with the conversion of debt into equity, with no comparable amount in the six months ended June 30, 2014.

Change in Fair Value of Derivative Liability
The change in fair value of the derivative was a gain of $1.9 million in the six months ended June 30, 2014 compared to a gain of $0.1 million the six months ended June 30, 2013.  The change is due to the decrease in the Company's stock price since December 31, 2013, which decreases value of the derivatives, and to the increase in warrants not qualifying for equity treatment due to the issuance of the new senior debt and the issuance of the Series B-2 Preferred Stock on December 31, 2013 and January 24, 2014.

 
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FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES
 
Other Expenses
Other expenses, net for the six months ended June 30, 2014 and 2013 reflects a net loss on the sale of accounts receivable of $0.1 million, partially offset by late fees charged to customers.

Gain on Extinguishment of Accounts Payable
In June of 2013, pursuant to the advice of counsel and based on applicable laws, we determined that the Company no longer had any liability pertaining to a trade payable in the amount of $2,908,882.  As a result, we derecognized this payable from our balance sheet and recorded a corresponding one-time gain on the extinguishment of accounts payable.

Provision for Income Taxes
The provision for income taxes for the six months ended June 30, 2014, consists primarily of deferred tax expense related to the goodwill acquired in the NBS and Broadvox transactions.

Net (Loss) Income
Our net loss was $1.0 million for the six months ended June 30, 2014, compared to net income of $0.1 million in the same period of a year ago, mainly due to the absence of the $2.9 million gain on the extinguishment of the trade payable in 2014 and the increase in interest expense in 2014, partially offset by the improvement in operating income and the $1.9 million gain on the change in fair value of derivatives in 2014.

LIQUIDITY AND CAPITAL RESOURCES

Since our inception, we have incurred significant operating and net losses. In addition, we have only recently begun to generate positive cash flow from operations.  At June 30, 2014, we had working capital of $5.6 million and stockholders’ equity of $12.0 million.  At December 31, 2013, we had working capital of $1.8 million and stockholders’ equity of approximately $7.0 million.  Our consolidated cash balance at June 30, 2014 was $9.8 million, as compared to $6.2 million at December 31, 2013.  While we believe that we have sufficient cash to fund our operations and meet our obligations for the next twelve months, we may be required to raise additional capital to support our business plan. There are no current commitments for such funds and there can be no assurances that such funds will be available to the Company as needed.  
 
During fiscal 2012, we relied primarily on the sale of our accounts receivable, including unbilled receivables, under our agreement with Prestige Capital Corporation (“Prestige”), as well as the sale of our equity securities, to fund our operations.  During fiscal 2013 and the first six months of 2014, we relied primarily on the sale of our equity securities and the cash generated from the operations of our Business Services business segment to fund our operations.

On December 31, 2013, we issued to a total of 82 accredited investors (the “Investors”), an aggregate of 18,480 shares of our newly designated Series B-2 Cumulative Convertible Preferred Stock, par value $0.01 per share (the “Series B-2 Preferred Stock”) and (b) warrants (the “Investor Warrants”) to purchase 1,182,720 shares of our common stock (the “Warrant Shares” and together with the Series B-2 Preferred Stock, the “Series B-2 Offering”).  The Series B-2 Offering included the issuance of 2,052 shares of Series B-2 Preferred Stock and Investor Warrants to purchase 131,328 Warrant Shares upon the conversion of $2.052 million in indebtedness of the Company, including the conversion of $2.0 million of notes payable to Marvin Rosen and $52,000 of other Company indebtedness payable to Matthew Rosen, our Chief Executive Officer, and another Director of the Company.  Gross cash proceeds received in 2013 from the Series B-2 Offering were $16.4 million, approximately $8.1 million of which was used to partially finance the Broadvox Transaction with the remainder, net of offering expenses, available for general corporate purposes.  On January 24, 2014 we held a second and final closing of the Series B-2 Offering and issued to a total of 40 accredited investors an aggregate of 4,358 shares of Series B-2 Preferred Stock and warrants to purchase 278,912 Warrant Shares, and we received net proceeds of approximately $4.0 million, which is being used for general corporate purposes.

Each share of Series B-2 Preferred Stock has a Stated Value of $1,000, and is convertible into shares of our common stock at a conversion price of $5.00 per share (the “Preferred Conversion Price”), subject to adjustment.  Subject to the other terms of the Series B-2 Preferred Stock, the Series B-2 Preferred Stock sold to the Investors is convertible into an aggregate of 4,567,600 shares of our common stock (the “Conversion Shares”).  The Investor Warrants may be exercised at any time following March 28, 2014 for a five-year term commencing on the date issuance  for a number of Warrant Shares that is equal to 40% of the Stated Value divided by 125% of the Preferred Conversion Price, as adjusted for stock splits, combinations and reclassifications.
 
 
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FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES
 
We also agreed to register the resale of the Conversion Shares and the Investor Warrant Shares, and to use its reasonable commercial efforts to cause the registration statement to remain effective until the date that all of the Conversion Shares and Warrant Shares have been sold or may be sold pursuant to Rule 144 under the Securities Act of 1933, as determined by the Company. The Company may be required to pay the Investors liquidated damages for periods during which the registration statement is not available to permit re-sales by the Investors.  We filed the registration statement on May 2, 2014 and it became effective on July 21, 2014.
Commencing January 1, 2016, we have the right to force the conversion of the Series B-2 Preferred Stock into common stock at the Preferred Conversion Price; provided that the volume weighted average price for our common stock is at least $12.50 for ten consecutive trading days.  In addition, shares of Series B-2 Preferred Stock bear a cumulative 6% annual dividend payable quarterly in arrears commencing March 31, 2014, in cash or shares of common stock, at the option of the Company.  We elected to pay the dividends in the form of our common stock for the quarters ended March 31, and June 30, 2014.

Also during the year ended December 31, 2013, we entered into subscription agreements with 60 accredited investors, under which we issued an aggregate of 1,005,144 shares of common stock and five-year warrants to purchase 502,572 shares of the our common stock for aggregate consideration of $4.1 million.   The warrants are exercisable at 125% of the volume weighted-average price of the Company’s common stock for the 10 trading days prior to the date of closing.

To finance the acquisitions of NBS and the Broadvox Assets, we entered into a Securities Purchase Agreement and Security Agreement (the “SPA”) with several private funds (the “Senior Lenders”).  The SPA was originally entered into on October 29, 2012 and amended on December 31, 2013.  Under the SPA, as amended, we have sold to the Senior Lenders senior secured notes in the aggregate principal amount of $42 million (the “Senior Notes”).  The Senior Notes pay interest monthly at a rate of 11.15% per annum and mature on December 31, 2018.  Monthly principal payments aggregating $52,083 are required from January 2014 through December 2014, and monthly principal payments aggregating $102,083 are required from January 2015 through December 2018.  As of June 30, 2014, the unpaid principal balance on the Senior Notes was $41.5 million.

The SPA contains a number of affirmative and negative covenants, including but not limited to, restrictions on paying indebtedness subordinate to the Senior Notes, incurring additional indebtedness, making capital expenditures, dividend payments and cash distributions by subsidiaries.  In addition, at all times while the Senior Notes are outstanding, we are required to maintain a minimum cash bank balance of no less than $1.0 million in excess of any amounts outstanding under a permitted working capital line of credit and in excess of any and all cash balances held by the entities that comprise our Business Services business segment.  The SPA also requires on-going compliance with various financial covenants, including leverage ratio, fixed charge coverage ratio and minimum levels of earnings before interest, taxes, depreciation and amortization.  Failure to comply with any of the restrictive or financial covenants could result in an event of default and accelerated demand for repayment of the Senior Notes.  We do not have the financial resources to repay the Senior Notes in the event they are accelerated.  As of and for the six months ended June 30, 2014, we were in compliance with all of the financial covenants under the SPA.

Under the terms of the SPA, as amended, we were required to deposit $3.0 million into an account controlled by the Senior Lenders, pending receipt of certain regulatory approvals for the pledging of assets as collateral for the Senior Notes.  The funds were to remain in escrow until such time as the necessary regulatory approvals are obtained.  We received all of the required regulatory approvals in May of 2014, and the funds were released to us at that time.

For 2014, monthly principal and interest obligations under the Senior Notes are approximately $0.4 million.  In 2015 and beyond, monthly principal and interest obligations are approximately $0.5 million.

While our Business Services business segment continues to generate positive cash flow from operations, the terms of the SPA prohibit any cash distributions from NBS, FBVX or FNAC to us prior to repayment of the Senior Notes.

On September 12, 2011, we entered into a purchase and sale agreement with Prestige, whereby we may sell certain of our accounts receivable to Prestige at a discount in order to improve our liquidity and cash flow. Under the terms of the purchase and sale agreement, Prestige pays a percentage of the face amount of the receivables at the time of sale, and the remainder, net of the discount, is paid to us within two business days after Prestige receives payment on the receivables, which generally have 15 to 30 day terms. From the fourth quarter of fiscal 2011 through the first quarter of 2013, this arrangement was our primary source of liquidity.  We may continue to utilize the agreement with Prestige to supplement our working capital needs until such time as we can consummate a traditional working capital line of credit.  In connection with the issuance of the Senior Notes, Prestige and the Lenders entered into an agreement establishing priorities among them and reached certain agreements as to enforcing their respective rights against the Company.

 
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FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES
 
From time to time we have also received short term advances from Prestige which are secured by a priority lien on certain of our accounts receivable; however such advances are not attributable to a transfer of specific accounts receivable and are therefore reflected as notes payable to non-related parties in the accompanying consolidated balance sheets.  During the year en