UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K/A
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 1996
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from __________ to _________
Commission file number: 0-28668
_______________________________________________________________
TELCO COMMUNICATIONS GROUP, INC.
Exact name of registrant as specified in its charter)
______________________________________________________________
Virginia 54-1674283
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
4219 Lafayette Center Drive, Chantilly, Virginia 20151-1209
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (703) 631-5600
Securities Registered Pursuant to Section 12(b) of the Act:
Name of each exchange on
Title of each class which registered
None
Securities Registered Pursuant to Section 12(g) of the Act:
Common Stock, no par value
Indicate by check mark whether the Registrant (1) had filed all
reports required to be filed by Section 13 or 15(d) of the Securities
Exchange Act of 1934 during the preceding 12 months (or for such
shorter period that the registrant was required to file such reports), and
(2) has been subject to such filing requirements for the past 90 days.
Yes X No ___
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of the Registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this
Form 10-K or any amendment to this Form 10-K. ___
The aggregate market value of the voting stock held by non-affiliates
of the Registrant as of March 18, 1997 was approximately $166,839,689 (based
upon the closing price of the Registrant's Common Stock on the Nasdaq National
Market on such date.) The number of shares outstanding of the
Registrant's Common Stock, as of the close of business on March 18, 1997 was
33,062,662 shares.
DOCUMENTS INCORPORATED BY REFERENCE
(1) Portions of the Registrant's Annual Report to Shareholders for
the fiscal year ended December 31, 1996 are incorporated by reference into
Parts II and IV hereof, as specifically set forth in Parts II and IV.
(2) Portions of the Registrant's definitive Proxy Statement filed
in
connection with its Annual Meeting of Shareholders to be held May 15, 1997,
are
incorporated by reference in Part III, as specifically set forth in Part III.
Exhibit Index on Page 30
<PAGE>
TELCO COMMUNICATIONS GROUP, INC.
Form 10-K/A
For the fiscal year ended December 31, 1996
Table of Contents
Part I Page
Item 1. Business 4
Item 2. Properties 21
Item 3. Legal Proceedings 22
Item 4. Submission of Matters to a Vote of Security Holders 23
Executive Officers of the Registrant 24
Part II
Item 5. Market for the Registrant's Common Equity and
Related Stockholder Matters 26
Item 6. Selected Financial Data 27
Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations 27
Item 8. Financial Statements and Supplementary Data 27
Item 9. Changes in and Disagreements with Accountants
on Accounting and Financial Disclosure 28
Part III
Item 10. Directors and Executive Officers of the Registrant 28
Item 11. Executive Compensation 28
Item 12. Security Ownership of Certain Beneficial Owners
and Management 28
Item 13. Certain Relationships and Related Transactions 28
Part IV
Item 14. Exhibits, Financial Statement Schedules and
Reports on Form 8-K 29
Index to Exhibits 30
Signatures 35
<PAGE>
PART I
Item 1. Business
Telco Communications Group, Inc., a Virginia corporation formed in
1993,
and its wholly owned subsidiaries (collectively "Telco" or "the Company") is
a
rapidly growing switch-based provider of domestic and international
long
distance telecommunication services primarily to residential customers in
the
United States. Substantially all of the Company's customers access its
network
by dialing a unique carrier identification code ("CIC Code") before dialing
the
number they are calling. Using a CIC Code to access the Company's network
is
known as "dial around" or "casual calling" because customers can use
the
Company's services at any time without changing their existing long
distance
carrier. The Company markets its residential long distance services
through
marketing subsidiaries under two brands, each with a unique CIC Code: Dial
&
Save (CIC Code 10457) and the Long Distance Wholesale Club ("LDWC") (CIC
Code
10297), and prices its services at a discount to the basic "1 plus"
rates
offered by the three major long distance carriers: AT&T, MCI and Sprint.
During
December 1996, the Company provided long distance services to approximately
2.6
million customers (switched access lines) in 48 states and the District
of
Columbia. All dial around operations are conducted through
marketing
subsidiaries that are referred to collectively as the Consumer Division.
Although dial around has been in existence since the mid-1980s,
only
recently have companies such as Telco aggressively pursued this
market
opportunity. The Company markets its services primarily through direct mail
and
inbound telesales and marketing, and believes that this marketing
strategy
enables the Company to attract residential customers in a cost effective
manner.
Because dial around customers are not required to cancel or change
their
presubscribed long distance carrier, the Company believes that
aggressive
"win-back" and other customer acquisition programs prevalent in the
residential
long distance market have a limited impact on the Company's business.
The Company bills its dial around customers through local exchange
carrier
("LEC") billing and collection agreements which enable the Company to place
its
charges on the monthly local phone bills of its dial around customers.
The
Company has agreements with LECs, including all of the Regional Bell
Operating
Companies ("RBOCs"), that cover substantially all of the switched access
lines
in the United States. The Company believes that these billing arrangements
are
the most effective mechanism for billing the Company's residential
customers,
because of the convenience to its customers of receiving one bill for both
local
and long distance service and the benefits derived from the LECs'
extensive
collections infrastructure. The Company's billing information systems
and
services are provided by Tel Labs, Inc. ("Tel Labs"), a wholly
owned
telecommunications billing company started in 1991 by Telco's Chairman of
the
Board.
Since the Company's existing customer base is primarily residential,
the
majority of calls are handled during off-peak evening and weekend periods.
In
order to increase its volume of call traffic, Telco has begun to sell
its
daytime capacity on a wholesale basis to other long distance carriers and
in
addition has created a Commercial Sales Division ("CSD") to target business
and
carrier customers. As of December 31, 1996, CSD had opened 22 sales offices
and
employed approximately 220 sales personnel. For the fourth quarter of
1996,
CSD's revenues were $9.3 million, or approximately 7.8% of the
Company's
consolidated revenues.
The Company's switch-based network currently consists of six DSC DEX
600S,
600 and 600E switches located in Washington, D.C.; Fort Lauderdale,
Florida;
Davenport, Iowa; Chattanooga, Tennessee; Austin, Texas and Las Vegas,
Nevada.
Additionally, the Company is installing a DEX 600E switch in the New York
City
metropolitan area which is expected to be made operational during the first
half
of 1997 and has taken receipt of an eighth switch to be installed later in
1997
in a yet undetermined location.
In August 1996, a total of 6,325,000 shares of the Company's common
stock
("Common Shares") were sold in an initial public offering ("IPO") at $14
per
share. Existing stockholders sold 1,644,000 Common Shares, and 4,681,000
Common
Shares were sold by the Company which resulted in net proceeds to the Company
of
approximately $60.0 million, after deducting the expenses of the
offering.
Concurrent with the IPO, the Company acquired Tel Labs in exchange for
593,334
Common Shares. Tel Labs was owned by Henry G. Luken, III, the Company's
Chairman
of the Board, Bryan K. Rachlin, the Company's Chief Operating Officer
and
General Counsel and two employees of Tel Labs.
Prior to April 1, 1996, LDWC was a 55.6%-owned subsidiary of the
Company;
the remaining 44.4% was held by Thomas J. Cirrito, President of the
Consumer
Division and a director of the Company, and two of his children. On April
1,
1996, the Company agreed to acquire the remaining 44.4% interest in LDWC
in
exchange for the issuance of 5,102,125 Common Shares. In connection with
the
transaction, options issued pursuant to the LDWC stock option plan
were
converted into options to purchase 291,842 Common Shares under the
Company's
Amended and Restated 1994 Stock Option Plan.
INDUSTRY OVERVIEW
The U.S. long distance market is dominated by the nation's three
largest
long distance carriers, AT&T, MCI and Sprint, which, according to a
recent
report issued by the Federal Communications Commission (the "FCC"),
together
accounted for approximately 81% of the $72 billion in aggregate
revenues
generated by all U.S. long distance carriers in 1995. Other long
distance
carriers, some with national transmission and marketing capabilities,
accounted
for the remainder of the market. The three largest long distance providers
and
certain other carriers own transmission and switching facilities, and
are
therefore sometimes referred to as facilities-based
carriers.
Non-facilities-based carriers lease transmission lines from
facilities-based
carriers and are either switch-based carriers, like the Company, or
switchless
resellers which rely on third-party carriers for all aspects of
call
transmission.
The structure of the telecommunications industry since 1984 has been
shaped
largely by the AT&T divestiture decree, which required the divestiture by
AT&T
of its Bell Operating Companies ("BOCs") and divided the country into 201
local
access and transport areas ("LATA") (the "AT&T Divestiture Decree"). The 22
Bell
operating companies were combined into seven RBOCs and were permitted to
provide
local telephone service, local access service to long distance carriers and
long
distance ("intraLATA") service within the LATAs. However, the Bell
operating
companies were prohibited from providing long distance service, or
service
between LATAs ("interLATA"). To encourage competition in the long
distance
market, the AT&T Divestiture Decree and certain regulations of the FCC
require
most LECs to provide carriers with access to local exchange service that
is
equal in type, quality and prices to that provided to AT&T and with
the
opportunity to be selected by customers as a preferred long distance
service
provider ("equal access").
For each long distance call, the originating and terminating LECs charge
an
access fee to the long distance carrier. The long distance carrier charges
its
customers a fee for its transmission of the call, a portion of which covers
the
cost of the access fees charged by the LECs. Access charges represent
a
significant portion of the Company's cost of services and, generally,
such
access charges are regulated by the FCC. The FCC has commenced a preceeding
to
reform the rules governing interstate access charges which is designed to
foster
a more efficient pricing of access, competition for access services, and
to
reflect the development of local services prompted by the
1996
Telecommunications Act.
Thus, judicial, legislative and regulatory factors have helped to create
a
foundation for smaller companies, such as the Company, to emerge as
competitive
alternatives to the larger facilities-based carriers for long distance
services.
Equal access, combined with the FCC's policy mandating that carriers
not
unreasonably restrict resale of their services, allows resellers such as
the
Company to lease transmission facilities from facilities-based long
distance
carriers and to offer consumers long distance telecommunications services
having
the same quality and convenience as those of the facilities-based carriers.
For policy reasons, equal access was fully implemented for interLATA
long
distance service only. For intraLATA long distance service, a modified form
of
equal access was adopted, which enables customers to reach a preferred
carrier
(other than the customers LEC) on a call-by-call basis by dialing a CIC Code.
Where equal access is available, a customer can reach the preferred carrier
by
dialing an access code, such as 10XXX, or 950-OXXX (or on a toll-free
basis),
where XXX is the CIC. The use of access codes to reach a preferred long
distance
carrier has recently gained significant exposure and customer acceptance,
as
evidenced by marketing campaigns of the larger facilities-based carriers,
such
as AT&T's "1-800-CALLATT" and MCI's "1-800-COLLECT".
In view of anticipated exhaustion of CIC Codes, in April 1994 the
FCC
initiated a proceeding on the issue and concluded that the expansion of
CIC
Codes is important because it increases access to the public switched
telephone
network by both end users and carriers. The FCC tentatively proposed to
expand
codes from 10XXX to a 101XXXX format, with a transition period of six
years,
during which both formats could be utilized. Under the FCC's proposal,
after
expiration of the transition period only the 101XXXX codes will be utilized.
The
FCC has not yet acted upon its proposal to finally determine the length of
the
transition period. On April 30, 1996, the FCC released a Public Notice in
which
it requested additional public comment on the issue of the appropriate length
of
the transition period. Comments were required to be filed with the FCC by
May
21, 1996. It is not known when the FCC will take final action in
this
proceeding. However, all of the 10XXX CIC Codes have been allocated. Since
March 31, 1995, Bell Communications Research, Inc., the administrator of
the
North American Numbering Plan, has been issuing 101XXXX codes.
The 1996 Telecommunications Act removed the restrictions concerning
the
provision of long distance service by the RBOCs and GTE Operating
Companies
("GTOCs"), although the RBOCs will need to obtain specific FCC approval
and
satisfy other conditions, including a checklist of interconnection and
other
requirements on LECs, prior to providing long distance service in the regions
in
which they provide local exchange service.
In addition to promoting competition in the U.S. long
distance
telecommunications market, the 1996 Telecommunications Act also opened
U.S.
local service telecommunication markets to competition by preempting state
and
local laws to the extent they prevent competitive entry into the provision
of
any telecommunications service, and by imposing a variety of new duties on
LECs
to promote competition in local exchange services. Among other requirements,
all
LECs are required to permit resale of their telecommunications services
without
unreasonable restrictions or conditions, and on a non-discriminatory basis.
The
law and its accompanying regulations will enable the Company, upon receipt
of
all necessary regulatory approvals, to resell local telecommunication
services
in addition to its long distance services. The bases upon which such
local
services will be available to carriers such as the Company for resale are to
be
determined in proceedings of the various state public service
commissions.
Significantly, the 1996 Telecommunications Act mandates that LECs make
their
services available to resellers at wholesale rates, defined as retail rates
less any marketing, bill collection and other costs that will be avoided by
the
LEC by providing the wholesale service. The Company believes that the opening
of
the local telecommunication services market to resellers provides the
Company
with significant growth opportunities.
BUSINESS STRATEGY
The Company's strategy is to achieve continued growth by providing a
broad
array of competitively priced long distance services. The Company's
primary
objectives in pursuing this strategy are to:
Continue to Expand the Consumer Division's Dial Around Distribution
Channel
and Brand Awareness by increasing its direct mail and telesales
marketing
efforts for both the Dial & Save and Long Distance Wholesale Club brand
names.
The Company continues to explore innovations within this product line
including
the use of advertising media that are alternative or complementary to
direct
mail, the development of dial around advertising targeting existing and
former
customers, specific affinity groups and the creation of new dial around
products
and services. The Company's goal in all of these efforts is to
increase
advertising response rates and customer usage and to lower customer
attrition,
thereby decreasing customer acquisition costs. During 1997 the Company
intends
to continue its re-marketing efforts in the contiguous 48 states and
the
District of Columbia, including the ten western states in which the
Company
began marketing in late 1996 and January 1997.
Expand CSD to enhance the growth prospects of the Company and to
optimize
the use of the network. CSD's sales strategy is to build its sales
force,
including direct and independent sales representatives and telesales
marketing
agents targeting commercial and carrier accounts. The Company intends
to
supplement this sales force with its existing strong customer support
functions
and field service operations and Tel Labs direct billing
capabilities.
Currently, usage of the Company's network occurs mostly during the evenings
and
on weekends. By increasing the number of commercial customers, the
Company
intends to more effectively use the significant available daytime capacity
of
its network.
Decrease Network Cost per minute of use through the continued expansion
and
development of the Company's network. The Company completed its national
network
in the third quarter of 1996 with the deployment of its Las Vegas, NV
switch.
The Company further intends to continue to add low cost fixed capacity to
its
network in order to keep pace with the Company's growth and to
reduce
off-network transmission expenses. To enhance the efficiency of the
fixed-cost
elements of its network, the Company seeks to increase both overall
traffic
volume and business-driven daytime traffic in order to balance the
existing
night and weekend off-peak traffic from residential customers. Low
cost
transmission expenses, coupled with an expansive network, are expected
to
provide the Company with the continued ability to grow its existing dial
around
distribution segment and to expand into new distribution channels. Such
growth
may also be facilitated by select strategic alliances, investments
or
acquisitions as the Company deems appropriate.
Offer Innovative Products and Services while leveraging its Network
and
Operating Infrastructure and Business Information Systems, to meet the needs
of
the Company's residential and commercial customer base. During December
1996,
Tel Labs, the Company's wholly owned billing subsidiary, processed
approximately
94 million call records. The Company believes that accurate and
sophisticated
information systems are key to growth and success in the
telecommunications
industry. Tel Labs provides the support that will enable the Company to grow
its
existing customer base and to provide new products and services to
its
residential and commercial customers, including the provision of direct bills
to
commercial customers. Such products and services may also include the resale
of
local exchange services, internet services, voice mail, FAX broadcast,
paging,
video conferencing and conference calling. The Company believes that its
network
intelligence, billing and reporting systems enhance the Company's
competitive
ability and provide a platform for future growth and product expansion.
MARKETING AND SERVICES
Since it commenced operations in 1993, the Company's primary focus has
been
residential sales through the Consumer Division's marketing of dial
around
services. The Company intends to expand its customer base by adding
business
customers through CSD. A discussion of the Company's service offerings
and
residential and commercial marketing follows.
Consumer Division. The Company markets its residential dial around
services
through marketing subsidiaries under the Dial & Save and Long Distance
Wholesale
Club brand names. The two brands are differentiated by rate structure
and
marketing approach, and the Company believes that its dual brand
strategy
heightens market penetration by broadening customer exposure to dial around
and
appealing to different segments of the population. Customers access
the
Company's network by dialing a five digit code before the number they
are
calling (10457 for Dial & Save; 10297 for the Long Distance Wholesale Club),
and
therefore are not required to permanently change or cancel their existing
long
distance carrier in order to use the Company's service. Since inception,
the
Company has targeted the domestic residential market, with an estimated
110
million households, and typically offers its customers savings off of the
basic
direct dialed "1 plus" rates charged by AT&T, MCI and Sprint. Recently,
the
Consumer Division also introduced a flat rate per minute product with a
monthly
fee. Approximately 99% of the Company's total customers were
residential
customers at December 31, 1996. Customers who prefer to access the
Company's
network by dialing "1 plus" rather than dialing the Company's CIC Codes
may
select Dial & Save or Long Distance Wholesale Club as their presubscribed
long
distance carrier. Whether a residential customer dials the Company's
access
codes or is presubscribed, their calls will appear on the customers
regular
monthly local telephone bill.
The Company markets its residential services primarily through direct
mail
pieces that seek to educate potential customers regarding dial around and
its
benefits. Direct mail is targeted towards residential customers within
a
specified geographic region and includes a service explanation and
dialing
instructions, a general pricing comparison and a set of reminder
stickers
highlighting the Company's CIC Codes for customers to keep near their
telephone.
Prospective customers do not need to sign-up or call the Company to
take
advantage of its discounted service offerings upon receiving a Company
mail
solicitation. The Company works with various outside advertising agencies
to
design the copy and creative components of the direct mail marketing pieces
and
contracts with various vendors of mail shop and printing services in an
effort
to ensure that mail is sent out in a timely and cost-effective manner.
The
Company's data processing resources allow for prompt monitoring of customer
long
distance usage and permit the Company to carefully measure response rates to
its
direct mail campaigns. The Company constantly strives to improve response
rates
by varying the design and components of its direct mail marketing packages,
and
seeks to engineer the timing of its initial and follow-on direct mail
campaigns
to maximize response rate and grow overall market penetration. In addition,
the
Company also utilizes other media to supplement direct mail.
The Company typically has targeted new and existing geographical areas
for
a mailing campaign when its switch network, marketing and back
office
infrastructure have allowed it to effectively manage incremental growth.
Initial
mailings to new states are usually sequenced over a time period of several
weeks
in an effort to ensure proper customer support and efficient call
transmission.
The Company has periodically conducted subsequent mailings into its
existing
territory to stimulate incremental usage by new and existing customers and
to
build brand awareness. The Company's experience indicates that
subsequent
mailings into its geographic markets have generated incremental new
customer
usage, in some cases with response rates equal to initial mailings into
such
markets.
<PAGE>
The Company's in-bound telesales customer service department is designed
to
complement the Company's direct mail marketing strategy. Customer
service
representatives ("CSRs") are available 24 hours a day, 7 days a week to
answer
marketing inquiries generated by the Company's marketing campaigns, as well
as
to support existing customers. CSRs are trained to answer a broad range
of
inquiries from prospective customers relating to service, pricing and
optional
features.
Commercial Sales Division. In order to provide an additional
distribution
channel for the Company's telecommunications products and services, the
Company
implemented a plan during 1996 to build a direct commercial sales force.
In
April 1996, the Company hired Stephen G. Canton as the President of its
newly
formed CSD as part of the Company's plan to sell voice, data and
enhanced
telecommunications services to business customers. By December 1996, the
Company
had opened 22 regional sales offices and employed approximately 220
sales
personnel in 13 states to market these services. Sales personnel will market
the
Company's services through personal contacts which emphasize customer
service,
term plans, network quality, value-added services, reporting, rating
and
promotional discounts. The expenses associated with the growth of CSD
are
expected to reduce net income at least through 1997.
Current products offered by the Commercial Sales Division include
long
distance, calling card, 800/888 services, call accounting and enhanced
billing
services and dedicated T-1. In addition to competitive rates and a wide
variety
of products, the Company is able to offer business customers a
highly
specialized direct bill summary package that includes call summaries by
service
type, call type, originating number, account code, area code, country
code,
time-of-day and most frequently called numbers.
The Company also markets basic long distance services on a
presubscribed
basis to small business customers through telemarketing campaigns. As
of
December 31, 1996, CSD employed approximately 37 people in its telesales
group.
CSD also sells transmission capacity and services to other long
distance
carriers. The Company believes that the combination of the Company's
nationwide
network and Tel Labs' data processing resources provides an avenue of
continuing
growth through the wholesaling of one-stop telecommunications services to
long
distance resellers. The Company offers a complete package of networking,
billing
and customer service, eliminating the need for resellers to coordinate
with
multiple vendors and giving them the ability to obtain all of their
long
distance services from a single source. Additionally, the Company
provides
reseller clients with a customized version of the Tel Labs' customer
account
database software, the TelePhone Maintenance system ("PM"). While revenue
per
minute from wholesale service sales is generally lower than the
Company's
average sales to end users, the cost of sales and overhead involved in
servicing
carrier customers is also lower. Moreover, the Company has used this
market
segment to more effectively utilize its network during the daytime hours,
the
busiest time of day for many carrier and reseller customers.
The Company is positioning itself to resell local exchange services
and,
accordingly, has filed or intends to file applications in all 50 states
seeking
authorization to resell local exchange telecommunications products and
services.
As of March 18, 1997, local exchange resale authorization has been obtained
from
21 states.
CUSTOMER SERVICES
To ensure that in-bound telesales marketing and customer service are
always
available, the Company's customer service department operates 24 hours a day,
7
days a week to provide full-service support for its residential and
commercial
customer base and to handle marketing inquiries from potential and
existing
customers. During December 1996, the Company's customer telesales and
service
department personally responded to approximately 230,000 customer inquiries
and
service calls.
As of December 31, 1996 the Company employed approximately 245 CSRs
and
related customer service personnel. In connection with its mailing
campaigns,
the Company also employs additional personnel through a temporary
employment
agency on an ongoing basis, particularly in connection with mass mailings.
An
intensive two week training program (including hands-on training in
the
Company's PM system and computer software, participation in role
playing
exercises, and monitoring of actual customer calls), as well as regular
training
and repeated quality assurance assessments ensure that CSRs are
properly
prepared to handle customer calls. The Company maintains a relationship with
an
inbound telemarketing service provider capable of handling incoming
customer
service calls should the Company's customer telesales and service
department
become disabled.
The Company's call centers are equipped with state-of-the-art computer
and
telecommunications technology. Incoming calls are managed efficiently with
the
help of a Mitel Phone System, which includes an automatic call distributor
and
an automated attendant. This high-powered, multi-tasked system allows for
swift
management of call queue time, the formation of distinct work groups
for
different projects and on-line monitoring of customer service calls for
quality
assurance purposes. Bilingual CSRs are available during day and evening
shifts.
CSRs use the Company's PM proprietary software which delivers prompt
access
to accurate, up-to-date customer account information. This customized
software
is a powerful database which provides CSRs the capability to respond swiftly
to
customer needs. CSRs are able to issue credits while speaking with a
customer,
log service trouble tickets for treatment by the Company's Network
Control
Center, record pertinent customer information into an account memo field
to
maintain customer history, enter new customers into the database and
assign
appropriate billing codes. The software also generates actual credit
vouchers,
as well as letters responding to customer requests for additional stickers
and
other marketing materials. While Tel Labs has customized the software
to
accommodate the Company's specific needs, Tel Labs also has made this
software
available to its other long distance clients.
BILLING AND DATA PROCESSING
The Company believes that accurate and sophisticated information
systems
are key to growth and success in the telecommunications industry. The
Company
has dedicated substantial resources to its information systems and believes
that
the strong growth of its dial around business is largely attributable to
the
existence of the Tel Labs back office and billing platform. The
Company's
information systems enable the Company to (i) monitor and respond to
the
evolving needs of its customers by developing new and customized services;
(ii)
provide sophisticated billing information that can be tailored to meet
the
requirements of its customer base; (iii) provide high quality customer
service;
(iv) detect and minimize fraud; (v) verify payables to suppliers; and
(vi)
integrate additions to its customer base. The Company believes that its
network
intelligence, billing and financial reporting systems enhance the
Company's
competitive ability and provide a platform for future growth and the
expansion
of its product line.
Tel Labs processes raw switch data into a format that can be used
to
produce end-user invoices. During December 1996, Tel Labs
processed
approximately 94 million call records for 20 telecommunications
companies,
including the Company. This data processing is executed on specially
designed
personal computers operating a proprietary software program. Tel Labs
receives
the Company's raw call records directly from the Company's switches,
and
prepares them for rating by determining the answer status, originating
location,
terminating location and mileage. The calls are then rated according to
standard
rates or according to customer specific rates, if applicable. Rated calls
are
then sorted depending on which LEC will actually bill the end-user and placed
in
an industry standard format ("EMI"). Tel Labs then prepares management
reports
which provide the Company with the total number of calls, minutes and
dollars
billed during that bill cycle.
Since its inception, the Company has billed all of its residential
traffic
through LECs. The Company has entered into billing and collection
agreements
with LECs, including all of the RBOCs, that cover substantially all of
the
switched access lines in the U.S. These agreements permit the Company to
place
its customers' call detail records on the customers' regular monthly local
phone
bill. In addition, by billing through the LECs, the Company benefits from
the
LECs' extensive collections infrastructure. The Company believes that
LEC
billing agreements are the most effective mechanism for billing the
Company's
residential customers because consumers can receive one bill for both local
and
long distance service. The Company also provides billing clearinghouse
services
through Tel Labs to other unaffiliated long distance carriers.
Since April 1995, the Company has contracted with a third party to
manage
its billing and collection agreements ("Contract Manager"). After
receiving
rated call records from Tel Labs, the Contract Manager transmits them to the
LEC
and ensures that incoming and outgoing call records and revenues are
properly
tracked. The Company is considering managing its own contracts to enable it
to
realize greater operating efficiencies and more effectively manage its
cash
flow.
NETWORK AND OPERATIONS
The Company operates a nationwide advanced telecommunications
network
consisting of six switches, leased transmission lines and sophisticated
network
management systems designed to optimize traffic routing. The Company's
network
currently originates traffic in all or some part of 48 states and the
District
of Columbia. The Company operates an "open network", meaning that any
individual
within the Company's originating service area whose LEC provides equal
access
can access the Company's long distance network by dialing either of
the
Company's CIC codes, 10457 or 10297, or by presubscribing to the Company
as
their long distance service provider. Because customers do not need to
register
with the Company before accessing its network, the Company must
determine
capacity needs and install and test circuits before entering a new
geographic
market.
The Company's network provides high quality, reliable transmission
and
switching. The Company's network surveillance capabilities,
including
self-diagnostic software, generally enable the Company to anticipate and
correct
problems before they result in service interruption. The Company's
technicians
remotely monitor the Company's entire network 24 hours a day, 7 days a
week,
from its two Network Control Centers located in Chantilly, Virginia and
Austin,
Texas. To reduce the potential impact of any equipment or transmission
failure,
the Company can reroute or restore transmissions through the Company's
standby
transmission facilities or reroute traffic over the networks of other
carriers.
The Company's technicians also monitor the network for fraud on a
real-time
basis, using computer systems that detect unusual or high volume
calling
patterns.
Switching Facilities. The Company currently operates six DSC DEX 600S,
600
and 600E digital telecommunications switches in Fort Lauderdale,
Florida;
Davenport, Iowa; Chattanooga, Tennessee; Austin, Texas; Washington, D.C. and
Las
Vegas, Nevada. Additionally, the Company is installing a DEX 600E switch
in
metropolitan New York City which is expected to be operational in 1997 and
has
acquired an eighth switch for a yet-to-be-determined location. Switches
are
digital computerized routing facilities that receive calls, route calls
through
transmission lines to their destination and record information about the
source,
destination and duration of the calls. In order for a call to be
completed
through a switch, there must be two ports available -- an incoming port and
an
outgoing port. For example, if a switch is equipped with 30,000 ports,
the
switch can accommodate up to 15,000 simultaneous telephone calls. The
Company's
switches are currently configured with between 13,824 and 42,420 equipped
ports.
The Company's DEX 600 switches can be expanded to a configuration with
30,720
equipped ports while the Company's four DEX 600E switches can be expanded to
a
configuration with 107,520 equipped ports. The Company continually evaluates
the
capacity of its switches and in the future may expand its switches' capacity
or
add new switches in selected markets where the volume of its customer
traffic
makes such an investment economically viable.
Leased Transmission Lines. The Company leases transmission lines from
a
variety of facilities-based and resale long distance carriers. The
Company's
contracts with these entities typically have terms ranging from 18 to 36
months.
The Company supplements its leased "on-network" capacity with "off-net"
services
from a variety of resale and facilities-based long distance carriers.
In
addition, the Company does not have any on-network international
network
arrangements and exclusively resells the network capacity of other resale
and
facilities-based long distance carriers to international destinations.
Network Management Systems. Once calls are originated over the
Company's
circuits, the calls are routed over leased digital, fiber optic
transmission
facilities to the Company's nearest switch location and then routed on
a
least-cost basis to either the Company's leased network or to an
off-net
supplier for termination. The Company utilizes state-of-the-art Digital
Access
Cross Connect Systems ("DACS") to electronically cross-connect circuits
thereby
increasing call routing and circuit provisioning efficiency and providing
better
network monitoring capabilities. The Company has installed Tellabs ABS
Titan
5500 3/1 and 530 1/0 DACS equipment on five of the Company's
switches.
Additional DACS systems are expected to be installed on the
remaining
operational switches by the end of 1997. In addition, the Company has
configured
a large portion of its network with Signaling System 7 Common Channel
Signaling
("SS7"). This network protocol reduces connect time delays and
provides
additional technical capabilities and efficiencies for call routing. The
Company
is currently in the process of deploying SS7 in additional portions of
its
network.
COMPETITION
The telecommunications industry is highly competitive and affected by
rapid
regulatory and technological change. The Company believes that the
principal
competitive factors in its business include pricing, customer service,
network
quality, service offerings and the flexibility to adapt to changing
market
conditions. The Company's future success will depend upon its ability to
compete
with AT&T, MCI, Sprint and other carriers (including the RBOCs when approved
to
enter the long distance market) and other dial around companies, many of
which
have considerably greater financial and other resources than the Company.
The Company believes it competes favorably in its targeted markets, due
to
its dial around service and billing services, competitive pricing, high
network
quality and customer service infrastructure. The Company also believes that
its
success will depend increasingly on its ability to offer on a timely basis
new
services based on evolving technologies and industry standards. There can be
no
assurance that new technologies or services will be available to the Company
on
favorable terms.
Regulatory trends have had, and may have in the future, significant
effects
on competition in the industry.
REGULATION
The services which the Company provides are subject to varying degrees
of
federal, state and local regulation. The FCC exercises jurisdiction over
all
facilities of, and services offered by, telecommunications common carriers
to
the extent that they involve the provision, origination or termination
of
jurisdictionally interstate or international communications. The state
Public
Service Commissions ("PSCs") retain jurisdiction over
jurisdictionally
intrastate communications.
1996 Telecommunications Act. The 1996 Telecommunications Act was enacted
in
February, 1996. The legislation is intended to introduce increased
competition
in U.S. telecommunication markets. The legislation opens the local
services
markets by requiring local exchange carriers to permit interconnection to
their
networks and by establishing local exchange carrier obligations with respect
to
unbundled access, resale, number portability, dialing parity, access
to
rights-of-way, mutual compensation and other matters. In addition,
the
legislation codifies the local exchange carriers' equal access
and
nondiscrimination obligations and preempts inconsistent state regulation.
The
legislation also contains special provisions that eliminate the restrictions
on
the RBOCs and the GTOCs from providing long distance services. These
new
provisions permit an RBOC to enter the "out-of-region" long distance
market
immediately, upon the receipt of any state and/or federal regulatory
approvals
otherwise applicable to the provision of long distance service, and
the
"in-region" long distance market if it satisfies several procedural
and
substantive requirements, including obtaining FCC approval upon a showing
that
in certain situations facilities-based competition is present in its market,
and
that it has entered into interconnection agreements which satisfy a
14-point
"checklist" of competitive requirements.
The legislation defines in-region service to include every state, in
its
entirety, in which the RBOC provides local exchange service, even if the RBOC
is
not the incumbent local exchange service provider in all portions of that
state.
The GTOCs are permitted to enter the long distance market as of the date
of
enactment of the 1996 Telecommunications Act, without regard to limitations
by
region, although necessary regulatory approvals to provide long
distance
services must be obtained, and the GTOCs are subject to the provisions of
the
1996 Telecommunications Act that impose interconnection and other
requirements
on LECs. The Company will be facing new competition from the RBOCs and the
GTOCs
that are able to obtain the necessary state and/or FCC approvals to
provide
out-of-region and/or in-region long distance service, and at last search
RBOCs
have announced their intention to request permission from the FCC to enter
the
long distance market in one or more of their state markets. The
legislation
provides for certain safeguards to protect against anti-competitive abuse by
the
RBOCs. Among other things, the legislation limits the ability of the RBOCs
to
market jointly for a certain time period interLATA long distance
service,
equipment, and certain information services together with local services.
The
RBOCs must pursue such activities only through separate subsidiaries
with
separate books and records, financing, management, and employees. All
affiliate
transactions must be conducted on an arms length and nondiscriminatory
basis.
The RBOCs are also prohibited from jointly marketing local and long
distance
services, equipment, and certain information services unless they
permit
competitors to offer similar packages of local and long distance
services.
Further, the RBOCs must obtain in-region long distance authority before
jointly
marketing local and long distance service in a particular state. It is
unknown
whether these safeguards will provide adequate protection
against
anti-competitive conduct by the RBOCs, and the impact of
anti-competitive
conduct on the Company, if such conduct occurs, is uncertain. In addition,
long
distance service providers such as the Company will be significantly affected
by
the implementation and enforcement of statutory and regulatory
provisions
designed to prevent the RBOCs and the GTOCs from capitalizing on
their
monopolistic provision of local services to existing subscribers to
win
interLATA business.
The 1996 Telecommunications Act also addresses a wide range of
other
telecommunications issues that will potentially impact the Company's
operations,
including a sunset provision pertaining to when safeguards designed to
prevent
RBOCs from capitalizing on their local exchange monopolies will cease to
apply;
provisions pertaining to regulatory forbearance by the FCC; the creation of
new
opportunities for competitive local service providers; and
requirements
pertaining to the treatment and confidentiality of subscriber
network
information. The legislation also restricts for some period AT&T and other
long
distance carriers serving more than five percent of the nations'
presubscribed
access lines from packaging their long distance services with local
services
provided over RBOC facilities. It is unknown at this time precisely the
nature
and extent of the impact that the legislation will have on the Company.
As
required by the legislation, the FCC is still in the process of conducting
a
large number of proceedings to adopt rules and regulations to implement the
new
statutory provisions and requirements.
Depending on the exact nature and timing of GTOC and RBOC out-of-region
and
in-region entry into the long distance market, such entry and the ability of
the
Company's competitors to market jointly local and long distance services
could
have a material adverse effect upon the Company's results of operations. It
is
expected by the Company that most or all of the RBOCs will file applications
for
out-of-region (and also eventually in-region) long distance service
authority.
Certain of the RBOCs have already obtained the necessary authority to
provide
out-of-region long distance services in multiple states. It is not known
when,
and under what specific conditions, other applications for long
distance
authority will be filed by the RBOCs and/or granted by state
utility
commissions.
FCC Interconnection Orders. As required by the 1996 Telecommunications
Act,
in August 1996, the FCC adopted new rules implementing certain provisions of
the
1996 Telecommunications Act (the "Interconnection Orders"). These rules
are
designed to implement the pro-competitive, deregulatory national
policy
framework of the new statute by removing or minimizing the regulatory,
economic,
and operational impediments to competition for facilities-based and resold
local
services, including switched local exchange service. Although setting
minimum,
uniform, national rules, the Interconnection Orders also rely heavily on
states
to apply these rules and to exercise their own discretion in implementing
a
pro-competitive regime in their local telephone markets.
The Interconnection Orders are primarily important to the Company at
this
time insofar as they establish the basis for the cost to the Company
of
providing resold local services. Consistent with the 1996
Telecommunications
Act, the Interconnection Orders require incumbent LECs to offer
their
telecommunications services at retail prices minus avoided costs.
The
Interconnection Orders also requires, among other things, that
intraLATA
presubscription (pursuant to which LECs must allow customers to choose
different
carriers for intraLATA toll service without having to dial extra digits)
be
implemented no later than February 1999.
Petitions seeking reconsideration of one or more aspects of
the
Interconnection Orders have been filed with the FCC and are pending.
Also,
Interconnection Orders have been appealed to various U.S. Court of
Appeals.
These appeals have been consolidated into proceedings currently pending
before
the U.S. Eighth Circuit Court of appeals. Certain of the rules adopted in
the
Interconnection Orders, including rules that concern the pricing of
local
services such as resold local service, have been stayed by the Court
pending
resolution of the appeal. Although a number of state regulatory Commissions
have
voluntarily adopted pricing rules similar to those mandated in
the
Interconnection Orders, there can be no assurance of how the
Interconnection
Orders will be implemented or enforced, or what effect they will have
on
competition within the telecommunications industry, generally, or on
the
competitive position of the Company, specifically. Nonetheless, the
Company
believes the trend toward increased competition and deregulation of
the
telecommunications industry will be accelerated by the 1996
Tele-communications
Act and subsequent developments.
Federal. The FCC has classified the Company as a
non-dominant
inter-exchange carrier. As a non-dominant carrier, the Company may
provide
domestic interstate communications without prior FCC authorization, although
FCC
authorization is required for the provision of international
telecommunications
by non-dominant carriers. Non-dominant carriers currently are required to
file
tariffs listing the rates, terms and conditions of interstate and
international
services provided by the carrier. However, generally the FCC has chosen not
to
exercise its statutory power to closely regulate the charges or practices
of
non-dominant carriers. Nevertheless, non-dominant carriers are required
by
statute to offer interstate and international services under rates, terms
and
conditions that are just, reasonable, and not unduly discriminatory, and the
FCC
acts upon complaints against such carriers for failure to comply with
statutory
obligations or with the FCC's rules, regulations and policies. The FCC also
has
the power to impose more stringent regulatory requirements on the Company and
to
change its regulatory classification. The Company believes that, in the
current
regulatory environment, the FCC is unlikely to do so.
Until October 1995, AT&T was classified as a dominant carrier, but
AT&T
successfully petitioned the FCC for non-dominant status in the
domestic
interstate market. Therefore, certain pricing restrictions that once applied
to
AT&T have been eliminated, which could result in increased prices for
services
the Company purchases from AT&T and more competitive retail prices offered
by
AT&T to customers. AT&T is, however, still classified as a dominant carrier
for
international services.
Currently, the Company maintains two types of tariffs on file with the
FCC
containing the rates, terms and conditions of its services. One
governs
interstate service and the other governs international service. (As is
required,
the Company obtained authority from the FCC prior to providing
international
services.) Changes to either tariff can be made on one-day notice, without
need
for cost support. The 1996 Telecommunications Act, however, grants the FCC
the
authority to "forbear" from regulating any provider or service if the
agency
determines that it is in the public interest to do so. In an exercise of
its
"forbearance authority," the FCC has recently issued an order changing this
and,
following a transition period which is currently scheduled to conclude
in
November 1997, nondominant carriers will no longer be able to file tariffs
with
the FCC concerning their interstate long distance services.
(International
services will continue to be tariffed.) In lieu of tariffs, nondominant
carriers
such as the Company will be required to maintain at their offices, and
to
provide to customers or regulators upon request, information concerning
their
long distance services.
The FCC order eliminating tariffs has been appealed to the U.S. Court
of
Appeals for the District of Columbia. That appeal is pending. The court
has
stayed the FCC's order pending the resolution of the appeal. The
appellants
argue that tariffing establishes a legally binding relationship between
carriers
and customers, and that detariffing eliminates certainty with regard to
those
relationships. They also argue that detariffing imposes costs upon
carriers
because carriers will need to enter into alternative forms of legally
binding
relationships with customers. There can be no assurance of whether the
appeal
will be successful or, if successful, what effect it may have on the Company.
However, if mandatory detariffing ultimately takes effect, the Company,
like
other long distance companies, would likely incur some additional costs
in
establishing legally binding relationships with customers.
The 1996 Telecommunications Act mandated several other important
federal
regulatory developments. The first concerns universal service. As required
by
the 1996 Telecommunications, a joint board of federal and state regulators
were
convened to consider possible changes to the FCC's existing universal
service
support mechanisms - mechanisms designed to ensure affordable telephone
service
is available to all customers, including low-income consumers - in light of
the
pro-competitive paradigm for local competition established by the
1996
Telecommunications Act. In November 1996, the FCC initiated a proceeding
to
examine universal service issues, and has received comment on the proposals
set
forth by the joint board. Any decision is expected to comply with the
policy
principles for preservation and advancement of universal telephone service
set
forth in the Act: quality service, affordable rates, access to
advanced
services, access to service in rural and high-cost areas, specific
and
predictable support mechanisms, equitable and non-discriminatory contribution
to
support mechanisms, and access to advanced telecommunications for
schools,
health care providers, and libraries. An initial decision is expected in
May
1997. It is uncertain how any decision might affect the Company.
Another issue that may affect the Company is access charge reform.
Access
charges are charges imposed by LECs on long distance providers for access to
the
local exchange network, and are designed to compensate the LEC for
its
investment in the local network. In addition to economic considerations,
when
adopted in 1984, at the time AT&T was required to divest the BOCs,
access
charges rates reflected public policy considerations related to
universal
service and the desirability of low local rates. Interstate access charges
are
regulated by the FCC and intrastate access charges are regulated by the
state
public service commissions. As required by the 1996 Telecommunications Act,
in
December 1996, the FCC issued an order which, among other things,
requested
comment on a number of access charge reform issues designed to foster
efficient
pricing of access, competition for access services, and to reflect
the
development for local services prompted by the 1996 Telecommunications Act.
The
FCC has also sought comment on whether Internet service providers and
other
information service providers should be subject to access charges. An
initial
decision is expected in May 1997. It is uncertain how any decision might
affect
the Company.
An additional issue that may affect the Company relates to the manner
in
which carriers will be required to compensate payphone owners when a payphone
is
used to originate a long distance call. The 1996 Telecommunications Act
requires
carriers to compensate payphone owners on a per call basis. In Orders issued
in
September and October of 1996, the FCC imposed a compensation scheme that
called
for certain carriers, including the Company, to compensate payphone owners
a
flat amount per month for one year before transitioning to a per
call
compensation system. This flat rate compensation scheme would
effectively
require the Company to pay for services it does not receive. The Company
and
other carriers such as AT&T, have appealed these decisions to the U.S. Court
of
Appeal for the District of Columbia. The appeal is pending. There can be
no
assurance of whether the appeal will be successful or, if successful,
what
effect it may have on the Company.
The FCC also imposes prior approval requirements on transfers of
control
and assignments of operating authorizations. The FCC has the authority
to
generally condition, modify, cancel, terminate or revoke operating authority
for
failure to comply with federal laws and/or the rules, regulations and
policies
of the FCC. Fines or other penalties also may be imposed for such
violations.
There can be no assurance that the FCC or third parties will not raise
issues
with regard to the Company's compliance with applicable laws and regulations.
Among domestic local carriers, only the incumbent local exchange
carriers
are currently classified as dominant carriers. Thus, the FCC regulates many
of
the local exchange carriers' rates, charges and services to a greater
degree
than the Company's, although FCC regulation of the local exchange carriers
is
expected to decrease over time, particularly in light of the
1996
Telecommunications Act. As a result of the Act, incumbent local
exchange
carriers have recently been afforded a degree of pricing flexibility in
setting
interstate access charges where adequate competition is perceived to exist.
In
January 1997, the FCC issued an order streamlining the process by
which
incumbent LECs file tariffs for switched and special access services. The
new
streamlined rules allow LECs to change tariffs on no more than 15-days
notice.
The shortened notice periods adopted by the FCC may prompt LECs to file
tariffs
containing discriminatory and anti-competitive rates. It is unclear whether
the
order will be subject to reconsideration or appeal and, if not, what effect
it
may have on the Company.
Like other long distance carriers, the Company has been the subject
of
informal complaints before the FCC regarding certain marketing and
billing
issues. The Company has filed timely responses to these informal complaints.
The
Company believes that such matters will be satisfactorily resolved without
a
material adverse impact upon the Company's results of operations.
State. The Company's intrastate long distance and anticipated
local
exchange operations are subject to various state laws and regulations
including,
in most jurisdictions, certification and tariff filing requirements. The
vast
majority of the states require the Company to apply for certification to
provide
intrastate local and long distance telecommunications services, or at least
to
register or to be found exempt from regulation, before commencing
intrastate
service. The vast majority of states also require the Company to file
and
maintain detailed tariffs listing their rates for intrastate service.
Many
states also impose various reporting requirements and/or require prior
approval
for transfers of control of certified carriers, and/or for
corporate
reorganizations; acquisitions of telecommunications operations; assignments
of
carrier assets, including subscriber bases; carrier stock offerings;
and
incurrence by carriers of significant debt obligations. Certificates
of
authority can generally be conditioned, modified, canceled, terminated,
or
revoked by state regulatory authorities for failure to comply with state
law
and/or the rules, regulations, and policies of the state regulatory
authorities.
Fines and other penalties also may be imposed for such violations.
The Company has received the necessary FCC authorization and
state
certificate and tariff approvals to provide interstate and intrastate
long
distance service in 48 states and the District of Columbia. In addition,
the
Company has received the necessary authorization to provide local
exchange
telecommunications service in 21 states as of March 18, 1997. Applications
are
pending for multiple subsidiaries for additional state certifications.
Although
the Company intends and expects to obtain operating authority in
each
jurisdiction in which operating authority is required, there can be no
assurance
that one or more of these jurisdictions will not deny the Company's request
for
operating authority. The Company monitors regulatory developments in all
50
states to ensure regulatory compliance.
Informal complaints concerning certain marketing and billing issues
have
been lodged against the Company before certain state PSCs. The Company
believes
that such matters will be satisfactorily resolved without a material
adverse
impact upon the Company's results of operations.
PSCs also regulate access charges and other pricing for
telecommunications
services within each state. The RBOCs and other local exchange carriers
have
been seeking reduction of state regulatory requirements, including
greater
pricing flexibility. This could adversely affect the Company in several ways.
If
regulations are changed to allow variable pricing of access charges based
on
volume, the Company could be placed at a competitive disadvantage over
larger
long distance carriers. The Company also could face increased price
competition
from the RBOCs and other local exchange carriers for intraLATA and interLATA
long distance services, which may be increased by the removal of
former
restrictions on long distance service offerings by the RBOCs as a result of
the
1996 Telecommunications Act.
INTELLECTUAL PROPERTY
The Company has registered several trademarks for use in its
marketing
materials. The original logo used to market Dial & Save residential
long
distance service is a registered trademark of the Company. The logo is used in
a
limited fashion today, as it has been replaced by a more updated logo
design.
The new logo used to market the Dial & Save residential long distance service
is
actively used on all Dial & Save marketing materials. The Company filed
a
registration application to obtain a trademark for the new logo design and
to
trademark the words "Dial & Save" in late 1994. The registration application
has
been suspended pending the disposition of one other application before
the
Patent and Trademark Office ("PTO"). While each of the Company and the
other
applicant filed an opposition to the others application, they
commenced
discussions to resolve the matter. In December 1996, however, the Company
was
named as a defendant in litigation brought by An Apple A Day, Inc. d/b/a
Dial
and Save ("Apple"), a company involved in telephone order sales of
electronic
equipment. The suit claims that the new logo design accompanied by the
words
"Dial & Save" is confusingly similar to a trademark held by Apple so as
to
constitute trademark infringement and violations of related laws. The
Company
believes it has strong defenses to Apple's claims including that the marks
and
markets at issue are dissimilar. See "Item 3 - Legal Proceedings." The
Company's
CIC Code for its Long Distance Wholesale Club brand is a registered trademark
of
the Company.
"Prime Business" is the name of the Company's commercial product line.
The
Company filed registration applications to obtain trademarks for the
phrase
"Prime Business" and for its logo in 1995. The registration was granted
in
September 1996.
EMPLOYEES
As of December 31, 1996, the Company has approximately 603
full-time
employees, 8 part-time employees, and approximately 185 workers who are
employed
through various temporary agencies. The temporary agency workers are CSRs
who
handle inbound marketing inquiries from customers. None of these employees
are
represented by a union. The Company believes that it has good relations with
its
employees.
FORWARD-LOOKING STATEMENTS
This annual report contains forward-looking statements which express
the
current beliefs and expectations of Telco's management, but are subject to
a
number of known and unknown risks that could cause actual results to
differ
materially from those projected or implied in the forward-looking statements
in
this press release. Among the risks, factors and uncertainties that could
cause
actual results to differ materially from those referred to above are:
the
Company's ability to maintain its current pace in attracting and
retaining
customers, the development of price competition in the long distance
industry,
an increase in rates for access and transmission facilities, the
costs
associated with the continued expansion of the Company's Commercial
Sales
Division and the ability of the Company to integrate the pending acquisition
of
the Advantis assets and to generate the anticipated earnings and cash flow.
Item 2. Properties
The Company currently leases approximately 36,327 square feet of space
for
its corporate headquarters at 4219 Lafayette Center Drive, 4215 Lafayette
Center
Drive and 4200 Pleasant Valley Road in Chantilly, Virginia, pursuant to
various
agreements. See "Certain Transactions- Leases of Real Property from Affiliate
of
Shareholder." The average monthly rent (not including electricity) as of
March
1997 is approximately $28,906. In addition, the Company occupies
approximately
14,508 square feet of leased office space on the 11th floor of 1401
Wilson
Boulevard in Arlington, Virginia, which also houses the Company's
Washington,
D.C. Commercial Sales Division. The monthly rental for this space as of
December
1996 is approximately $25,651. The lease expires on May 31, 2000 with an
option
to renew for one additional term of five years. The Company also leases
an
aggregate of 27,432 square feet of space in seven locations in Florida,
Iowa,
Nevada, Tennessee, Texas, and Washington, D.C., to house its
telecommunications
switching equipment sites and one of its network control centers. Due to
the
rapid expansion and growth of the Company, there may be a need to
lease
additional office space. If this need arises, the Company believes
additional
space can be readily obtained as needed. The Company's Commercial Sales
Division
is currently utilizing temporary office space in twenty-one of its
twenty-two
existing locations. The Company expects to secure longer term office space
in
1997.
<PAGE>
Item 3. Legal Proceedings
In December 1996, Telco Communications Group, Inc. and Long
Distance
Wholesale Club (LDWC) became involved in a civil action, AT&T Corp. v.
Telco
Communications Group, Inc. and Long Distance Wholesale Club, pending in
the
United States District Court for the District of New Jersey. In this
litigation,
AT&T claims that Long Distance Wholesale Club advertisements that consumers
can
save up to 50% off AT&T's basic rates are false and misleading under federal
and
state law. AT&T seeks treble damages, statutory attorneys' fees and costs,
and
an injunction. The Company denies the allegations in this litigation and
is
vigorously defending against them, including that all disclosures are
clearly
contained in LDWC's advertisements and that it is possible for consumers in
any
geographic location of the United States to place calls that will achieve up
to
a 50% savings. Toward that end, the Company is preparing to stipulate
the
transfer of its own false advertising and tortious interference claims
against
AT&T, presently pending in the United States District Court for the
Eastern
District of Virginia, to the District of New Jersey for consolidation
with
AT&T's action. The Company also plans to file additional counterclaims
against
AT&T based on AT&T's advertising which the Company believes contains a
variety
of misleading and deceptive statements. The Company could be found liable
for
damages and an injunction might issue against future use of the
LDWC
advertisements, although such advertisements are no longer in use.
On December 31, 1996, Apple filed suit against the Company in the
United
States District Court for the Eastern District of Maryland alleging
trademark
and tradename infringement, unfair competition, false designation of
origin,
federal trademark dilution, trade dress dilution and violations of
Missouri
common law. According to the complaint, Apple holds a Dial and Save service
mark
for telephone order services in the field of electronic equipment. Apple
alleges
that the Company's use of a Dial & Save logo and tradename in connection
with
its sale to consumers of long distance service infringes Apple's mark.
Apple
seeks an injunction against the Company's further use of the Dial & Save
logo
and name, disgorgement of all profits made from use of the Dial & Save logo
and
name, damages for loss of sales, loss of good will and damage to
reputation,
trebling of damages and payment of attorneys fees and costs. The Company
denies
the allegations and is vigorously defending against them, including on
the
grounds, among others, that there is no competitive proximity of the
electronic
equipment that Apple sells and the long distance service that the Company
offers
and no likelihood of, or actual, confusion regarding the seller, and
therefore
the source, of each. If the Company is found to have infringed Apple's
mark,
and/or to have liability for Apple's other claims, then it may be found
liable
to Apple in whole, or in part, for damages of the nature sought by Apple.
On May 8, 1995, the Company, and its subsidiary, Dial & Save of
Nevada,
Inc., filed suit against Central Telephone Company-Nevada, d/b/a
Sprint/Central
Telephone Company-Nevada, a division of the Central Telephone Company,
Sprint,
Inc., et al, in the District Court of Clark County, Nevada. The suit
includes
claims for breach of contract, promissory and equitable estoppel, unfair
trade
practices, and breach of the duty of good faith and fair dealing, all
in
violation of the laws of Nevada. The Company and its subsidiary seek an
order
for temporary injunctive relief preventing the defendant from denying
possession
of certain commercial real property in Las Vegas to the Company and
its
subsidiary and compelling the defendant to execute and honor a commercial
real
property lease with the Company, as well as compensatory and punitive
damages,
attorneys fees and costs.
In related litigation, on May 5, 1995, Central Telephone
Company-Nevada,
d/b/a Sprint/Central Telephone Company-Nevada, a division of the
Central
Telephone Company, filed suit against the Company in the United States
District
Court for the District of Nevada. The suit includes claims for negligent
and/or
malicious omission or concealment of material facts, conversion of
personal
property and trespass to chattel in violation of the common laws of Nevada,
in
connection with certain commercial real property and
telecommunications
facilities owned by the plaintiff in Las Vegas, Nevada. The plaintiff
seeks
damages and a declaratory judgment specifying the respective rights of
the
plaintiff and the Company regarding occupancy of the commercial real
property
and use of the telecommunications facilities in Las Vegas, and requiring
the
Company to present any complaint against the plaintiff to the FCC prior
to
bringing any court action. The Company denies the allegations, intends to
defend
vigorously against them and has filed the suit described above the against
the
plaintiff.
On March 14, 1997, Frontier Corporation and Frontier
Communication
Services, Inc. filed suit against the Company, and three (3) of the
Company's
employees, in the United States District Court for the Southern District
of
Indiana, alleging breach of contract, tortious interference with
contractual
relations and tortious interference with prospective economic relations.
The
plaintiffs allege that three (3) of the Company's employees, who were
employed
formally by the plaintiffs, left the employ of plaintiffs, joined the
Company,
and thereafter solicited on behalf of the Company plaintiffs' employees,
and
plaintiffs' customers, in breach of written agreements between the
plaintiffs
and the employees, and in violation of the common laws of Indiana.
The
plaintiffs also allege that the Company breached a written agreement between
the
Company and the plaintiffs in which the Company agreed not to allow
solicitation
of the plaintiffs' employees or customers by the Company's employees who
were
formerly employed by the plaintiffs. The plaintiffs seek an
injunction
preventing the Company and the three (3) employees from breaching
their
respective written agreements with plaintiffs and preventing the Company
from
aiding or abetting the employees in breach of the employees' written
agreements
with the plaintiffs; an accounting and disgorgement of all profits made by
the
Company and the employees arising from the breach of the written agreements
with
the plaintiffs; a declaratory judgment that the Company and the employees
have
breached their respective written agreements with the plaintiffs, and
have
tortiously interfered with the plaintiffs' existing contractual and
prospective
economic relations; damages for breach of contract and interference
with
plaintiffs' existing contractual and prospective economic relations; and
payment
of attorneys' fees, and costs. The Company denies the allegations and intends
to
defend vigorously against them.
Item 4. Submission of Matters to a Vote of Security Holders
None.
<PAGE>
Executive Officers of the Registrant
The following table sets forth, as of March 18, 1997, certain
information
regarding the Company's executive officers and certain other
significant
employees.
Name Age Position
- -------------------------------------------------------------------------------
Henry G. Luken, III 37 Chairman of the Board
Donald A. Burns 33 Vice Chairman of the Board, Chief
Executive
Officer and President
Thomas J. Cirrito 48 President-Consumer Division and Director
Stephen G. Canton 41 President-Commercial Division
Bryan K. Rachlin 40 Chief Operating Officer, Secretary and
General Counsel
Nicholas A. Merrick 34 Chief Financial Officer, Treasurer and
Vice President
Natalie J. Marine-Street 28 Executive Vice President
Janet D. Anastasi 50 Vice President and Corporate Controller
Mark J. Stodter 37 Vice President-Electronic Data Processing
Henry G. Luken, III, a co-founder of the Company, has served as
the
Chairman of the Company's Board of Directors since its formation in July
1993.
Mr. Luken served as the Company's Chief Executive Officer and Treasurer
from
July 1993 to April 1996. Mr. Luken has also served as chairman of Tel Labs
since
1991 and chairman of Telco Development Group, Inc., a computer systems
company
owned by Mr. Luken, since 1987, both of which entities he founded.
Donald A. Burns, a co-founder of the Company, has served as Chief
Executive
Officer and Vice Chairman of the Company's Board of Directors since April
1996,
and has served as the President and as a director of the Company since
its
formation in July 1993. Mr. Burns served as the Company's Secretary from
July
1993 to April 1996. Prior to joining the Company, Mr. Burns held
several
positions with Mid Atlantic Telecom, Inc. ("Mid Atlantic"), a regional
long
distance carrier based in Washington, D.C., including executive vice
president
and chief operating officer from October 1992 to July 1993 and director
of
operations from 1988 to October 1992.
Thomas J. Cirrito has served as the President of the Company's
Consumer
Division since April 1996 and as a director of the Company since June 1996.
Mr.
Cirrito is a co-founder of LDWC and has served as its president and
chief
executive officer since its formation in September 1993. From November
1991
through September 1993, Mr. Cirrito served as president and chief
executive
officer of Telecommunications Associates, Inc., an operator assisted
services
company. Mr. Cirrito was vice president of marketing/sales with Mid
Atlantic
from November 1988 to November 1991.
Stephen G. Canton has served as the President of the Company's
Commercial
Division since April 1996. Prior to joining the Company, Mr. Canton held
several
positions with Allnet Communications Services, Inc., a long
distance
telecommunications company, including vice president of the sales division
and
regional sales director from 1988 to 1995.
Bryan K. Rachlin has served as the Chief Operating Officer and Secretary
of
the Company since April 1996. Mr. Rachlin has served as Vice President
and
General Counsel of the Company since its inception, and as the Chief
Executive
Officer of Tel Labs since May 1994. Prior to joining the Company, Mr.
Rachlin
was a partner in the law firm of Rachlin & Fitzgerald.
Nicholas A. Merrick has served as Chief Financial Officer of the
Company
since March 1996. Prior to joining the Company, from July 1990 to March
1996,
Mr. Merrick held several positions as an investment banker in the
corporate
finance department of The Robinson-Humphrey Company, Inc. In this capacity,
Mr.
Merrick was involved in numerous public and private financing and merger
and
acquisition transactions involving companies in the telecommunications
industry.
Natalie J. Marine-Street has served as an Executive Vice President of
the
Company since February 1996. Ms. Marine-Street served in several other
positions
with the Company since its formation in July 1993, including vice president
of
administration from February 1995 to February 1996 and marketing
manager/special
projects from July 1993 to February 1995. Prior to joining the Company,
Ms.
Marine-Street served as marketing coordinator and in other capacities at
Mid
Atlantic from April 1991 to July 1993.
Janet D. Anastasi has served as Vice President and Corporate Controller
of
the Company since October 1994. Prior to joining the Company, Ms.
Anastasi
served as a manager at Chase and Associates CPAs, P.C., certified
public
accountants, from 1988 to 1994.
Mark J. Stodter has served as Vice President-Electronic Data Processing
of
the Company since its formation in July 1993. Additionally, Mr. Stodter
served
as Chief Operating Officer of the Company from July 1993 to March 1996. Prior
to
joining the Company, Mr. Stodter served as director of management
information
systems with Long Distance Service, Inc., a regional long distance carrier
based
in Washington, D.C. from 1986 to 1993.
<PAGE>
PART II
Item 5.Market for the Registrant's Common Equity and Related Shareholder
Matters
The Common Shares are traded on the Nasdaq National Market under the
symbol
"TCGX". The following table sets forth, on a per share basis, the range of
the
high and low sales price information of the Common Shares as reported by
the
Nasdaq National Market, for the periods indicated.
1996
High Low
Third Quarter (from August 9, 1996) $19 1/2 $14
Fourth Quarter $19 1/4 $15
As of March 18, 1997, the closing price of the Common Shares as reported
by
the Nasdaq National Market was $20.38. As of March 18, 1997, there
were
approximately 2,877 registered holders of Common Shares.
The Company has never paid any dividends. The Company currently intends
to
retain all future earnings for use in the operation of its business
and,
therefore, does not anticipate paying any cash dividends in the
foreseeable
future. The declaration and payment in the future of any cash dividends will
be
at the discretion of the Company's Board of Directors and will depend
upon,
among other things, the earnings, capital requirements and financial position
of
the Company, existing and/or future loan covenants and general
economic
conditions.
Recent Sales of Unregistered Securities
On March 19, 1996, options to acquire 425,000 Common Shares were issued
to
Mr. Merrick at an exercise price of $7.53 per share.
On April 1, 1996, Bonita Anderson, James Sznadjer, Dennis Jarman and
Mr.
Rachlin exchanged their options in LDWC for options to acquire 25,511;
51,021;
113,267 and 102,043 Common Shares, respectively, under the Company's
Stock
Option Plan.
On April 1, 1996, the Company issued 5,102,125 Common Shares in
exchange
for the remaining minority interest in LDWC.
On April 4, 1996, options to acquire 1,062,500 Common Shares were issued
to
Mr. Canton at an exercise price of $7.53 per share.
On June 1, 1996, the Company agreed to issue 593,334 Common Shares to
the
shareholders of Tel Labs in exchange for all of their shares in Tel Labs.
On June 21, 1996, Mr. Rachlin exercised options to purchase 649,198
Common
Shares at a weighted average exercise price of $0.44 per share.
On August 9, 1996, Ms. Marine-Street exercised options to purchase
169,575
shares at a weighted average exercise price of $1.76 per share.
Each issuance of securities described above was made in reliance on
the
exemption from the registration provided by Section 4(2) of the Securities
Act
as a transaction by an issuer not involving any public offering. The
recipients
of securities in each such transaction represented their intention to
acquire
the securities for investment only and not with a view to or for sale
in
connection with any distribution thereof and appropriate legends were affixed
to
the share certificates issued in such transactions. All recipients had
adequate
access, through their relationships with the Company, to information about
the
Company.
Item 6. Selected Financial Data
The information called for by Item 6 is incorporated herein by reference
to
page 10 of the Registrant's Annual Report to Shareholders for the year
ended
December 31, 1996 (the "1996 Annual Report").
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations
The information called for by Item 7 is incorporated herein by reference
to
pages 11 through 15, inclusive, of the 1996 Annual Report.
Item 8. Financial Statements and Supplementary Data
The information called for by Item 8 is incorporated herein by reference
to
pages 16 through 30, inclusive, of the 1996 Annual Report.
With the exceptions of the aforementioned information and the
additional
information incorporated by reference in Parts II and IV hereof, the 1996
Annual
Report is not deemed to be filed as part of this report.
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure
None.
Item 10. Directors and Executive Officers of the Registrant
The information required by Item 10 and Item 401 of Regulation S-K as
to
the Directors of the Company, and the information required by Item 405
of
Regulation S-K, is incorporated herein by reference to the Company's
definitive
proxy statement dated April 8, 1997 to be filed with the Securities and
Exchange
Commission pursuant to Regulation 14A in connection with the Company's
Annual
Meeting of Shareholders to be held on May 15, 1997 (the "Proxy Statement").
Item 11. Executive Compensation
The information required by Item 11 is incorporated herein by reference
to
the Proxy Statement, except for the sections entitled "Board Report on
Executive
Compensation" and "Performance Graph" which shall not be deemed to
be
incorporated herein.
Item 12. Security Ownership of Certain Beneficial Owners and Management
The information required by Item 12 is incorporated herein by reference
to
the Proxy Statement.
Item 13. Certain Relationships and Related Transactions
The information required by Item 13 is incorporated herein by reference
to
the Proxy Statement.
<PAGE>
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K
(a) 1. Financial Statements:
The following consolidated financial statements of the Company
are
included in Part II, Item 8 (which incorporates information by
reference to the 1996 Annual Report):
Consolidated balance sheets as of December 31, 1996 and
December 31, 1995.
Consolidated statements of income and retained earnings
for
the years ended December 31, 1996, December 31, 1995 and
December 31, 1994.
Consolidated statements of cash flows for the years ended
December 31, 1996, December 31, 1995 and December 31,
1994.
Notes to Consolidated Financial Statements and Independent
Auditors' Report.
2. Financial Statement Schedules:
Independent Auditors' Report
3. Exhibits: See Exhibit Index on pages 30 to 34.
The Registrant hereby agrees to furnish the Commission a copy
of each of the indentures or other instruments defining the
rights of security holders of the long-term debt securities of
the
Registrant and any of its subsidiaries for which consolidated
or
unconsolidated financial statements are required to be filed.
(b) Reports on Form 8-K:
The Company filed no reports on Form 8-K during the quarter ended
December 31, 1996.
(c) Refer to Item 14 (a) (3) above for Exhibits required by Item 601 of
Regulation S-K.
(d) Schedules other than set forth in response to Item 14(a)(2)
above
for which provision is made in the applicable accounting regulations
of
the Securities and Exchange Commission are not required under the
related instructions or are inapplicable and therefore have been
omitted.
<PAGE>
TELCO COMMUNICATIONS GROUP, INC.
EXHIBIT INDEX
Exhibit Number Exhibit Description
- --------------------------------------------------------------------------------
*2.1 Share Exchange Agreement between Telco Communications
Group,
Inc., Henry G. Luken, III, Bryan Rachlin, Michael Cheng and
Kevin
Yang dated as of June 1, 1996 (Tel Labs, Inc., Share
Exchange
Agreement)
- --------------------------------------------------------------------------------
*2.2 Share Exchange Agreement between Telco Communications Group,
Inc., Thomas Cirrito, Nicole Cirrito and Michael Cirrito
dated as of April 1, 1996 (Long Distance Wholesale Club
Share Exchange Agreement)
- --------------------------------------------------------------------------------
*3.1 Restated Articles of Incorporation of Telco Communications
Group,
Inc.
- --------------------------------------------------------------------------------
*3.2 Amended and Restated Bylaws of Telco Communications Group,
Inc.
- -------------------------------------------------------------
- ------------------
*4.1 Form of Common Stock Certificate of Telco Communications
Group,
Inc.
- --------------------------------------------------------------------------------
*10.1 Agreement for the Provision of Billing and Collection
Services between Telco Development Group of Delaware, Inc.
and the Ameritech Companies dated July 1, 1995
- --------------------------------------------------------------------------------
*10.2 Agreement for the Provision of Billing and Collection
Services between the Bell Atlantic Operating Telephone
Companies and Telco Development Group of Delaware, Inc.
dated June 10, 1994
- --------------------------------------------------------------------------------
*10.3 Clearinghouse Billing and Collection Services Operating
Contract between Telco Development Group of Delaware, Inc.
and Bell South Communications dated January 3, 1994
- --------------------------------------------------------------------------------
*10.4 Agreement for Billing Services by Tel Labs, Inc. and Esprit
Telecom dated December 29, 1995
- --------------------------------------------------------------------------------
*10.7 Agreement between Nevada Bell and Telco Development Group
of Delaware, Inc. for Billing and Collection Services dated
September 3, 1995
<PAGE>
Exhibit Number Exhibit Description Page
- ----------------
- ---------------------------------------------------------------
*10.8 Agreement for Interstate Billing and Collection Services
Agreement between New England Telephone and Telegroup
Company and Telco Development Group of Delaware, Inc. dated
July 31, 1995
- --------------------------------------------------------------------------------
*10.9 Agreement for Interstate Billing and Collection Services
between New York Telephone Company and Telco Development
Group of Delaware, Inc. dated July 31, 1995
- --------------------------------------------------------------------------------
*~10.10 Agreement for the Provision of Billing and Collection
Services between Pacific Bell and Telco Development Group of
Delaware, Inc. dated July 12, 1996
- ------------------------------------------------------------
- ------------------
*~10.11 Casual Billing Services Agreement between the Southern
New England Telephone Company and Telco Development Group of
Delaware, Inc. dated February 9, 1996
- --------------------------------------------------------------------------------
*10.12 Agreement for the Provision of Billing and Collection
Services between Southwestern Bell Telephone Company and
Telco Development Group of Delaware, Inc. dated December 16,
1994; and Amendment to the Agreement for the Provision of
Billing and Collection Services between Southwestern Bell
Telephone Company and Telco Development Group of Delaware,
Inc. dated December 19, 1994
- --------------------------------------------------------------------------------
**~10.15 Agreement for the Provision of Billing and Collection
Services for Clearing Agents between US West, Inc. and Telco
Development Group of Delaware, Inc. dated April 1, 1995;
Amendment dated June 6, 1996
- --------------------------------------------------------------------------------
*~10.16 Standard Agreement for the Provision of Billing and
Collection Services between United Telephone Company of
Florida and Telco Development Group of Delaware, Inc. dated
October 19, 1994
- --------------------------------------------------------------------------------
*10.17 Service Agreement between IXC Carrier, Inc. and Telco
Communication Group, Inc. dated December 15, 1995
- --------------------------------------------------------------------------------
*10.18 Telco Communications Group, Inc. Wholesale Customer
Agreement for Special International Pricing with Esprit
Telecom dated February 21, 1996
- --------------------------------------------------------------------------------
*10.19 Telco Communications Group, Inc. Amended and Restated 1994
Stock Option Plan
- ----------------
- ---------------------------------------------------------------
*10.20 Lease Agreement between CPL Properties and Telco
Communications Group, Inc. effective March 1, 1995
(Davenport, Iowa Switch Site)
- --------------------------------------------------------------------------------
*10.21 Lease Agreement between Thomas Kurschner and Telco
Communications Group, Inc. effective November 2, 1995 (Las
Vegas, Nevada Switch Site)
- --------------------------------------------------------------------------------
*10.22 Deed of Lease Agreement between Bricks in the Sticks, Ltd.
and Telco Communications Group, Inc. effective March 1, 1995
(Chattanooga, Tennessee Switch Site)
- --------------------------------------------------------------------------------
*10.23 Lease Agreement between The University of Texas System and
Telco Communications Group, Inc. effective August 22, 1994
(Austin, Texas Switch Site)
- --------------------------------------------------------------------------------
*10.24 Agreement of Lease between 13th and L Associates and Telco
Communications Group, Inc. effective August 25, 1994
(Washington, DC Switch Site)
- --------------------------------------------------------------------------------
*10.25 Deed of Lease Agreement between Bricks in the Sticks, Ltd.
and Tel Labs, Inc. effective July 1, 1994 (Corporate Office)
- --------------------------------------------------------------------------------
*10.26 Deed of Lease Agreement between Bricks in the Sticks, Ltd.
and Telco Communications Group, Inc. effective March 1, 1995
(Corporate Office)
- --------------------------------------------------------------------------------
*10.29 Equipment Leases between DSC Finance Corporation and Telco
Communications Group, Inc. (Master Lease dated January 1,
1994 and Schedules A-P1)
- -------------------------------------------------------------------------------
*10.30 Credit Agreement between Telco Communications Group,
Incorporated, Signet Bank and the Banks listed therein,
dated as of January 24, 1996
- -------------------------------------------------------------------------------
*10.31 Employment Agreement between Telco Communications Group,
Inc. and Donald A. Burns dated as of July 10, 1996
- --------------------------------------------------------------------------------
*10.32 Employment Agreement between Telco Communications Group,
Inc. and Thomas J. Cirrito dated as of April 1, 1996
- --------------------------------------------------------------------------------
*10.33 Employment and Stock Option Agreement between Telco
Communications Group, Inc. and Stephen G. Canton dated as of
April 4, 1996
- --------------------------------------------------------------------------------
*10.34 Employment Agreement between Telco Communications Group,
Inc. and Bryan K. Rachlin dated as of July 10, 1996
- --------------------------------------------------------------------------------
*10.35 Employment Agreement between Telco Communications Group,
Inc. and Nicholas A. Merrick dated as of March 19, 1996
- --------------------------------------------------------------------------------
*10.36 Employment Agreement between Telco Communications Group,
Inc. and Janet D. Anastasi dated as of May 2, 1996
- --------------------------------------------------------------------------------
*10.37 Employment Agreement between Telco Communications Group,
Inc. and Natalie Marine-Street dated as of May 3, 1996
- --------------------------------------------------------------------------------
*10.38 Employment Agreement between Telco Communications Group,
Inc. and Mark J. Stodter dated as of May 2, 1996
- --------------------------------------------------------------------------------
*10.39 Employment Agreement between Telco Communications and
Henry G. Luken, III dated as of July 10, 1996
- --------------------------------------------------------------------------------
*10.41 Form of Registration Rights Agreement between Telco
Communications Group, Inc. and holders of certain shares of
common stock of the Company and certain options to purchase
common stock
- --------------------------------------------------------------------------------
*10.42 Billing and Collection Services Agreement between GTE
Telephone Operations and Telco Development Group of
Delaware, Inc. dated March 15, 1995
- --------------------------------------------------------------------------------
+10.43 Credit Agreement between Telco Communications Group, Inc.
and NationsBank of Texas, N.A. as Administrative Lender and
Lenders, dated December 20, 1996
- --------------------------------------------------------------------------------
+10.44 Carrier Agreement between AT&T Corp. and Telco
Communications Group, Inc., dated December 23, 1996
- --------------------------------------------------------------------------------
+~10.45 Network Purchase Agreement between Advantis and Telco
Network Services, Inc., dated March 11, 1997
- --------------------------------------------------------------------------------
+10.46 Lease Agreement between Telco Communications Group, Inc.
and Frederic C. Stein, dated May 1, 1996 (Fort Lauderdale,
Florida Switch Site)
- --------------------------------------------------------------------------------
+10.47 Lease Agreement between Telco Communications Group, Inc.
and Hudson Telegraph Associates, dated September 26, 1996
(New York, New York Switch Site)
- --------------------------------------------------------------------------------
+11.1 Schedule of Computation of Earnings Per Share
- --------------------------------------------------------------------------------
13.1 Portions of the Telco Communications Group, Inc. Annual
Report to Shareholders for the year ended December 31, 1996
- --------------------------------------------------------------------------------
+21.1 Subsidiaries of Telco Communications Group, Inc.
- --------------------------------------------------------------------------------
23.1 Independent Auditors' Consent
- --------------------------------------------------------------------------------
+27.1 Financial Data Schedule
- --------------------------------------------------------------------------------
* Incorporated by reference from the Company's Registration Statement
on
Form S-1 (Commission File No. 333-05857)
~ Portions of this Exhibit have been omitted pursuant to a request for
confidential treatment and filed separately with the Commission.
+ Incorporated by reference to the Company's Form 10-K Annual Report for
the reporting period ending December 31, 1996 (Commission File
No. 333-05857) filed March 31, 1997.
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the
Securities Exchange Act of 1934, the Registrant has duly caused this report to
be signed on its behalf by the undersigned, thereunto duly authorized.
TELCO COMMUNICATIONS GROUP, INC.
/s/Donald A. Burns
By: __________________________
Donald A. Burns
President and Chief Executive
Officer
Date: September 11, 1997
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf
of the Registrant and in the capacities and on the date indicated.
Signature Date
/s/Henry G. Luken, III
______________________ ________
Henry G. Luken, III
Chairman of the Board and Director
/s/Donald A. Burns
_____________________ ________
Donald A. Burns
Vice Chairman of the Board, President,
Executive Officer and Director (Principal
Chief Executive Officer)
/s/Thomas J. Cirrito
_____________________ ________
Thomas J. Cirrito
President of Consumer Division and Director
/s/Robert W. Ross
______________________ ________
Robert W. Ross
Director
/s/Gary L. Nelson
______________________ ________
Gary L. Nelson
Director
/s/Nicholas A. Merrick
______________________ ________
Nicholas A. Merrick
Chief Financial Officer and Treasurer
(Principal Financial Officer)
/s/Janet A. Anastasi
______________________ ________
Janet D. Anastasi
Vice President and Corporate Controller
<TABLE>
<CAPTION>
Selected Consolidated Financial Data
Years Ended December 31,
<S> <C> <C> <C> <C>
1993(1) 1994 1995 1996
(in thousands, except per share
and per minute of use amounts)
Statement of Operations Data:
Revenues, net $ 1,135 $ 44,707 $ 215,376 $ 428,552
Cost of services 993 27,736 133,728 252,036
Gross margin 142 16,971 81,648 176,516
Selling, general and
administrative 1,310 12,018 55,936 125,575
Depreciation and amortization 54 496 3,326 7,967
Operating income (loss) (1,222) 4,457 22,386 42,974
Interest expense 25 897 2,952 3,515
Other income (expense) -- 15 (92) 501
Provision for income taxes -- 1,432 7,531 16,394
Minority interest -- 137 1,046 689
Net income (loss) $ (1,247) $ 2,006 $ 10,765 $ 22,877
Net income (loss) per share $ (0.05) $ 0.07 $ 0.38 $ 0.75
Weighted average number of
shares outstanding
(in thousands) 26,077 26,884 28,285 30,533
Balance Sheet Data (at Period End):
Cash and cash equivalents $ 140 $ 475 $ 937 25,373
Total assets 2,051 33,533 87,124 210,596
Total debt (including capital
lease obligations) 1,559 18,884 44,411 3,301
Minority interest -- 137 1,183 --
Shareholders' equity (deficit) (376) 1,655 12,420 145,720
Other Operating Data:
Billed minutes of use 1,384,300 2,963,080
Revenue per billed minute of use $ 0.156 $ 0.145
Cost of services per billed minute of use $ 0.097 $ 0.085
(1) The Company commenced operations in November 1993.
</TABLE>
Forward-Looking Information
Statements in this report concerning future results,
performance,
achievements, expectations or trends, if any, are forward-looking
statements.
Actual results, performance, achievements, events or trends could
differ
materially from those expressed or implied by such forward-looking statements
as
a result of known and unknown risks, uncertainties and other factors
including
those described below and those identified by the Company in the Company's
other
filings with the Securities and Exchange Commission.
Introduction
Telco Communications Group, Inc. and its wholly owned
subsidiaries
(collectively "Telco" or "the Company") is a rapidly growing
switch-based
provider of domestic and international long distance telecommunication
services
primarily to residential customers in the United States. Substantially all
of
the Company's customers access its network by dialing a unique five
digit
Carrier Identification Code (CIC) before dialing the number they are
calling.
Using a CIC Code to access the Company's network is known as "dial around"
or
"casual calling" because customers can use the Company's services at any
time
without changing their existing presubscribed long distance carrier. The
Company
markets its residential long distance services through marketing
subsidiaries
under two brands, each with a unique CIC Code: Dial & Save (CIC Code 10457)
and
the Long Distance Wholesale Club (LDWC) (CIC Code 10297), and prices
its
services at a discount to the basic "1 plus" rates offered by the three
major
long distance carriers: AT&T, MCI and Sprint. During December 1996, the
Company
provided long distance services to approximately 2.6 million customers
(switched
access lines) in 48 states and the District of Columbia. All dial
around
operations are conducted through marketing subsidiaries that are referred
to
collectively as the Consumer Division.
To increase its volume of call traffic, Telco has begun to sell its
daytime
capacity on a wholesale basis to other long distance carriers and in
addition
has created a Commercial Sales Division ("CSD") to target business and
carrier
customers. Because the Company's existing customer base is
primarily
residential, the majority of calls are handled during off-peak evening
and
weekend periods. As of December 31, 1996, CSD had opened 22 sales offices in
13
states and employed approximately 220 sales personnel. For the fourth quarter
of
1996, CSD revenues were $9.3 million, or approximately 7.8% of
total
consolidated revenues.
The Company bills its dial around customers through local exchange
carrier
("LEC") billing and collection agreements which enable the Company to place
its
charges on the monthly local phone bills of its casual calling customers.
The
Company has agreements with LECs, including all of the Regional Bell
Operating
Companies ("RBOCs"), that cover substantially all of the switched access
lines
in the United States. The Company believes that these billing arrangements
are
the most effective mechanism for billing the Company's residential
customers,
because of the convenience to its customers of receiving one bill for both
local
and long distance service and the benefits derived from the LECs'
extensive
collections infrastructure. The Company's billing information systems
and
services are provided by Tel Labs, Inc. ("Tel Labs"), a wholly
owned
telecommunications billing company started in 1991 by Telco's Chairman of
the
Board.
The Company's switch-based network currently consists of six DSC DEX
600S,
600 and 600E switches located in Washington, D.C.; Fort Lauderdale,
Florida;
Davenport, Iowa; Chattanooga, Tennessee; Austin, Texas and Las Vegas,
Nevada.
Additionally, the Company is installing a DEX 600E switch in the New York
City
metropolitan area which is expected to be made operational during the first
half
of 1997 and has taken receipt of an eighth switch to be installed later in
1997
in a yet undetermined location.
Future issues affecting the Company's operations for 1997 and beyond are
as
follows:
Competitive Factors. The Company has observed new entrants and
increased
competition in the Company's dial around segment. Additionally, although
the
basic rates of the largest long distance carriers available to most
residential
customers increased during 1996, the Company has also observed an increase
in
the number of promotional, discounted ca lling plans available to long
distance
consumers.
Regulatory Changes. The operations of the Company will continue to
be
affected by the ongoing events associated with the 1996 Telecommunications
Act.
Such events include access charge reform which could materially
reduce
transmission costs for both the Company and other long distance companies,
the
entrance of the RBOCs into the long distance marketplace and the ability of
long
distance companies like Telco to begin marketing local telephone services.
Availability of Transmission Facilities. The Company has observed
a
tightening in the market for the availability of leased fiber optic
facilities
connecting the Company's switches. The Company leases these facilities
under
multi-year contracts with three major vendors and, to date, has been able
to
secure the necessary facilities.
Expansion of the Commercial Sales Division. The costs associated with
the
continuing expansion of CSD are expected to reduce the Company's net income
at
least through 1997. The Company expects that the revenue growth associated
with
this division will represent a material portion of the overall growth of
the
Company.
Integration of Voice Network Acquisition. On March 11, 1997, the
Company
announced the proposed acquisition of certain voice network assets which
include
the capacity rights to 100,000 DS-3 miles of transmission capacity, 5 Nortel
DMS
250 switches and other associated telecommunications equipment. The ability
of
the Company to generate adequate ca sh flow from this asset acquisition will
be
based on the integration of these network assets into Telco's existing
network
and the resale of surplus capacity to third party customers.
Results of Operations
The following table sets forth for the periods indicated certain
financial
data as a percentage of revenues:
<TABLE>
<CAPTION>
Percentage of Revenues
Year Ended December 31,
<S> <C> <C> <C> <C>
1993 1994 1995 1996
Revenues, net 100.0% 100.0% 100.0% 100.0%
Cost of services 87.5 62.0 62.1 58.8
Gross margin 12.5 38.0 37.9 41.2
Operating expenses:
Selling, general and administrative 115.3 26.9 26.0 29.3
Depreciation and amortization 4.8 1.1 1.5 1.9
Operating income (107.6) 10.0 10.4 10.0
Interest and other 2.2 2.0 1.4 0.7
Income taxes -- 3.2 3.5 3.8
Net income (109.8%) 4.5% 5.0% 5.3%
</TABLE>
1996 Compared to 1995
Revenues. Revenues increased 99%, or $213.2 million, from $215.4
million
for 1995 to $428.6 million for 1996. The increase in revenue was due to
an
increase in billed customer minutes from both the Company's Consumer
and
Commercial Sales Divisions offset by a decline in revenue per billed minute
of
use. Total billed minutes of use were 2,963.1 million for 1996, a 114%
increase,
versus 1,384.3 million minutes for 1995. Revenue per minute of use was
$0.145
for 1996 versus $0.156 per minute of use for 1995. This revenue per
minute
decrease was primarily attributable to an increase in carrier revenue both as
a
percentage of total revenue and in aggregate, which is a lower revenue
per
minute of use product than the Company's other product lines.
Revenues for the Consumer Division were $405.7 million, a 96%
increase
versus $206.9 million for 1995. The Consumer Division expanded its
marketing
efforts during 1996 into new states through both LDWC and Dial & Save, and
also
targeted its marketing efforts into many of its existing geographical
markets.
Revenues for CDS, which consists of revenue from commercial and
carrier
customers, were $22.1 million for 1996 versus $8.5 million for 1995, a 160%,
or
$13.6 million increase. The total for both 1995 and for the first six months
of
1996 consists solely of carrier revenue.
The Company generated $0.8 million in revenue from its Tel Labs
subsidiary
for 1996, all of which occurred after Telco's acquisition of Tel Labs in
the
third quarter of 1996. The offsets to revenue increased during 1996 compared
to
1995 both as a percentage of revenue and in the aggregate due to
increased
billed customer minutes and incre ases in revenue allowances, principally due
to
increases in revenues in geographical areas where LECs require higher
holdback
percentages.
Cost of Services. Cost of services increased 88%, or $118.3 million,
from
$133.7 million for 1995 to $252.0 million for 1996. Approximately $101.8
million
of this increase was attributable to direct costs relating to LEC access
charges
and the Company's transmission of on-net and off-net traffic, all of which
was
partially offset by a decrease in per minute costs. The remaining $16.5
million
increase was the result of higher facilities lease costs associated with
the
expanded transmission network and Tel Labs expenses offset by a $0.9
million
reduction in installation charges. The cost per minute for 1996 was
$0.085
versus $0.097 for 1995. The cost per minute decrease was largely the result of
a
higher percentage of on-net traffic coupled with greater network
efficiencies
and improved off-net pricing.
Gross Margin. Gross margin increased 116%, or $94.9 million, from
$81.6
million for 1995 to $176.5 million for 1996, due to the reasons discussed
above.
As a percentage of revenues, gross margin increased from 37.9% for 1995 to
41.2%
for 1996.
Selling, General and Administrative Expense. Selling, general
and
administrative expense increased $69.7 million, or 125%, from $55.9 million
for
1995 to $125.6 million for 1996. Approximately $11.4 million of this
increase
was attributable to the direct expenses of the Commercial Sales
Division,
commenced in June 1996. Approximately $31.0 million of the increase was
the
result of higher Consumer Division marketing expenses for 1996 compared to
1995,
and the remaining $27.3 million increase was the result of higher LEC
billing
expenses, customer service costs and other corporate general and
administrative
expense generally associated with increased customer minutes of use. As
a
percentage of revenues, selling, general and administrative expense increased
to
29.3% for 1996 from 26.0% for 1995.
Depreciation and Amortization Expense. Depreciation and
amortization
expense increased by $4.7 million, from $3.3 million for 1995 to $8.0
million
for 1996. As a percentage of revenues, depreciation and amortization
expense
increased to 1.9 % for 1996 from 1.5% for 1995. The aggregate increase in
this
expense was primarily attributable to increase d depreciation expense related
to
the expansion of the Company's switch network and amortization of
goodwill
associated with the Long Distance Wholesale Club and Tel Labs
acquisitions
during 1996.
Interest Expense. Interest expense increased by $0.5 million, from
$3.0
million for 1995 to $3.5 million for 1996. This increase was due primarily
to
increased borrowings and an increase in the Company's capital lease
obligations,
partially offset by the net proceeds generated by the Company's initial
public
offering (IPO) in August 1996, which substantially reduced
outstanding
borrowings and capital lease obligations for the remainder of the year.
Net Income. Net income increased $12.1 million from $10.8 million for
1995
to net income of $22.9 million for 1996.
1995 Compared to 1994
Revenues. Revenues increased 382%, or $170.7 million, from $44.7 million
in
1994 to $215.4 million in 1995. This increase was due primarily to an
increase
in billed customer minutes of use from Consumer Division customers. During
1994,
the Consumer Division marketed dial around services in Florida,
five
mid-Atlantic states and the District of Columbia. During 1995, the
Consumer
Division expanded its mail campaigns into 21 additional states and
conducted
remailings in certain states targeted during 1994. Dial & Save and Long
Distance
Wholesale Club products were jointly marketed in two states and nine
states
during 1994 and 1995, respectively, and in the District of Columbia.
The
Company's offsets to revenues increased in the aggregate due to an increase
in
billed customer minutes.
Cost of Services. Cost of services increased 382%, or $106.0 million,
from
approximately $27.7 million in 1994 to approximately $133.7 million in
1995.
Approximately $93.4 million of this increase was attributable to direct
costs
relating to LEC access charges and from the Company's transmission of on-net
and
off-net traffic, all of which increased primarily as a result of the increase
in
the Company's billed minutes of use. Facilities lease costs increased by
$8.9
million from $1.3 million in 1994 to $10.2 million in 1995 due to the
expansion
of the Company's transmission network. Installation expenses increased from
$0.5
million in 1994 to $4.2 million in 1995 primarily as a result of
one-time
expenses associated with provisioning local network circuits at Company
switch
facilities brought on-line during 1995. During 1995, the Company deployed
three
switches, in Austin, Texas, Chattanooga, Tennessee and Davenport, Iowa, while
in
1994 the Company deployed one switch in Washington, D.C.
Gross Margin. Gross margin increased 381%, or $64.6 million, from
$17.0
million in 1994 to $81.6 million in 1995, due to the reasons discussed above.
As
a percentage of revenues, gross margin decreased from 38.0% in 1994 to 37.9%
in
1995.
Selling, General and Administrative Expense. Selling, general
and
administrative expense increased 365%, or $43.9 million, from $12.0 million
in
1994 to $55.9 million in 1995. Approximately $28.3 million of this increase
was
due to increased mail marketing expenses as the Company expanded
geographically
and remailed to certain existing markets and to increased LEC billing
costs
which are directly related to the increase in the minutes of use. In
addition,
customer service expense increased $6.8 million primarily as a result of
an
increase in customer service personnel required to service the
Company's
expanding customer base. As a percentage of revenues, selling, general
and
administrative expense decreased from 26.9% in 1994 to 26.0% in 1995
primarily
as a result of operating efficiencies associated with the Company's growth
in
revenues.
Depreciation and Amortization Expense. Depreciation and
amortization
expense increased by $2.8 million, from $0.5 million in 1994 to $3.3 million
in
1995. As a percentage of revenues, depreciation and amortization increased
from
1.1% in 1994 to 1.5% in 1995. These expenses were primarily attributable
to
depreciation related to the expansion of the Company's switch network.
Interest Expense. Interest expense increased $2.1 million from $0.9
million
in 1994 to $3.0 million in 1995. This increase was due primarily to
interest
expense associated with borrowings under the Credit Facility used primarily
to
fund working capital requirements and increases in capital leases outstanding
as
a result of the expansion of the Company's switch network.
Net Income. Net income increased $8.8 million from $2.0 million in 1994
to
$10.8 million in 1995.
Liquidity and Capital Resources
The Company conducts its operations through its direct and indirect
wholly
owned subsidiaries. There are no restrictions on the movement of cash within
the
consolidated group, and the Company's discussion of its liquidity is based
on
the consolidated group. The Company measures its liquidity based on cash flow
as
reported in its Consolidated Statements of Cash Flows.
On August 14, 1996 the Company sold 4,681,000 shares of Common Stock
(of
which 825,000 shares were sold on August 27, 1996 in conjunction with
the
underwriters' exercise of the over-allotment option) in its IPO. The
net
proceeds to the Company (after expenses) of approximately $60.0 million
were
used to repay existing indebtedness, including capital lease obligations and
the
outstanding balance on the Company's existing credit facility. The
remaining
proceeds, coupled with the Company's cash and borrowing capacity under
the
credit facility, were used to fund working capital and capital expenditures
and
for general corporate purposes.
Since commencing operations in 1993, the Company has experienced
rapid
growth requiring substantial investments in working capital,
capital
expenditures and mail marketing expenses. Additionally, start-up
costs
associated with the formation of CSD are expected to reduce the
Company's
consolidated net income at least through 1997. In December 1996, the
Company
entered into a new credit facility for borrowings up to $100 million (the
New
Credit Facility). Borrowings under the New Credit Facility are subject
to
limitations within various financial covenants and ratios including
Total
Leverage Ratio, Interest Coverage Ratio and Current Ratio. The interest rate
on
the New Credit Facility is based on the prevailing Total Leverage Ratio not
to
exceed 2.5 times and ranges on a Eurodollar (LIBOR) option from a spread
of
0.75% to 1.625%, and on a Base (Prime) Rate option from a spread of 0%
to
0.625%.
Net cash from operating activities increased $24.8 million from $0 for
1995
to $24.8 million for 1996. The increase was largely the result of increases
in
net income and depreciation and amortization expense offset by an increase
in
working capital accounts. Net cash used for investing activities increased
$2.2
million from $9.8 million for 1995 to $12.0 million for 1996.
Including
equipment acquired under capital leases, net cash used for investing
activities
decreased $5.6 million from $25.0 million for 1995 to $19.4 million for
1996.
The decrease was the result of reducing expenditures on the Company's
nationwide
transmission network. Net cash from financing activities increased $1.3
million
from $10.3 million for 1995 to $11.6 million for 1996. This increase was
the
result of the receipt of proceeds from the IPO offset by the use of
proceeds
from the IPO to reduce the outstanding debt under Company's existing
Credit
Facility and capital lease obligations.
In connection with the Company's March 11, 1997 announcement of
the
proposed acquisition of certain voice network assets for $170 million,
the
Company has received a commitment for a $100 million increase in the New
Credit
Facility, bringing the total facility, upon completion of documentation and
the
satisfaction of the other requirement s stated in the bank's commitment
letter,
to a total of $200 million. The commitment calls for an increase in the
overall
interest costs of the New Credit Facility versus those discussed above.
The
Company intends to utilize a portion of the $200 million facility along with
its
existing cash balances, to fund the purchase price of the voice network
asset
acquisition. There can be no assurance that the Company will be able to
satisfy
the requirements stated in such commitment letter necessary to obtain the
$100
million increase in the New Credit Facility and, in such circumstances,
the
Company may be forced to seek other alternatives.
<PAGE>
To the Shareholders and Board of Directors of Telco
Communications Group, Inc.,
We have audited the accompanying consolidated balance sheets of
Telco
Communications Group, Inc. and subsidiaries as of December 31, 1996 and 1995
and
the related consolidated statements of income and retained earnings, and of
cash
flows for each of the three years in the period ended December 31, 1996.
These
consolidated financial statements are the responsibility of the
Company's
management. Our responsibility is to express an opinion on these
consolidated
financial statements based on our audits.
We conducted our audits in accordance with generally accepted
auditing
standards. Those standards require that we plan and perform the audit to
obtain
reasonable assurance about whether the financial statements are free of
material
misstatement. An audit includes examining, on a test basis, evidence
supporting
the amounts and disclosures in the financial statements. An audit also
includes
assessing the accounting principles used and significant estimates made
by
management, as well as evaluating the overall financial statement
presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all
material respects, the financial position of Telco Communications Group, Inc.
and subsidiaries at December 31, 1996 and 1995, and the results of their
operations and their cash flows for each of the three years in the period
ended December 31, 1996 in conformity with generally accepted accounting
principles.
/s/Deloitte & Touche
Richmond, Virginia
February 7, 1997
<PAGE>
<TABLE>
Consolidated Balance Sheets
(In thousands, except share data)
December 31
<CAPTION>
<S> <C> <C>
1995 1996
ASSETS
Current Assets
Cash and cash equivalents $ 937 $ 25,373
Accounts receivable, trade (net of
allowances of $3,771 and $7,972
at December 31, 1995 and 1996,
respectively) 55,824 89,114
Prepaid income taxes 333 2,394
Deferred income tax asset 885 357
Other 1,112 8,947
Total current assets 59,091 126,185
Property and Equipment
Leasehold improvements 1,148 2,189
Network equipment 4,534 34,749
Office furniture 1,958 5,474
Network equipment under capital lease 19,290 --
Network facilities under development 4,076 7,375
Accumulated depreciation (3,479) (10,121)
Total property and equipment, net 27,527 39,666
Other Assets
Goodwill 245 43,663
Other assets 261 1,082
506 44,745
Total Assets $ 87,124 $210,596
Liabilities and Shareholders' Equity
Current Liabilities
Capital lease obligation, current portion 2,973 681
Excise taxes payable 1,289 3,103
Accounts payable 15,303 21,062
Accrued network access and
transmission expense 9,429 21,450
Other accrued expenses 1,322 12,670
Deferred income taxes payable -- 1,225
Payable to related parties 414 --
Total current liabilities 30,730 60,191
Long Term Liabilities
Long-term debt 28,262 --
Capital lease obligation, noncurrent 13,176 2,620
Deferred income taxes 1,353 2,065
Total long term liabilities 42,791 4,685
Minority Interest 1,183 0
Commitments and Contingencies (Note 14)
Shareholders' Equity -- --
Common stock (no par value; 150,000,000
shares authorized 32,754,869 shares
outstanding) 896 111,309
Preferred stock (15,000,000 shares
authorized, unissued) -- --
Additional paid-in capital-accumulated
deficit remaining upon termination
of S-corporation election (1,247) (1,247)
Unrealized gain on marketable securities,
net of tax -- 10
Retained earnings 12,771 35,648
Total shareholders' equity 12,420 145,720
Total Liabilities and Shareholders'
Equity $ 87,124 $ 210,596
</TABLE>
<PAGE>
<TABLE>
Consolidated Statements of Income and
Retained Earnings
(in thousands, except per share data)
Years ended December 31
<CAPTION>
<S> <C> <C> <C>
1994 1995 1996
Revenues, net $ 44,707 $215,376 $428,552
Cost of services 27,736 133,728 252,036
Gross margin 16,971 81,648 176,516
Operating Expenses:
Selling, general and administrative 12,018 55,936 125,575
Depreciation and amortization 496 3,326 7,967
Total operating expenses 12,514 59,262 133,542
Operating income 4,457 22,386 42,974
Interest expense 897 2,952 3,515
Other income (expense) 15 (92) 501
Income taxes:
Current 1,075 7,420 14,175
Deferred 357 111 2,219
Total income taxes 1,432 7,531 16,394
Minority interest 137 1,046 689
Net income 2,006 10,765 22,877
Retained earnings (deficit), beginning
of period (1,247) 2,006 12,771
Conversion of S-Corporation tax status 1,247 -- --
Retained earnings, end of period $ 2,006 $ 12,771 $ 35,648
Net income per common and common
equivalent share $ 0.07 $ 0.38 $ 0.75
Average common and common equivalent 26,884 28,285 30,533
shares
</TABLE>
<PAGE>
<TABLE>
Consolidated Statements of Cash Flows
(In thousands)
Year Ended December 31
<CAPTION>
<S> <C> <C> <C>
1994 1995 1996
Cash Flows From (Used For) Operations
Net income $ 2,006 $ 10,765 $ 22,877
Adjustments to reconcile net income to
net cash from (used for) operating
activities:
Depreciation and amortization 496 3,326 7,968
Minority interest 137 1,046 689
Loss on disposal of fixed assets -- 110 526
Deferred income taxes 357 123 2,465
Change in current assets and liabilities:
Trade accounts receivable (24,115) (30,838) (33,290)
Prepaid and other assets (1,617) 514 (6,964)
Accounts payable 1,300 13,828 7,158
Accrued expenses 8,796 2,172 23,369
Income taxes payable 741 (1,075) --
Net cash from (used for) (11,899) (29) 24,798
operating activities
Cash Flows Used For Investing
Activities:
Equipment purchases (1,301) (9,815) (11,987)
Investments, net of cash acquired (8) -- --
Net cash from (used for)
investing activities (1,309) (9,815) (11,987)
Cash Flows From Financing
Activities:
Proceeds from the line of credit 29,127 28,262 --
Payments on the line of credit (13,759) (15,367) (28,262)
Payments on capital leases (1,267) (2,376) (20,281)
Payments on short-term debt (583) (213) --
Proceeds from contributed capital 50 -- --
Repurchase of common shares (25) -- --
Proceeds from sale of options -- -- 256
Proceeds from sale of stock -- -- 59,912
Net cash from financing activities 13,543 10,306 11,625
Increase in Cash 335 462 24,436
Cash, beginning of the period 140 475 937
Cash, end of the period $ 475 $ 937 25,373
</TABLE>
<PAGE>
1. Nature of the Business and Significant Accounting Policies
Nature of Operations-The Company is a switch-based long distance
telephone
company headquartered in Chantilly, Virginia. The Company principally
provides
service to residential and commercial customers in 48 states and the District
of
Columbia.
Significant Accounting Policies:
Basis of Consolidation-The consolidated financial statements include
the
accounts of Telco Communications Group, Inc. and its wholly owned Dial &
Save
subsidiaries as well as Long Distance Wholesale Club, Telco Development Group
of
Delaware, Inc. and Tel Labs, Inc. (collectively, the Company). All
intercompany
transactions and accounts have been e liminated in consolidation (see Note 3).
Revenue Recognition-Revenue is recorded when service is rendered, which
is
measured when a long distance call is completed and is recorded net of
an
allowance for revenues which the Company estimates will ultimately be
refunded,
rebated, uncollectible or unbillable.
Sales, Advertising and Related Marketing Expenses-Costs incurred
in
connection with sales, advertising and marketing activities are recognized
in
the period in which they are incurred. Costs incurred in advance of
utilization
in sales, advertising or marketing activity are recognized as prepaid
assets
until such activity occurs. The Company had re corded prepaid advertising
and
mail marketing costs of $1,055,414, $377,745 and $1,681,898 at December
31,
1994, 1995 and 1996, respectively. These expenditures were utilized
in
promotional activities and mailings in subsequent periods and were expensed
in
the periods in which the items were mailed. The Company defers the
recognition
of certain sales commissions paid pursuant to long-term customer
commitments
(one year or greater) and recognizes the expense for the commissions over
an
estimated time in which the commissions are earned. All other sales
commissions
are expensed when incurred. As of December 31, 1996, the Company had
recorded
prepaid commissions of $737,987.
Cash and Cash Equivalents-For the purposes of reporting cash flows,
the
Company considers all highly liquid instruments with original maturities of
less
than three months to be cash equivalents.
Accounts Receivable-Accounts receivable principally consists of amounts
due
from customers. The Company contracts with Local Exchange Carriers (LECs), or
an
authorized clearinghouse, to bill and collect from its residential
customers.
The fees vary by LEC.
Marketable Securities-Marketable securities are classified as available
for
sale. These are reported at fair value with unrealized gains and losses
reported
in shareholders' equity, net of tax.
Property and Depreciation-Property, plant and equipment is recorded
it
cost. Depreciation is computed using the straight-line method on
estimated
useful lives (or lease terms, if shorter for facilities under capital leases
and
leasehold improvements) of five years. Expenditures for maintenance and
repairs
are charged to expense as incurred whereas expenditures for additions
and
replacements are capitalized. The cost and related accumulated depreciation
of
assets sold or otherwise disposed of during the period are removed from
the
accounts. Any gain or loss is reflected in the year of disposal.
Income Taxes-Income taxes are provided for the tax effects of
transactions
reported in the financial statements and consist of taxes currently due
and
deferred taxes. Deferred taxes are recognized for differences between the
basis
of assets and liabilities for financial statement and income tax purposes.
Excise Taxes Payable-Excise taxes payable represent sales and excise
tax
amounts collected which are subsequently remitted to taxing authorities.
Reclassification-Certain amounts in the 1994 and 1995
consolidated
financial statements have been reclassified to conform to the 1996
presentation.
Use of Estimates-The preparation of financial statements in conformity
with
generally accepted accounting principles requires management to make
estimates
and assumptions that affect the reported amounts of assets and liabilities
at
the date of the financial statements and the reported amounts of revenues
and
expenses during the reporting period. Actual results could differ from
those
estimates.
Net Income Per Share-Net Income per share is based on the weighted
average
number of shares of common stock and common stock equivalent shares
outstanding
using the treasury stock method. Pursuant to Securities and Exchange
Commission
requirements, common and common equivalent shares issued during the
twelve-month
period prior to the initial filing of the Company's public offering
were
included in the calculation as if they were outstanding for all
periods
presented using the treasury stock method, based on an estimated initial
public
offering price of $15.
Long-Lived Assets, Identifiable Intangibles and Goodwill-The Company
has
recorded goodwill and certain identified intangibles in connection with
its
acquisitions of Long Distance Wholesale Club, Tel Labs and Dial & Save
of
Pennsylvania. These assets are amortized over periods ranging from 5 to
35
years. Telco reviews long-lived assets, certain identifiable intangibles,
and
goodwill pertaining to those assets for impairment whenever events or changes
in
circumstances indicate that the carrying amount of an asset may not
be
recoverable. In performing the review for recoverability, the Company
estimates
the future cash flows expected to result from the use of the asset and
its
eventual dispos ition. If the sum of the expected future cash flows is less
than
the carrying amount of the asset, an impairment loss is recognized.
Stock Based Compensation-The Company, as permitted by the Statement
of
Financial Accounting Standards No. 123, 'Accounting for
Stock-Based
Compensation' (SFAS No. 123), has chosen to continue to account for stock
based
compensation using the intrinsic value method prescribed in
Accounting
Principles Board Opinion No. 25, "Accounting for Stock Issued to
Employees."
Accordingly, compensation cost for stock options is measured as the excess,
if
any, of the quoted market price of the Company's stock at the date of grant
over
the amount an employee must pay to acquire the stock. The Company has
adopted
the disclosure requirements of SFAS No. 123 (see Note 9).
2. Initial Public Offering
In August 1996, a total of 6,325,000 shares of the Company's common
stock,
no par value (the Common Shares), were sold in an initial public offering
(IPO)
at $14 per share. Certain selling stockholders sold 1,644,000 Common Shares,
and
4,681,000 Common Shares were sold by the Company which resulted in net
proceeds
to the Company of approximately $60.0 million after deducting the expenses
of
the offering.
3. Business Combinations
Long Distance Wholesale Club-Pursuant to an agreement dated April 1,
1996,
the Company acquired the remaining minority interest in LDWC in a transaction
in
which all of the remaining LDWC shares were exchanged for a total of
5,102,125
shares of the Company's common stock and LDWC became a wholly owned
subsidiary
of the Company. In connection with such transaction, all outstanding
options
under the LDWC stock option plan were converted into options to purchase a
total
of 291,842 shares of common stock under the Company's Stock Option Plan and
the
LDWC stock option plan was terminated.
In June 1995, the Company exercised its option to convert a
$250,000
short-term note receivable from its majority-owned subsidiary Long
Distance
Wholesale Club to equity in that entity. 3.046 shares of Long Distance
Wholesale
Club common stock were issued in the transaction, resulting in an increase
in
the Company's ownership interest from 55% to 55.55%.
Tel Labs, Inc.- Pursuant to the Share Exchange Agreement dated as of
June
1, 1996 and concurrent with the completion of the IPO, Tel Labs became a
wholly
owned subsidiary of the Company, and the Tel Labs shareholders received
an
aggregate of 593,334 shares of the Company+s common stock in exchange for all
of
their shares in Tel Labs. As a result of the Tel Labs share exchange
described
above, the remaining minority interest in Telco Development Group of
Delaware,
Inc. was acquired. (see Note 4)
The following represents the results of operations on a proforma basis
as
though the LDWC and Tel Labs combinations had occurred at the beginning of
the
respective periods presented:
<TABLE>
<CAPTION>
<S> <C> <C>
1995 1996
(in thousands)
Revenues, net $ 217,011 $ 430,434
Net income 10,688 23,144
Net income per share $ .37 $ .76
</TABLE>
4. Related Party Transactions
The Company leases office and switch site facilities from Bricks In
The
Sticks, Ltd., which is controlled by the Company's Chairman who is also
a
shareholder of the Company. The Company paid total rents of $63,500,
$179,420
and $221,868 for these facilities, for the years ended December 31, 1994,
1995
and 1996, respectively.
Total annual future minimum operating lease payments due to the
related
party for the above lease are as follows for the years ending December 31:
1997 $ 251,981
1998 265,127
1999 213,669
2000 13,913
2001 2,539
The Company purchased data processing services for call translation
and
rating from Tel Labs, which prior to its acquisition by Telco in August 1996
was
controlled by the Company's Chairman. The Company paid $155,000, $1,260,000,
and
$751,382 for these services for the years ended December 31, 1994, 1995
and
1996, respectively. Concurrent with the Company's initial public offering,
Tel
Labs became a wholly owned subsidiary of Telco (see Note 3).
The Company purchased computer equipment and support until May 1996
from
Telco Development Group, Inc. which is controlled by the Company's Chairman,
who
is also a shareholder of the Company. The Company paid $229,100, $779,918
and
$552,424 for these services for the years ended December 31, 1994, 1995
and
1996, respectively.
A non-management shareholder of the Company also holds a minority
ownership
interest in an international long distance services provider. This
international
provider and the Company purchase transmission services from one
another
pursuant to service agreements.
5. Allowances
Changes in the allowance for unbillable or uncollectible accounts
and
billing services fees were as follows at December 31:
<TABLE>
<CAPTION>
<S> <C> <C> <C>
1994 1995 1996
Balance at the beginning of year $ 59,763 $ 1,078,442 $ 3,771,413
Provision charged to operations 2,545,350 11,517,017 22,525,369
Write-offs, net of recoveries (1,526,671) (8,824,046) (18,324,678)
Balance at the end of year $ 1,078,442 $ 3,771,413 $ 7,972,104
</TABLE>
Amounts reducing gross revenues as a result of refunds, rebates,
and
unbilled or uncollectible revenue totaled $2,625,451, $9,143,602 and
$23,045,788
for the years ended 1994, 1995 and 1996, respectively.
6. Long Term and Other Debt
On December 27, 1996, the Company entered into a credit agreement with
a
group of banks under which the company may borrow up to $100,000,000
(the
Facility). The Facility expires on December 27, 1999. The interest rate on
the
Facility is determined either at a Prime Rate or an Eurodollar (LIBOR)
option
based on the Company's prevailing total leverage ratio as defined in the
loan
agreement. The applicable margin on the Prime Rate is from 0% to 0.625% and
on
the Eurodollar Rate from 0.75% to 1.625%. The Facility is secured by a pledge
of
stock of all the Company's subsidiaries and a negative pledge of its assets.
The
Facility contains certain financial covenants which prescribe certain
leverage,
interest coverage and working capital ratios as well as limitations on
capital
expenditures. There were no borrowings under the Facility as of December
31,
1996.
As of December 31, 1995 the long term debt consisted of a $25,000,000
line
of credit, plus interim financing of $10,000,000. The credit agreement
also
included a warrant agreement which was exercised concurrent with the
Company's
IPO (see note 11). Also concurrent with the IPO, the Company utilized
the
proceeds from the IPO to reduce the line of credit. On January 24, 1996,
the
Company entered into a two year credit agreement with a group of banks
totaling
$45,000,000. On March 20, 1996, the credit agreement was amended to
provide
$20,000,000 of additional financing. The credit agreement was secured
by
substantially all of the Company's assets and required the Company to
maintain
certain financial ratios, restricted the payment of dividends, and required
all
subsidiary companies' stock to be pledged as collateral. As a result of the
new
financing in January and March 1996, $28,261,527 was reclassified to long
term
debt at December 31, 1995.
7. Obligations Under Capital and Operating Leases
The Company leases certain equipment under capital leases. Accordingly,
the
Company has capitalized such equipment in the amount of $4,819,099,
$22,214,849
and $4,886,175 less accumulated depreciation of $412,372, $2,587,847 and $
- -0-
as of December 31, 1994, 1995 and 1996, respectively. At December 31, 1996,
100%
of such equipment was leased from one vendor. Total equipment under
capital
leases includes $1,685,000, $2,925,000 and $4,886,175 classified as
network
facilities under development, as of December 31, 1994, 1995 and
1996,
respectively.
During September and October of 1996, the Company utilized proceeds
from
the IPO to retire $20,177,000 in capital lease obligations.
Future minimum lease payments for assets under capital leases at
December
31, 1996 are as follows:
1997 $ 720,131
1998 823,006
1999 823,007
2000 823,007
2001 720,131
Thereafter 102,876
Total minimum payments 4,012,158
Imputed interest (711,426)
Net obligation 3,300,732
Current portion 681,000
Capital lease obligation, noncurrent $ 2,619,732
In addition to operating leasing activities discussed in Note 4,
the
Company leases switch sites and office space in various cities throughout
the
United States. The total minimum rental commitment as of December 31, 1996
due
in future years is as follows:
Years ending December 31,
1997 $ 718,875
1998 718,465
1999 617,454
2000 362,818
2001 49,760
Total rent expense under these leases was $68,809, $206,534 and
$614,256
for the years ended December 31, 1994, 1995 and 1996, respectively.
8. Income Taxes
The Company accounts for income taxes using the liability method,
whereby
deferred tax liabilities and assets are determined based on the
temporary
differences between the financial statements and tax bases of assets
and
liabilities by applying enacted statutory tax rates applicable to future
years
in which the differences are expected to reverse.
Significant components of income taxes are as follows for the years
ended
December 31, 1994, 1995 and 1996:
<TABLE>
<CAPTION>
<S> <C> <C> <C>
1994 1995 1996
Current:
Federal $ 822,612 $6,023,084 $11,618,476
State 252,225 1,397,387 2,556,995
Total Current $1,074,837 $7,420,471 $14,175,471
Deferred:
Federal $ 320,589 $ 91,780 $1,878,830
State 36,200 19,341 339,744
Total Deferred $ 356,789 $ 111,121 $2,218,574
</TABLE>
Temporary differences which give rise to significant components of
the
Company's deferred tax liabilities and assets for the years ended December
31,
1994, 1995 and 1996 are as follows:
<TABLE>
<CAPTION>
<S> <C> <C>
1995 1996
Deferred Tax Liabilities (current):
Bad debts-non-accrual method $ -- $(1,035,505)
Other -- (189,652)
-- (1,225,157)
Deferred Tax Liabilities (non-current):
Book over tax basis in property, plant and
equipment (1,161,939) (1,726,877)
Other (191,443) (338,802)
(1,353,382) (2,065,679)
Deferred Tax Assets (current):
Bad debts-non-accrual method 580,643 --
Other 304,126 357,212
884,769 357,212
Deferred Tax Liability, net $ (468,613) $(2,933,624)
</TABLE>
No valuation allowance has been recorded for the realization of
the
deferred tax asset resulting from the temporary differences as
management
believes that it will, more likely than not, be able to realize the deferred
tax
asset.
Reconciliation of income taxes computed at the federal statutory tax
rate
to actual income tax expense for the years ended December 31, 1994, 1995
and
1996 are as follows:
<TABLE>
<CAPTION>
<S> <C> <C> <C>
1994 1995 1996
Federal Statutory Rate 34.00% 35.00% 35.00%
Effect of:
State taxes-net of Federal benefit 6.23 4.76 4.66%
Other 1.42 1.40 2.09%
Income Tax Expense 41.65% 41.16% 41.75%
</TABLE>
9. Incentive Stock Options
On July 1, 1994, the Company adopted a stock plan which provides for
the
granting of one or any combination of incentive stock options,
nonqualified
stock options, restricted stock awards and bargain purchases of Company
stock.
In April 1996, the Board of Directors of the Company adopted and
the
shareholders of the Company approved the Telco Communications Group,
Inc.
Amended and Restated 1994 Stock Option Plan, (the "Plan") which provides for
the
grant to officers, key employees and directors of the Company and
its
subsidiaries of both "incentive stock options" within the meaning of
Section
422 of the Internal Revenue Code of 1986, as amended, and stock options that
are
non-qualified for federal income tax purposes. The total number of shares
for
which options may be granted pursuant to the Plan and the maximum number
of
shares for which options may be granted to any person is 7,500,000
shares,
subject to certain adjustments reflecting changes in the
Company's
capitalization. The Company has adopted the disclosure-only provisions
of
Statement of Financial Accounting Standards No. 123, "Accounting for
Stock-Based
Compensation". Accordingly, no compensation cost has been recognized for
the
Plan. Had compensation cost for the Company's Plan been determined on the
fair
value at the grant date for awards in 1996 consistent with the provisions
of
SFAS No. 123, the Company's net income and earnings per share would have
been
reduced to the pro forma amounts indicated below:
<TABLE>
<CAPTION>
<S> <C> <C>
1995 1996
Net income - as reported $ 10,764,912 $22,876,735
Net income - pro forma $ 10,734,973 $22,125,831
Earnings per share - as reported $ 0.38 $ 0.75
Earnings per share - pro forma $ 0.38 $ 0.72
</TABLE>
The fair value of each option grant is estimated on the date of grant
using
the Black-Scholes option-pricing model with the following weighted
average
assumptions used for grants in the following periods:
<TABLE>
<CAPTION>
<S> <C> <C> <C>
1995 1996(pre-IPO) 1996(post-IPO)
Expected lives 5 years 5 years 5 years
Expected volatility Near 0% Near 0% 110%
Dividend yield 0% 0% 0%
Risk-free interest rate 6.383% 6.175% 6.175%
</TABLE>
Information regarding the Plan for 1994, 1995 and 1996 is as follows:
<TABLE>
<CAPTION>
<S> <C> <C> <C>
1994 1995 1996
Weighted- Weighted-
Average Average
Exercise Exercise
Shares Shares Price Shares Price
Options outstanding,
beginning of year -- 1,633,487 $1.22 2,137,829 $0.54
Options exercised -- -- $0.80 (878,151) $0.80
Options granted 1,633,487 504,342 $2.61 2,482,000 $10.55
Options outstanding,
end of year 1,633,487 2,137,829 $1.54 3,741,678 $7.69
Option price range
at end of year $0.31 to $0.31 to $0.67 to
$1.85 $3.55 $18.75
Option price range
for exercised shares $0.31 to
$3.55
Options available for
grant at end of year 5,866,513 5,362,171 2,880,171
Weighted-average fair
value of options,
granted during the year $0.70 $6.09
</TABLE>
The following table summarizes information about fixed price stock
options
outstanding at December 31, 1996:
Options Outstanding Options Exercisable
-------------------- --------------------
Weighted-
Average Weighted-
Weighted-
Number Remaining Average Number
Average
Outstanding Contractual Exercise Exercisable
Exercise
Exercise Price at 12/31/96 life Price at 12/31/96 Price
$0.67 109,101 8.0 years $0.67 109,101 $0.67
$1.76 to $1.85 803,080 7.9 years $1.78 803,080 $1.78
$2.51 to $3.55 347,497 8.7 years $2.56 171,111 $3.01
$7.53 1,487,500 9.3 years $7.53 -- --
$14.00 to $18.75 994,500 9.7 years $15.08 -- --
Total 3,741,678 1,083,292
10. Supplemental Cash Flow Information
The following represents supplemental cash flow information for the
years
ended December 31, 1994, 1995 and 1996:
<TABLE>
<CAPTION>
<S> <C> <C> <C>
1994 1995 1996
Cash paid for:
Interest $ 656,958 $ 2,939,472 $ 3,324,870
Income taxes 336,598 8,223,750 10,611,427
Non-cash investing and financing
activities:
Conversion of note receivable
to equity -- 250,000 --
Equipment purchased through
capital leases 2,821,353 15,220,222 7,433,469
Business Combination:
Fair value of assets acquired 1,025,533 -- 47,388,826
Stock issued -- --
(46,629,000)
Liabilities assumed (855,173) --
(759,826)
Cash paid for common stock $ 170,360 $ -- $ --
</TABLE>
11. Capital Stock
Accumulated Deficit
Remaining Upon
Termination of Unrealized
Gains
Shares Common S-Corporation On Securities
Outstanding Stock Election Held For Sale
(in thousands)
Balance December 31, 1995: 20,864 $ 896 $ (1,247) --
Issuance of common shares 5,317 59,912 -- --
Loans to option holders (584) -- --
Purchase of subsidiary 5,696 47,725 -- --
Proceeds from exercise
of options 878 840 -- --
Tax benefit from net
warrant activity -- 2,520 -- --
Unrealized gain on marketable
securities -- -- -- $ 10
Net income -- -- -- --
Balance December 31, 1996: 32,755 $111,309 $ (1,247) $ 10
Stock Split-On June 12, 1996, the shareholders and directors executed
a
joint consent in lieu of a meeting. The joint consent provided that
effective
immediately prior to the completion of the Company's IPO, the Company declared
a
425 to 1 stock split to shareholders of record on that date. Per share
amounts
in the accompanying financial statements and footnotes have been adjusted
for
the split.
Preferred Stock-The Company has authorized but not issued 15,000,000
shares
of Preferred Stock. Such shares may be issued in one or more series with
rights,
designations, preferences, qualifications, limitations and restrictions as
may
be authorized by the Board of Directors of the Company.
Warrants-As part of the consideration for establishing the Company's
credit
facility in June 1994, the Company issued to Signet Media Capital Group,
a
division of Signet Bank, the Signet Warrant to acquire 2% of the common stock
of
the Company on a fully diluted basis. The exercise price for the warrant was
a
nominal price which was negotiated at the time the Company entered into
the
credit agreement. Concurrent with the Company's IPO, Signet Media Capital
Group
exercised the Signet Warrant in full for 636,158 shares of common stock and
sold
all shares of common stock issuable upon exercise of such warrant in the IPO.
Shareholder Loans-As of December 31, 1996 the Company had outstanding
loans
to shareholders in the amount of $584,147. The loans were made in
connection
with the concurrent exercise of options to acquire 818,773 shares of
the
Company's common stock. As a result, such loans are recorded as a
separate
component of stockholders' equity. Each of the loans were made at the
lowest
interest rate permitted by law and either will become due and payable upon
the
earlier of three years from the date of the loan; or three days after the
shares
purchased from the exercised options are sold; or due and payable the day
the
shares purchased upon exercise of the options are marginable.
12. Employee Benefit Plans
The Company implemented a 401(k) pension plan in December 1996.
Employees
are eligible to participate in the plan if they have been employed by
the
Company for six months. Generally, employees can defer up to 15% of their
gross
bi-weekly salary into the plan. The Company's contribution is to be
determined
annually by the Board of Directors. In 1995 the Company's subsidiary
Long
Distance Wholesale Club implemented a 401(k) pension plan. Concurrent with
the
formation of the Company's plan , no more contributions by the employees or
the
employer will be made to the LDWC plan. The Company contributed $11,781
and
$65,605 to the plan for the years ended December 31, 1995 and 1996.
13. Deferred Compensation Plan
The Company, through its wholly owned subsidiary LDWC, provided a
deferred
compensation plan for one of its officers. The plan provided for
annual
elections to be made by the officer of deferral amounts, such deferral to
be
made only from compensation amounts earned and otherwise payable. The
plan
required funding of the deferred compensation amount equal to the
officer's
deferral plus interest at an annual rate that was determined by the Board
of
Directors from time to time. The Company recognized expense of $257,661 in
1995
and $274,506 in 1996 related to this agreement. Amounts funded by the
Company
were $215,877 in 1995 and $363,636 in 1996.
14. Commitments and Contingencies
The Company is a party from time to time to litigation in the
ordinary
course of business including employment related litigation. No provision
has
been reflected in the accompanying financial statements for any
litigation.
Based upon information presently available, management believes the
final
disposition of these items will not have an adverse material effect
on
operations or the financial position of the Company.
During 1996, the Company entered into employment and consulting
agreements
with certain members of management. The agreements provide for the employees
to
receive amounts not less than specified base annual salaries through the
terms
of the agreements, which have terms of one to five years. Certain of
the
contracts also include non-competition covenants and options to purchase
shares
of the Company's common stock.
15. Fair Value of Financial Instruments
The carrying amounts of cash, accounts receivable, accounts payable
and
accrued expenses approximate fair value because of the short maturity of
these
items.
The carrying amounts of notes payable and debt issued pursuant to
the
Company's bank credit agreements approximate fair value because the
interest
rates on these instruments change with market interest rates.
16. Quarterly Operating Results (Unaudited)
The following amounts reflect all adjustments, consisting of only
normal
recurring accruals (except as disclosed below), necessary in the opinion of
the
Company's management for a fair statement of the results for the
interim
periods.
1995
First Second Third Fourth
Quarter Quarter Quarter Quarter
Total revenues $45,276,969 $47,317,674 $58,341,464
$64,439,376
Earnings (loss)
before income taxes 5,863,870 6,122,628 6,526,647
(216,640)
Net earnings (loss) 3,538,031 3,735,088 3,766,887
(275,094)
Net earnings (loss) per
common and common equivalent
share $ 0.13 $ 0.13 $ 0.13 $
(0.01)
1996
First Second Third Fourth
Quarter Quarter Quarter Quarter
Total revenues $91,927,548 $104,078,360 $113,768,316
$118,778,212
Earnings before income
taxes 6,415,231 8,727,375 10,412,800
13,715,374
Net earnings 3,280,690 5,185,541 6,165,852
8,244,651
Net earnings per common
and common equivalent
share $ 0.12 $ 0.18 $ 0.20 $
0.24
The Company's results for the fourth quarter of 1995 were affected
by
increased allowances, significant switch installation charges, and end
of
quarter mail marketing expenses materially exceeding those of any
previous
quarter.
17. Subsequent Events (Unaudited)
On March 11, 1997, the Company signed a definitive asset purchase
agreement
to acquire the voice networks of Advantis, a data and voice network
partnership
of International Business Machines Corp. and Sears, Roebuck and Co.,
for
approximately $170 million in cash. The Advantis assets include service
rights
to approximately 100,000 network miles of DS-3 fiber optic capacity (under
a
long term lease), five Nortel DMS 250 switches and other ancillary
network
equipment. In conjunction with the agreement, the Company has received
a
commitment for an increase in its credit facility to $200 million. The
bank
financing commitment calls for an increase in the prevailing interest
costs,
other fees and related items. The transaction is conditioned upon, among
other
things, receiving governmental approval under Hart-Scott-Rodino Act.
It
anticipated that the acquisition will be completed during the second quarter
of
1997.
INDEPENDENT AUDITORS' CONSENT
We consent to the incorporation by reference in Registration Statement
No. 333-05857 of Telco Communications Group, Inc. and Subsidiaries on Form
S-8 of our report dated February 7, 1997, incorporated by reference in the
Annual Report on Form 10-K/A of Telco Communications Group, Inc. and
Subsidiaries for the year ended December 31, 1996.
DELOITTE & TOUCHE LLP
Richmond, Virginia
September 11, 1997
