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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10-K
(MARK ONE)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED AUGUST 31, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSACTION PERIOD FROM TO
333-24881
(Commission file number)
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OPTEL, INC.
(Exact name of Registrant as specified in its charter)
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OPTEL, INC.
DELAWARE 1111 W. MOCKINGBIRD LANE
(State or other jurisdiction DALLAS, TEXAS 75247
of (214) 634-3800 95-4495524
incorporation or (Name, address, including Zip code (I.R.S. Employer
organization) of principal executive offices) Identification No.)
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Securities registered pursuant to Section 12(b) of the Securities Exchange Act
of 1934: NONE
Securities registered pursuant to Section 12(g) of the Securities Exchange Act
of 1934: NONE
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [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 registrant's knowledge, in definitive proxy or information statements
contained by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. Yes [X] No [ ]
COMMON STOCK AS OF NOVEMBER 15, 1998
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COMMON STOCK AUTHORIZED ISSUED AND OUTSTANDING
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Class A common stock, $.01 par value........ 8,000,000 164,272
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Class B common stock, $.01 par value........ 6,000,000 2,353,498
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Class C common stock, $.01 par value........ 300,000 225,000
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DOCUMENTS INCORPORATED BY REFERENCE
The following documents are incorporated into this Form 10-K by reference:
None
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PART I...................................................... 1
Item 1: Business............................................ 1
The Company............................................... 1
Recent Developments....................................... 2
Industry.................................................. 3
Strategy.................................................. 4
Markets................................................... 6
Services.................................................. 7
Network Architecture...................................... 8
Sales and Marketing....................................... 9
Strategic Relationships with MDU Owners................... 11
Competition............................................... 12
Regulation................................................ 14
Risk Factors.............................................. 24
Employees................................................. 36
Item 2: Properties.......................................... 36
Item 3: Legal Proceedings................................... 37
Item 4: Submission of Matters to a Vote of Security
Holders................................................... 37
PART II..................................................... 38
Item 5: Market for the Registrant's Common Equity and
Related Stockholder Matters............................... 38
Item 6: Selected Financial Data............................. 39
Item 7: Management's Discussion and Analysis of Financial
Condition and Results of Operations....................... 42
Overview.................................................. 42
Factors Affecting Future Operations....................... 44
Results of Operations..................................... 44
Liquidity and Capital Resources........................... 47
Year 2000 Compliance...................................... 49
Recently Issued Accounting Principles..................... 50
Inflation................................................. 51
Item 7A: Quantitative and Qualitative Disclosures about
Market Risk............................................... 51
Item 8: Financial Statements and Supplementary Data......... 51
Item 9: Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure....................... 51
PART III.................................................... 52
Item 10: Directors and Executive Officers................... 52
Item 11: Executive Compensation............................. 54
Item 12: Security Ownership of Certain Beneficial Owners and
Management................................................ 59
Item 13: Certain Relationships and Related Transactions..... 62
PART IV..................................................... 64
Item 14: Exhibits, Financial Statement Schedules and Reports
on Form 8-K............................................... 64
SIGNATURES.................................................. 68
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References in this report to the "Company" or "OpTel" mean OpTel, Inc.
together with its subsidiaries, except where the context otherwise requires.
This report contains certain "forward-looking statements" concerning OpTel's
operations, economic performance and financial condition, which are subject to
inherent uncertainties and risks, including those identified under "Risk
Factors." Actual results could differ materially from those anticipated in this
report. When used in this report, the words "estimate," "project," "anticipate,"
"expect," "intend," "believe" and similar expressions are intended to identify
forward-looking statements.
PART I
ITEM 1: BUSINESS
THE COMPANY
OpTel is a leading network based provider of integrated communications
services, including local and long distance telephone and cable television
services, to residents of multiple dwelling units ("MDUs") in the United States.
As a rapidly growing integrated communications provider ("ICP"), OpTel continues
to build upon its position as the largest provider of private cable television
services to MDUs in the United States. In each market that it serves, OpTel
seeks to become the principal competitor in the MDU marketplace to the incumbent
local exchange carrier ("ILEC") and the incumbent franchise cable television
operator by providing a package of voice, video and Internet access services at
competitive prices. OpTel believes its contractual relationships with MDU owners
and associations and its ability to deliver an integrated service offering to
MDU residents over its own networks provide it with a competitive advantage.
MDUs comprise a wide variety of high density residential complexes,
including high- and low-rise apartment buildings, condominiums, cooperatives,
town houses and mobile home communities. According to 1990 U.S. Census Bureau
data, there are more than 13.2 million dwelling units in MDUs with greater than
10 dwelling units in the United States. Within the MDU market, the Company
focuses on MDUs of 150 or more dwelling units ("Large MDUs"). Based on industry
sources, the Company believes that, within its existing markets, as of March 25,
1998, there were approximately 3.0 million dwelling units within these Large
MDUs.
The Company is currently building telecommunications infrastructure in its
serviced markets and expects, by the end of calendar 1999, to be in a position
to offer facilities based telecommunications services in each of its major
markets. The Company presently offers services where it has a right of entry
agreement ("Right of Entry") with an MDU owner to provide its cable television
and/or telecommunications services. The Company classifies a unit as "passed" if
it is within an MDU for which the Company has a Right of Entry and the Company
has connected the equipment necessary to provide services. As of August 31,
1998, the Company had 399,210 units passed for cable television services. At
that date, OpTel had 216,249 cable television subscribers and 9,244
telecommunication lines in service.
OpTel began operations in April 1993 with a strategy of consolidating the
then fragmented "private cable" television, or non-franchise cable television,
industry serving MDUs. Securing long-term Rights of Entry has been an integral
element of this strategy. The Company's Rights of Entry typically have original
terms of 10 to 15 years (five years for Rights of Entry with condominium
associations). The weighted average unexpired term of the Company's Rights of
Entry was approximately eight years as of August 31, 1998 (assuming the
Company's exercise of available renewal options). Rights of Entry generally
provide financial incentives to the property owners to promote and sell the
Company's cable television and telecommunications services to MDU residents. The
Company provides video programming to MDUs primarily under exclusive Rights of
Entry. The Company initially offered shared tenant telecommunications services
("STS") to MDUs serviced under telephone Rights of Entry utilizing remote
private branch exchange ("PBX") switches. In accordance with its communications
strategy, the Company has begun the process of migrating its STS traffic to its
own central office switches and its own network facilities. The Company intends
to grow its business by negotiating additional Rights of Entry to serve MDUs
currently served by other providers and newly-constructed MDUs, by acquiring
other existing operators that serve MDUs, as appropriate, and by providing MDUs
it currently serves for cable television with additional services, such as
telephone and Internet access.
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The Company currently provides cable television and telecommunications
services in a number of metropolitan areas including Houston, Dallas-Fort Worth,
Los Angeles, San Diego, Miami-Ft. Lauderdale, Phoenix, Denver, San Francisco,
Chicago, Atlanta and Orlando-Tampa. The Company has commenced offering central
office switched local exchange services in Houston and Dallas-Fort Worth and is
licensed as a competitive local exchange carrier ("CLEC") in each of its other
major markets. The Company selected its current markets based upon their growth
characteristics, competitive conditions, MDU concentrations, favorable
demographics and regulatory environment.
Since April 1995, OpTel has been indirectly majority owned by Le Groupe
Videotron Ltee ("GVL"), which also owns the second largest cable television
operator in Canada (based on number of subscribers). GVL has invested
approximately $250 million in OpTel in the form of equity capital and
subordinated convertible notes (including accrued interest). See "-- Recent
Developments." These invested amounts have been critical to OpTel's growth. In
addition, key members of the Company's management team gained experience in the
competitive offering of telecommunications and cable television to residential
markets while serving as executives of a GVL affiliate in the United Kingdom.
OpTel management's extensive operating experience in both the telecommunications
and cable television industries, including the construction and design of
networks and sales and customer support, provides OpTel with significant
expertise in managing and developing an infrastructure to support voice, video
and Internet access operations.
OpTel was incorporated in Delaware in July 1994 as the successor to a
California limited partnership that was organized in April 1993. The Company's
principal offices are located at 1111 W. Mockingbird Lane, Dallas, Texas 75247,
and its telephone number is (214) 634-3800.
RECENT DEVELOPMENTS
The Company commenced operating a central office telephone switch in
Houston in September 1997 and has migrated most of its telecommunications
subscribers in the Houston market to this switch. The Company has recently
commenced operating a central office telephone switch in the Dallas-Fort Worth
market and intends to migrate the MDUs it currently serves through PBX switches
in that market to that central office switch over the coming months.
Effective March 1, 1998, the Company's majority stockholder, VPC
Corporation ("VPC"), an indirect wholly-owned subsidiary of GVL, exchanged
$139.2 million of the Company's 15% Convertible Notes (the "GVL Notes"),
constituting all of the outstanding GVL Notes (including accrued interest), for
approximately 6,962 shares of the Company's 9.75% Series A Preferred Stock, par
value $.01 per share, (the "Series A Preferred").
On April 13, 1998, OpTel completed the acquisition of the private cable
television and telecommunications service agreements and related assets of
Interactive Cable Systems, Inc. ("ICS") in Houston, Dallas-Fort Worth, Los
Angeles, San Diego, Miami-Ft. Lauderdale, Phoenix, Denver, San Francisco,
Chicago, Atlanta, Orlando-Tampa, Indianapolis, Austin and greater Washington,
D.C. (the "ICS Operations"), subject to the consummation of certain transfer
conditions. As of October 31, 1998, OpTel had acquired approximately 78,000
cable television and telecommunications units under contract (or approximately
87% of the approximately 90,000 units under contract to be acquired). A
corresponding percentage of the aggregate $83.4 million purchase price remains
in escrow subject to release upon fulfillment of transfer conditions. While the
Company expects the transfer of the remaining units to be completed over the
next few months, the transfer of these units is subject to certain conditions,
including the receipt of third party consents, and there can be no assurance
that the transfer of all or part of the balance of the acquisition will be
completed. See "Risk Factors -- Risks Associated with Acquisitions." The Company
also services, under a management agreement, the approximately 12,000 units with
respect to which, as of October 31, 1998, there remained unsatisfied transfer
conditions. Pursuant to its management agreement with ICS, during the management
period, the Company receives all the revenues from and incurs the expenses
associated with delivering services to such units. The $83.4 million purchase
price comprises approximately $4.8 million in cash, approximately $16.1 million
in shares of the Company's Class A Common Stock, par value $.01 per share (the
"Class A Common Stock"), approximately $59.5 million in shares of the Company's
8% Series B Preferred Stock, par
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value $.01 per share (the "Series B Preferred") plus assumed liabilities of $1.6
million and including transaction costs of approximately $1.4 million.
On June 5, 1998, OpTel filed a registration statement on Form S-1 with the
Commission with respect to a proposed initial public offering (the "IPO") of
$100.0 million of its Class A Common Stock. No assurance can be given that the
IPO will be consummated or, if consummated, when it will be consummated or that
the proceeds received by the Company will be the amount currently contemplated.
On July 7, 1998, the Company consummated a private placement of $200
million principal amount of 11.5% Senior Notes due 2008 (the "11.5% Senior
Notes"). In October 1998, the Company commenced an exchange offer in connection
with the 11.5% Senior Notes. On November 19, 1998, $200 million principal amount
of the 11.5% Senior Notes were exchanged for a series of notes (the "Registered
Notes") registered under the Securities Act of 1933, as amended (the "Securities
Act"), with terms substantially identical to those of the 11.5% Senior Notes.
(The Registered Notes and the 11.5% Senior Notes are referred to interchangeably
as the "1998 Notes".) The net proceeds of the 1998 Notes were approximately
$193.5 million. Of this amount, approximately $126.3 million was used to repay
all outstanding amounts under the Company's senior secured credit facility (the
"Senior Credit Facility") and to pay other costs associated with terminating the
Senior Credit Facility (the "Senior Credit Facility Retirement"), and
approximately $22.0 million was placed in an escrow account to fund the first
two interest payments on the 1998 Notes.
INDUSTRY
Widespread Changes in Communications Industry
Both the telephone and cable television segments of the communications
industry are currently undergoing widespread changes brought about by, among
other things, (i) decisions of federal and state regulators which have opened
the monopoly local telephone and cable television markets to competition, (ii)
the ensuing transformation of the previously monopolistic communications market
controlled by heavily regulated incumbents into a consumer-driven competitive
service industry and (iii) the need for higher speed, higher capacity networks
to meet the increasing consumer demand for expanded communications services
including broader video choices and high speed Internet services. The
convergence of these trends has created opportunities for new types of
communications companies capable of providing a wide range of voice, video and
data services.
Opening of Communications Markets
Divestiture of the Bell System. Until the passage of federal legislative
reform in 1996 and other state and federal regulatory efforts to expand
competition into the local telephone market, the structure of the U.S.
telecommunications industry was shaped principally by the 1984 court-supervised
divestiture of local telephone services from AT&T, Inc. ("AT&T") (the
"Divestiture") and other judicial and regulatory initiatives which were designed
primarily to implement structural and technical industry changes through which
competition could develop in the long distance market. Under this structure, the
regional Bell operating companies ("RBOCs") and certain other local exchange
carriers ("LECs") were permitted to retain their monopolies in the provision of
local exchange services, but were required to connect their local subscribers to
the long-distance services of AT&T and other interexchange carriers ("IXCs").
Under this regime, two distinct industry segments developed; competitive IXCs,
which offered subscribers long distance telephone services between judicially
defined local access and transport areas ("LATAs"), and monopoly LECs, which
offered subscribers local and toll services within judicially defined LATAs,
including connection (or "access") to IXCs for interLATA long-distance services.
As a result, the long-distance business became intensely competitive, with low
barriers to entry and many service providers competing in a commodity-type
market, while providers of local exchange services continued to face relatively
little competition.
Deregulation of Local Telephone Services. After the structural and
technical network changes were put in place following the Divestiture to give
IXCs other than AT&T "equal access" to the local exchange facilities of the
monopoly ILECs, and with long-distance competition beginning to provide
consumers with diverse services and lower rates, regulatory policy makers
gradually began to examine whether the competitive
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benefits which were being experienced in the long-distance marketplace as a
result of Divestiture should be expanded to local exchange services. While a
small number of states and the Federal Communications Commission ("FCC") had
already adopted rules and regulations which opened certain limited and discrete
segments of the local exchange market to competition from competitive access
provides ("CAPs") and CLECs offering primarily dedicated high-speed private line
and some local switching services to large business users, the passage of the
Telecommunications Act of 1996 (the "Telecom Act") codified the pro-competitive
policies on a national level and required both the FCC and the state regulatory
commissions to adopt significant changes in their rules and regulations in
furtherance of those policies. The Telecom Act required regulators to remove
market entry barriers and to enable companies like OpTel to become full service
providers of local telephone service by, among other things, mandating that the
ILECs provide interconnection and competitively priced network facilities to
competitors. In addition, the Telecom Act permits RBOCs to offer long-distance
interLATA services in competition with IXCs once they have demonstrated that
they have implemented changes to permit economically efficient competition in
their local markets for both business and residential services. The Telecom Act
also repealed the LEC/cable television cross-ownership restriction, which
prohibited LECs from providing multichannel television directly to subscribers
in their telephone service areas. See "-- Regulation."
Deregulation of Cable Television. Unlike the local telephone market, the
cable television market is not subject to regulatory or statutory prohibitions
on competition. Nevertheless, competition to incumbent franchised cable
television operators has developed in very few of markets nationwide. Because of
the lack of any meaningful competition, in 1992 Congress passed legislation
providing for the regulation of certain cable rates. Subsequently, as part of
its general goal of supplanting regulation with competition, the Telecom Act
took further steps to provide alternative regulatory structures to encourage
entry into the multichannel video programming distribution market.
OpTel's Opportunity. The incumbent local telephone and cable television
providers to date have generally been slow to expand their services beyond their
traditional lines of business. In particular, the LECs generally have not
offered video programming services, nor have the incumbent cable operators
generally entered the telephone services market. In addition, most of the other
new competitive entrants, including most CLECs, have focused almost exclusively
on providing telephone service to medium to large commercial customers and have
tailored the coverage area of their networks and the configuration of their
business operations to provide services accordingly. Similarly, while a number
of companies have begun to market wireless alternatives to cable television
service, those companies have not generally begun to offer telephone services to
their customers.
Typically, the last mile connection between an ILEC and its customer is a
copper wire twisted pair and the last mile connection of a cable television
company is coaxial cable. The Company believes that in its markets, it is the
only competitor able to serve a single subscriber with both twisted pair and
coaxial cable last mile connections. Accordingly, OpTel believes that it is
well-positioned to take advantage of the new regulatory and market environment
and that it will be among the first to offer a single-source package of
integrated voice, video and Internet access services in its MDU markets. By
combining the enhanced telephone and Internet access services offered by CLECs
with high quality video programming, OpTel will act as a single source provider
of a wide range of voice, video and Internet access services to the MDU market.
OpTel's integrated service offerings are available either individually or in
bundled packages, providing the consumer with added choice and convenience.
STRATEGY
OpTel's goal is to become the nation's largest ICP focusing on MDU markets.
OpTel's strategy for achieving this goal includes the following key components:
Provide an Integrated Service Offering. OpTel believes that by utilizing a
single advanced network infrastructure it can be among the first to market a
competitive integrated package of voice and video services in its target
markets. OpTel focuses exclusively on the integrated communications needs of the
MDU resident, which distinguishes OpTel from other competitors. OpTel believes
that MDU residents are attracted by
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bundled service offerings, competitive pricing and integrated billing. The
Company plans to supplement its voice and video offerings with high speed
Internet access in all of its serviced markets. The Company also intends to
introduce integrated billing of its bundled services during fiscal 1999.
Deploy Cost Effective Networks. OpTel's networks are specifically designed
to provide services to MDUs. The Company uses a combination of point-to-point
microwave transmission equipment and fiber optic cable in order to offer a
single source for video, voice telecommunications and eventually high speed
Internet access services. A substantial amount of the capital required to
provide property-specific voice and video services to an individual MDU is
invested only after the Company and the owner of the MDU have entered into a
Right of Entry for the MDU. The capital expenditures required to serve an MDU
are therefore, to a large extent, "success-based" and will only be incurred
shortly before properties are first brought into service or as needed to bring
non-network served MDUs onto the Company's networks. In markets served by the
Company's microwave networks, OpTel expects that the incremental capital
required for it to launch central office switched telecommunications services
and to connect customers will be lower than that of its competitors. Unlike
copper- and fiber-based systems that require installation and maintenance of a
significant amount of wire and cable, the Company's microwave networks generally
will not require the installation and maintenance of physical wires between the
MDU based equipment and the Company's Network Hubs (as defined under "-- Network
Architecture"). As a result, OpTel expects to enjoy a lower network cost
structure than certain of its competitors.
Pursue Focused Marketing Strategy. Strategic relationships with MDU owners
are a key element of the Company's marketing strategy. The Company negotiates
long term Rights of Entry with MDU owners under which the Company obtains, among
other things, the exclusive right to provide cable television services to an MDU
or group of MDUs and an undertaking by the MDU owner to promote OpTel as the
preferred telecommunications alternative to the ILEC within the MDU. The Rights
of Entry generally provide MDU owners with financial incentives to work closely
with the Company to promote its products and services. The Company offers
prospective customers the opportunity to subscribe for Company services at the
same time they sign their unit leases. The Company believes this access, coupled
with customer preference for a single source of cable television and
telecommunications services, significantly enhances its customer marketing
efforts. In addition, the Company markets to MDU residents through (i) direct
mail and direct sales campaigns, (ii) special promotion and sign-up parties,
(iii) establishment of a physical presence at a MDU and (iv) distribution of
point-of-sale marketing materials.
Provide Superior Customer Service. The Company believes that superior
customer service is important to MDU residents. Therefore, the Company has
dedicated resources to providing services that attract and retain subscribers.
The Company has a national customer service center staffed with knowledgeable
representatives to address the needs of customers 24-hours-a-day,
seven-days-a-week. The Company has established direct lines to facilitate rapid
response to calls initiated by MDU owners and managers. The Company also has
dedicated local service teams that provide prompt installation and response to
customer service calls. Because the Company believes that the best way to
control the quality and consistency of technical and field services is to train
and supervise the service technicians, the Company relies primarily on its own
personnel to perform these functions. The Company also has established stringent
staff training procedures, including its Operational Excellence continuous
improvement program, and internal customer service standards.
Pursue Selective Acquisitions and Strategic Relationships. To expand its
markets and to achieve critical mass in its existing markets, the Company often
evaluates opportunities to make acquisitions. Since May 1996, the Company has
completed six acquisitions representing approximately 700 MDUs served and
103,000 subscribers. In addition, the Company has entered into a strategic
relationship for the delivery of high speed Internet access services and will
continue to evaluate other alliances, including those permitting it to host
additional third-party traffic on its switches.
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MARKETS
Historically, the Company's strategy has been to enter markets either
through the acquisition of private cable television operators serving the target
market or by entering into Rights of Entry with a major MDU owner in the market.
Upon acquisition of an operator, the Company historically has begun the process
of upgrading the acquired systems by converting MDUs from satellite master
antenna television ("SMATV") technology to the Company's microwave or, in
Houston, to fiber optic networks, adding additional programming and improving
customer service. In addition, the Company has been able to achieve cost
efficiencies by consolidating acquired operations into its existing
organization. The Company's strategy for entering new telecommunications markets
is through the deployment of network infrastructure and interconnecting such
infrastructure to the Company's existing video distribution network. See
"-- Network Architecture."
The following table sets forth, as of August 31, 1998, the markets where
OpTel currently operates and, for each such market, certain additional
information including the date the Company launched, or intends to launch, its
central office switched telecommunications service offering. The timing and
order of the launch of central office switched telecommunications services in
each of the Company's markets may vary and will depend on a number of factors,
and no assurance can be given the Company will launch such services in each of
its markets.
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CABLE
UNITS PASSED TELEVISION TELECOMMUNICATIONS EXPECTED CLEC SERVICES
LOCATION FOR CABLE(1) SUBSCRIBERS LINES IN SERVICE LAUNCH DATE
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Houston............................. 138,814 66,467 2,682 In service
Dallas-Fort Worth................... 51,465 25,031 3,385 In service
Los Angeles......................... 20,464 13,088 103 Fiscal 1999
San Diego........................... 23,037 13,432 146 Fiscal 1999
Miami-Ft. Lauderdale................ 21,936 17,112 148 Fiscal 1999
Phoenix............................. 26,154 10,265 358 Fiscal 1999
Denver.............................. 18,939 10,763 338 Fiscal 1999
San Francisco....................... 23,648 16,254 87 Fiscal 1999
Chicago............................. 29,708 18,082 117 Fiscal 1999
Atlanta............................. 12,550 7,445 169 Fiscal 2000
Orlando-Tampa....................... 17,231 10,184 286 Fiscal 2000
Other markets(2).................... 15,264 8,126 1,425
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Total(3).................. 399,210 216,249 9,244
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(1) Units passed represents the number of units to which the Company has
connected its cable television systems. As of August 31, 1998, the Company
had connected telecommunications infrastructure at only 35,671 units.
(2) Other markets include Austin, Corpus Christi and San Antonio, Texas; Daytona
Beach and Tallahassee, Florida; Las Vegas, Nevada; Indianapolis, Indiana;
and greater Washington, D.C. Other than with respect to Austin, Texas and
Indianapolis, Indiana, the Company has not yet decided whether to
concentrate in these markets and launch telecommunication services or to
dispose of assets in these markets.
(3) Includes 15,156 units passed for cable, 8,317 cable television subscribers,
and 254 telecommunications lines in services related to the portion of the
acquisition of the ICS Operations for which, as of August 31, 1998, the
transfer conditions had not yet been satisfied.
The Company installed its first central office switch in the Houston market
in October 1997 and currently offers switched access local exchange services to
most of its telecommunications customers in Houston. The Company installed,
activated and tested its central office switch in the Dallas-Fort Worth market
in April 1998 and is currently providing switched access local exchange services
to select customers in Dallas-Fort Worth. As of August 31, 1998, the Company had
50,640 units under contract and 24,081 units passed for telecommunications in
Houston and Dallas-Fort Worth. The Company intends to progressively commence
full scale marketing of local exchange based telecommunications services in all
of its major markets by the end of calendar 1999. The Company is licensed as a
CLEC in all of its major markets and has completed or is negotiating
interconnection agreements with the principal ILECs in each of these markets.
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SERVICES
OpTel provides a wide range of voice, video and Internet access services,
both individually and as integrated service offerings.
Voice. OpTel's telephone Rights of Entry generally provide that the MDU
owner will market exclusively OpTel's local telephone services to MDU residents.
In the markets where it has central office switches, OpTel offers local exchange
telephone service, including standard dial tone access and substantially all
other feature groups provided by the ILEC. OpTel offers a wide range of
value-added services, including call forwarding, call waiting, caller
identification, conference calling, speed dial, calling card, 800-numbers and
voice mail. OpTel generally prices its local telephone offering at a discount to
the ILEC rates in each of its serviced markets. OpTel also provides long
distance services, including outbound, inbound and calling card services. OpTel
contracts or plans to contract for other ancillary services, including operator
service, directory listings and emergency 911 service and, in certain markets,
transport, from the local ILEC and other service providers.
The Company currently provides telephone service under two regulatory
frameworks. In Houston and Dallas-Fort Worth, the Company provides telephone
services as a CLEC through Company owned central office switches. In other
markets, and to a limited extent in Houston and Dallas-Fort Worth, OpTel
provides telephone services as an STS provider. The Company intends to convert
substantially all of its STS telephone operations to CLEC operations and to
provide switched access local exchange services to substantially all of its
telephone customers by the end of calendar 1999.
Video. OpTel offers its subscribers a full range of popular cable
television programming at competitive prices. The Company's networks are capable
of delivering up to 72 uncompressed analog channels of programming. The Company
offers various programming packages to its cable television subscribers. The
Company's basic video programming package provides extensive channel selection
featuring all major cable and broadcast networks. The Company's premium video
programming package features uninterrupted, full-length motion pictures,
sporting events, concerts and other entertainment programming and includes HBO,
Cinemax, Showtime and The Movie Channel, as well as supplementary channels such
as HBO 2, HBO 3 and Cinemax 2. Premium services are offered individually or in
discounted packages with basic or other services. Certain of the Company's
systems are capable of offering movies, sporting events, concerts and other
special events on a pay-per-view basis.
In addition, the programming selections available at an MDU served by the
Company's microwave networks can be tailored to the demographics of each MDU
and, unlike franchise cable television systems which may be required to carry
all local broadcast channels and public access channels, the Company's microwave
networks can utilize all of their available channels to provide popular
entertainment, news and information programming.
The Company's programming packages are generally competitively priced
compared to similar packages offered by the incumbent franchise cable television
operator.
To enhance its video programming offerings, the Company has made
arrangements with a direct broadcast satellite ("DBS") service provider for
distribution of additional video programming via DBS technology. The Company
currently provides this programming on a limited basis to MDUs in its San
Francisco and Miami-Ft. Lauderdale markets using a single, standard direct
broadcast satellite receiving antenna at each serviced MDU. The DBS signal is
received in digital form, converted at the MDU receiver site to analog form and
over coaxial cable distributed to the subscriber's unit. DBS transport permits
the Company to provide basic programming or to supplement the Company's other
programming services.
High-Speed Internet Access. OpTel currently provides Internet access
service to residents of certain properties in the Houston market in
collaboration with a local Internet service provider ("ISP") and a local CAP.
OpTel has recently initiated a high-speed Internet access service in Dallas-Fort
Worth in conjunction with I(3)S, Inc. ("I(3)S"), an ISP. The Company and I(3)S
have a strategic alliance to provide high-speed Internet services in the
Company's major markets. The Company intends to roll out its high speed Internet
access service in substantially all of its major markets prior to the end of
fiscal 2000.
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The Company expects to offer customers a choice of transmission speeds
ranging from approximately 64 kilobits ("KB") per second (normal dial-up
Internet speed is typically 28.8 KB per second) to 10 megabits ("MB") per
second. In MDUs where data transport is to be provided via the Company's
networks, the Company expects to be able to offer transmission speeds of up to
10 MB per second. In MDUs where the Company utilizes leased transport
facilities, the Company may choose to offer transmission speeds of up to 1.5 MB
per second; however, higher transmission speeds could be offered through the
lease of incremental bandwidth. Internet connections providing transmission
speeds over 0.5 MB per second are generally referred to as "high-speed." The
transmission speeds that the Company intends to offer will greatly exceed the 64
KB per second speed available from many LECs through Integrated Services Digital
Network ("ISDN") technology.
OpTel initially will connect each property to the ISP's point of presence
using OpTel's microwave transport or its owned or leased fiber transport. At
each property, the data stream will be carried to the subscriber's unit via the
property's existing coaxial cable distribution wiring. The subscriber will
connect a personal computer to the high-speed Internet service using software
provided by the ISP and the subscriber's cable modem which will be connected to
a standard cable television outlet.
Wholesale Services to ISPs. The Company believes that with the recent
growth in demand for Internet services, numerous ISPs are unable to obtain
network capacity rapidly enough to meet customer demand and eliminate network
congestion problems. The Company plans to supplement its core end user product
offerings by providing a full array of local services to ISPs, including
telephone numbers and switched and dedicated access to the Internet.
NETWORK ARCHITECTURE
The Company's strategy is to deliver all of its service offerings through
integrated networks. The Company uses a combination of point-to-point microwave
transmission equipment and fiber optic cable in order to offer a single source
for video, voice telecommunications and eventually high speed Internet access
services. As of October 31, 1998, the Company had 51 microwave networks in
service in eleven metropolitan areas, and, in Houston, three fiber optic
networks, covering over 400 route miles. In order to integrate service
offerings, the Company actively adds properties it services within existing
network coverage to these networks and seeks to cost effectively develop new
networks to cover MDU clusters serviced by the Company in new or expanded
markets.
To maximize network coverage of its microwave networks, the Company
establishes hubs designed to service MDU clusters (each a "Network Hub").
Network Hubs usually are located on rooftops or towers. The network is extended
from the Network Hubs to the serviced MDUs via point-to-point microwave. Each
Network Hub includes equipment to receive and transmit the Company's video
programming. The signal is transmitted to a receiving dish at the MDU which must
be within the line of site of the Network Hub or a repeater site. To ensure
transmission quality, the Company limits the radius of each microwave link to
between four and ten miles, depending on topographic and climatic conditions.
Within the MDUs it serves, the Company distributes video programming via
conventional coaxial cable. The on-property network uses a combination of traps
(electronic filtering devices), addressable decoder-converter boxes and
interdiction.
OpTel's network design is digital capable. All voice traffic over OpTel's
networks is digitally compressed. The networks will facilitate digital
compression for video signal when economical and required by the marketplace. If
OpTel is required to carry digital broadcast programming (e.g., high definition
television ("HDTV")), then the networks may be upgraded to transmit such
programming without material architectural change. See "-- Regulation."
The Company transports video programming to MDUs which are not yet on the
Company's networks by receiving video programming at a self-contained SMATV head
end located at the MDU. The Company intends to convert the vast majority of its
SMATV systems to microwave or fiber optic networks by the end of fiscal 2000.
See "-- Regulation."
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To roll out its central office switched voice telecommunications offering
in areas covered by its microwave networks, the Company will link certain of its
Network Hubs to both the central office switch and other Network Hubs to form a
network backbone. This network backbone will utilize either of 6GHz or 11GHz
microwave or fiber optic transmission capacity to form synchronous optical
network ("SONET") self-healing rings that provide high speed redundant
connections for the delivery of voice traffic. Where it uses fiber, the Company
either will install its own fiber optic facilities or on a limited basis will
lease fiber from other providers. Voice traffic will be delivered from a Network
Hub to a serviced MDU over 23GHz microwave links. The 23GHz microwave links will
use the same microwave transmission equipment that is used to relay video
signal. Voice traffic is delivered to the individual unit using a traditional
copper wire twisted pair. The Company has recently commenced offering network
based central office switched telecommunication services in Houston over its
fiber optic networks and in Dallas-Fort Worth over its microwave networks.
The Company has chosen the 5ESS-2000 digital switch manufactured by Lucent
Technologies Inc. ("Lucent"). Unlike traditional long distance or local
switches, the Lucent switch enables the Company to provide local and long
distance services from a single platform. This uniform and advanced switch
platform enables the Company to (i) deploy features and functions quickly in all
of its networks, (ii) expand switch capacity in a cost effective manner and
(iii) lower maintenance costs through reduced training and spare part
requirements. The Company expects to continue to deploy Lucent switches to
provide a consistent technology platform throughout its network. The Company
will use its networks to aggregate MDU long distance and local traffic at its
central office switch. As an initial entry strategy in certain markets, the
Company intends to lease telecommunication switch capacity in certain markets
from third-party providers in order to accelerate the roll out of telephone
services and to migrate telecommunications services to its own switch over time.
OpTel has entered into an agreement with a national CLEC, pursuant to which
OpTel may purchase local telephone service and local loop elements. During any
time period and in any market that the Company is purchasing such services from
the CLEC, the CLEC has the exclusive right to provide OpTel with these services.
OpTel is required to maintain each service ordered for a 24-month minimum
period.
From time to time, prior to or in lieu of establishing a microwave link for
telecommunications services, the Company may lease transport (T-1 service) from
another facilities based carrier. The Company is also studying collocating
certain of its facilities at ILEC switch offices as a means of providing
telecommunications services. Under this type of arrangement, the Company will
provide its own switching but will purchase local loops from the ILEC to connect
the switch to the serviced customer.
In areas where the Company offers telecommunications services but where it
has not yet migrated to its networked central office switch architecture, a PBX
switch is installed at the MDU and traffic from the MDU is transported via
leased trunk lines to the LEC's central office. From the LEC's central office,
local calls are routed through the LEC's network. The Company intends to convert
all of its PBX serviced properties to its central office switched
telecommunications offering.
OpTel has contracted with a third party to monitor its central office
switches and certain network elements connected to those switches. In 1999,
OpTel will establish a Network Operations Center to internalize the functions
now provided by the third party and to enhance monitoring, control and
maintenance of its networks. OpTel's Network Operational Center will be located
at its Dallas headquarters and will be staffed 24-hours-a-day,
seven-days-a-week. The Network Operations Center will monitor and manage OpTel's
central office telephone switches, PBX switches and certain additional elements
of its telecommunications and cable television networks.
SALES AND MARKETING
A critical aspect of the Company's sales and marketing efforts is the
development of strategic contractual relationships with MDU owners. These
relationships encourage the owners to promote and sell the Company's cable
television and telecommunications services to MDU residents. The Company intends
to grow its business by negotiating additional Rights of Entry to serve MDUs
currently served by other providers and newly-constructed MDUs, by acquiring
other existing operators that serve MDUs, as appropriate, and by
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providing MDUs it currently serves for cable television with additional
services, such as telephone and Internet access.
The Company tailors its sales and marketing efforts to two different
constituencies: (i) owners of MDUs and their agents and (ii) residents at MDUs
for which the Company has obtained Rights of Entry. Each constituency is served
by a separate sales and marketing team.
Sales and Marketing to MDU Owners
The Company maintains a full-time professional sales force dedicated to
securing Rights of Entry from owners of MDUs. Many of the Company's sales
representatives have previous experience in commercial real estate sales and
leasing. The Company has developed an incentive compensation plan for sales
personnel which the Company believes encourages sales personnel to target MDUs
with more favorable demographic characteristics.
Marketing to local MDU owners is conducted primarily by (i) using
established relationships with property developers, owners and management
companies, (ii) direct mail and direct sales campaigns to owners and apartment
managers, (iii) canvassing MDU owners with properties within the coverage of the
Company's existing and planned networks and (iv) attending and participating in
trade shows, conventions and seminars targeted to the MDU industry. In addition,
the Company markets to owners of large multiregional portfolios of MDUs via a
dedicated sales team. When marketing to MDUs, the Company emphasizes the
following competitive advantages:
New Revenue Source for MDU Owner. An MDU owner who enters into a Right of
Entry with the Company generally receives a percentage of the revenue generated
by the MDU. The revenue sharing percentages generally range between six and ten
percent of such revenue, are often scaled based on penetration and are fixed
over the term of the Right of Entry. The Company may from time to time pay
up-front "key-money" in lieu of or in combination with revenue participation.
While some franchise cable television operators and ILECs now offer revenue
sharing and access fee arrangements to some MDU owners, it is the Company's
experience that neither the ILECs nor the incumbent franchise cable television
operators are generally willing to offer broad-based, revenue-based incentive
compensation to MDU owners.
Property Enhancements. The Company often installs a package of
telecommunications and security enhancements at the MDUs it serves, at a nominal
cost or at no cost to the MDU owner. For example, the Company can install a
monitoring camera at the main entrance that permits MDU residents to identify
guests by tuning their television set to the building's security channel. In
addition, the Company often provides a dedicated information channel that
permits the building's management to send messages to the MDU residents over the
private cable television system. These enhancements are relatively inexpensive
for the Company to provide and can be important to MDU owners and property
managers.
New Marketing Tool and Amenity to Rent Apartments. The principal concern of
an MDU owner is to rent apartments. The Company believes that its services and
property enhancements can serve as an important marketing tool for owners to
attract prospective tenants because its services are generally provided at a
price competitive with those charged by the franchise cable operator and lower
than those charged by the ILEC and long distance carriers. The Company works
with on-site managers to emphasize the benefits of the Company's services and
the added value and convenience provided by the Company. The Company also
maintains direct lines to facilitate rapid response to customer support calls
initiated by MDU owners and managers.
Marketing to MDU Residents
Once an MDU owner executes a Right of Entry, the Company aggressively
markets its services to actual and potential subscribers within the MDU in order
to increase penetration rates for basic and additional services. The Company
believes that its best opportunity for a sale arises when a resident first signs
a lease and takes occupancy in an MDU. Accordingly, the Company believes that
during the first few years after it activates cable television or
telecommunications services at an MDU it benefits from the high rate of MDU
resident turnover. The Company has developed orientation and incentive programs
for on-site property
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managers and leasing agents, with the objective of enlisting them as the
Company's subscriber sales force. In addition, the Company markets to MDU
residents through (i) direct mail and direct sales campaigns, (ii) special
promotions and sign-up parties, (iii) establishment of a physical presence at a
building and (iv) distribution of point-of-sale marketing materials. The Company
stresses the following themes when marketing its services to MDU tenants:
Simplicity and Convenience. In general, a subscriber can order any of the
Company's services through the MDU's leasing agent at the time of lease signing.
In addition, in certain of its markets, the Company is able to provide one-stop
shopping for both cable television and telecommunications services.
Competitive Pricing. The Company believes it offers a competitive
telecommunications offering and cable television channel line-up (often
including pay-per-view and premium services) at prices that are generally
competitive with those charged by the ILEC and local franchise cable television
operator. Upon introduction of its integrated billing system, the Company plans
to offer pricing incentives to purchase more than one service from OpTel.
Superior Video Offering. The number of channels provided by the Company at
an MDU generally equals or exceeds that of the local franchise operator in that
market. In addition, the programming selections available at an MDU served by
the Company's microwave networks can be tailored to the demographic
characteristics of the MDU and, unlike franchise cable television systems which
may be required to carry all local broadcast channels and public access
channels, the Company's microwave networks can utilize all of their available
channels to provide popular programming.
Better Service and Quality. The Company is upgrading its networks and
support systems to ensure continued reliable, high quality delivery of a range
of cable television and telecommunications services and expanding its offerings
to encompass a broad range of value-added telecommunications services. The
Company is committed to providing excellent customer service. The Company
believes the most effective means of attracting and retaining MDU owners and
subscribers is by providing high quality subscriber service, including: (i)
maintaining a 24-hour-a-day, seven-day-a-week subscriber telephone support, (ii)
computerized tracking of all incoming calls to minimize waiting times, (iii)
scheduling service calls generally the same day the subscriber indicates a
service problem, (iv) scheduling flexible, seven-day-a-week installation and
service appointments, (v) placing follow-up calls and on-site inspections to
verify subscriber satisfaction and (vi) completing 80% of installations within
three business days of receiving the initial installation request, often within
24 hours. The Company also uses focus groups and subscriber surveys to monitor
subscriber satisfaction.
STRATEGIC RELATIONSHIPS WITH MDU OWNERS
A critical aspect of the Company's growth strategy is the development of
strategic relationships with owners of MDU portfolios. These relationships
encourage the MDU owner (which may be an ownership association) to promote and
sell the Company's cable television and telecommunications services to MDU
residents.
The Company solicits and negotiates Rights of Entry with owners of
national, regional and local portfolios of MDUs, as well as with institutions
such as hospitals, universities and hotels. The Company's Rights of Entry
typically have original terms of ten to fifteen years (five years for Rights of
Entry with condominium associations). The weighted average unexpired term of the
Company's Rights of Entry was approximately eight years as of August 31, 1998
(assuming the Company's exercise of available renewal options).
Many Rights of Entry provide MDU owners with financial incentives to work
closely with the Company to promote its products and services. Financial
incentives may include revenue sharing or payment of up-front inducements to MDU
owners. In addition, the Company believes that the delivery of special services
tailored to MDU owners and residents provides marketing advantages to the MDU
owner in leasing its units. The Rights of Entry acquired by the Company through
its various acquisitions (which represent approximately 78% of the Company's
units under contract as of August 31, 1998) have not always contained all of the
foregoing terms and provisions.
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The long-term Rights of Entry negotiated with MDU owners effectively make
the Company the exclusive multichannel television provider, leaving MDU
residents with the option of receiving multichannel television from the Company
or receiving off-air programming from local broadcasters. Rights of Entry
covering telecommunications include an undertaking by the MDU owner to promote
OpTel as the preferred telecommunications alternative to the ILEC within the
MDU. The Company believes that the development of strategic relationships with
MDU owners will enable the Company to maintain its preferred competitive
position even if the exclusivity of the Rights of Entry becomes limited by
future developments. However, legal and regulatory limitations on exclusivity
could adversely affect the Company's ability to form new strategic relationships
with MDU owners and could increase the capital costs associated therewith.
COMPETITION
Substantially all markets for voice, video and Internet services are highly
competitive, and the Company expects that competition will intensify. In each of
its markets, the Company faces significant competition from larger companies
with greater access to capital, technology and other competitive resources. The
Company's switched local exchange services compete with ILECs, other STS
providers, CLECs and CAPs and will compete with long distance telephone
companies and franchise cable television operators as they begin to enter the
local telephone business. The Company's long distance services compete with
established IXCs and resellers. In addition, recent telecommunications
offerings, including personal communications systems ("PCS"), and future
offerings may increase competition in the telecommunications industry. The
Company's private cable television services compete with incumbent franchise
cable television operators as well as wireless cable television operators, other
private cable television operators, DBS operators and stand-alone satellite
service providers.
Recent and future legislative, regulatory and technological developments
likely will result in additional competition in each of the markets in which the
Company competes. Moreover, mergers, joint ventures and alliances among
franchise, wireless or private cable television operators, RBOCs and IXCs may
result in providers capable of offering bundled cable television and
telecommunications services in direct competition with the Company. Although the
Company as a matter of course investigates new sources of programming and
technologies that may increase its range of services, other larger and more
diversified competitors may attract the targeted MDUs based on their increased
menu of services. While the Company believes that the exclusivity provisions of
its Rights of Entry provide it with competitive advantages, such advantages may
be significantly diminished by technological and other developments beyond the
control of the Company. In addition, technological developments may allow
competitors of the Company to bypass property owners altogether and market their
services directly to tenants of MDUs. See "Risk Factors -- Risks Associated with
Rights of Entry" and "-- Competition."
Certain of the Company's current and potential competitors are described
below.
ILECs. In each of its markets, OpTel faces, and expects to continue to
face, significant competition for the local exchange services it offers from the
ILECs, which currently dominate their local telephone markets. OpTel competes
with the ILECs in its markets on the basis of product offerings (including the
ability to offer integrated voice and video services), reliability, technology
and customer service, as well as price.
In addition, under the Telecom Act and ensuing federal and state regulatory
initiatives, barriers to local exchange competition are being removed. The
introduction of such competition also establishes the predicate for the
incumbent RBOCs to provide in-region interexchange long distance services. The
RBOCs are currently allowed to offer "incidental" long distance service
in-region and to offer out-of-region long distance service. Once the RBOCs are
allowed to offer in-region long distance services, they will also be in a
position to offer single source local and long distance service similar to that
offered by OpTel and proposed by the three largest IXCs (AT&T, MCI and Sprint
Corporation). The Company expects that the increased competition made possible
by regulatory reform will result in certain pricing and margin pressures in the
telecommunications services businesses. See "Risk Factors -- Regulation" and
"-- Regulation."
OpTel has sought, and will continue to seek, to provide a full range of
local voice services in competition with ILECs in its service areas. The Company
expects to compete in this market by (i) establishing strategic
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relationships with MDU owners so as to allow the Company to market effectively
to MDU residents, (ii) providing value added, enhanced services to MDU
residents, (iii) bundling its telecommunications and cable television services,
(iv) providing a high level of customer service and responsiveness and (v)
competitively pricing its products.
The Telecom Act permits the ILECs and others to provide a wide variety of
video services directly to subscribers in competition with OpTel. Various LECs
currently provide video services within and outside their telephone service
areas through a variety of distribution methods, including both the deployment
of broadband wire facilities and the use of wireless transmission facilities.
The Company cannot predict the likelihood of success of video service ventures
by LECs or the impact on the Company of such competitive ventures.
CLECs and Other Competitors. Other CLECs compete for local telephone
services, although they have to date focused primarily on the market for
corporate customers. In addition, potential competitors capable of offering
private line and special access services also include other smaller long
distance carriers, cable television companies, electric utilities, microwave
carriers, wireless telephone system operators and private networks built by
large end-users. However, OpTel believes that it will be among the first to
offer an integrated package of voice, video and Internet access services to
customers in MDUs.
Incumbent Franchise Cable Systems. The Company's major competition for
cable television Rights of Entry in each market comes from the incumbent
franchise cable television operator. In certain markets serviced by the Company,
franchise cable television operators now offer revenue sharing and access fee
arrangements to MDU owners. There can be no assurance that these payments will
not increase in the future as competition increases for access to the higher
quality MDUs. Another basis of competition is the breadth of programming and
range of services offered. The Company competes with franchise cable operators
by (i) focusing exclusively on MDUs, (ii) sharing profits with MDU owners, (iii)
providing an integrated product offering that to an increasing extent in the
future will include Internet services, (iv) offering customized programming and
(v) charging lower cable and local telephone rates to subscribers.
Wireless Cable. Wireless cable systems are similar to the Company's 18GHz
and 12GHz networks in that they use microwave transmitting and receiving
equipment. Wireless cable systems differ from 18GHz and 12GHz systems in that
(i) they "broadcast" their video programming directly to individual subscribers
and generally not to an MDU's receiver (ii) their systems transmit in an
omni-directional manner, while 18GHz systems are point-to-point, which allows
them to provide service to all households within a wireless operator's
"line-of-sight," and (iii) wireless cable systems may include subscriber-to-hub
transmission capabilities, which would allow them to provide interactive and
telecommunication services. Historically, wireless operators have had difficulty
acquiring or leasing the critical mass of channels required to offer a
competitive programming lineup.
Local Multipoint Distribution Service. The FCC has issued rules
reallocating the 28GHz band to create a new local exchange and video programming
delivery service referred to as local multipoint distribution service ("LMDS").
LMDS systems, like wireless cable systems, will use point-to-multipoint
microwave distribution. Unlike wireless cable systems, however, LMDS systems,
using the proposed allocation in the 28GHz band, will be able to provide channel
capacity equal or greater to that of most cable systems, including the Company's
cable systems. In addition, LMDS systems may include subscriber-to-hub
transmission capabilities, which would allow them to provide interactive and
telecommunication services. In March 1998, the FCC completed its auction of LMDS
licenses. So far, however, there has been no significant commercial deployment
of LMDS systems in the Company's serviced markets.
SMATV Systems. The largest number of private cable companies are operators
of SMATV systems. Like the Company, these SMATV operators offer a multichannel
television service pursuant to Rights of Entry with MDU owners. Where the
Company has introduced or will introduce 18GHz systems, the Company competes
with SMATV systems on the basis of (i) larger channel offerings (typically SMATV
offers 33 to 45 channels), (ii) the quality of its video programming delivery,
(iii) customer service and (iv) the perceived high price of SMATV relative to
the programming package provided.
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Direct Broadcast Satellite. DBS systems involve the transmission of encoded
video programming direct from a satellite to the home user without any
intermediate processing or retransmission by a terrestrial operator. Although
prices have been decreasing, DBS service typically requires the purchase of
equipment and installation fees which are a significant cost to the subscriber.
In addition, subscribers generally pay a monthly programming fee to receive DBS
service, which can be lower than those charged by the Company before
consideration of the equipment costs. However, the Company believes that it can
effectively compete with DBS systems in the MDU marketplace for the following
reasons. First, DBS line-of-sight problems are significant (unless an entire MDU
is connected to the service) because a DBS antenna must be pointed in the proper
direction to receive video programming from the satellite. More importantly, DBS
operators are generally not permitted to retransmit network or local
broadcasting programming. Certain DBS operators have announced "MDU programs"
which generally consist of either (i) paying commissions to a local satellite
dish dealer who has, at its own expense, overbuilt an MDU or (ii) billing MDU
owners for the service on a bulk basis. The Company's Rights of Entry currently
prohibit an MDU owner from allowing a DBS system to be installed at the MDU
subject to legal and regulatory limitations. See "-- Regulation of Cable
Television -- Subscriber Access" for discussion of a recent FCC decision
limiting the enforceability of restrictions on DBS antennae placement in MDU
areas (such as apartment balconies or patios) under the exclusive occupancy of a
renter.
Internet Services. The market for Internet access services is extremely
competitive and highly fragmented. No significant barriers to entry exist, and
competition in this market is expected to intensify as use of the Internet
grows. The Company competes (or in the future may compete) directly or
indirectly with (i) national and regional ISPs, (ii) national telecommunications
companies, (iii) LECs, (iv) cable operators and (v) nonprofit or educational
ISPs. Some of these present or potential future competitors have or can be
expected to have substantially greater market presence and financial, technical,
marketing and other resources than the Company. Certain of the Company's online
competitors have introduced unlimited access to the Internet and their
proprietary content at flat rates, and certain of the LECs have also introduced
competitive flat-rate pricing for unlimited access (without a set-up fee for at
least some period of time). There can be no assurance that competition will not
lead to increased pricing pressures in the Internet business.
Advances in communications technology as well as changes in the marketplace
and the regulatory and legislative environment are constantly occurring. In
addition, a continuing trend towards business combinations and alliances in the
communications industry may also create significant new competitors to OpTel.
The Company cannot predict whether competition from such developing and future
technologies or from such future competitors will have a material impact on its
operations. See "Risk Factors -- Competition."
REGULATION
The telecommunications and multichannel television industries are subject
to extensive regulation at the federal, state and local levels. The following
summary does not purport to describe all present and proposed federal, state and
local regulations and legislation relating to the telecommunications and
multichannel television industries. Legislative and regulatory proposals under
consideration from time to time by Congress and various federal agencies, as
well as state and local franchise requirements, have in the past, and may in the
future, materially affect the Company and the telecommunications and
multichannel television industries. Additionally, many aspects of regulation at
the federal, state and local levels currently are subject to judicial review or
are the subject of administrative or legislative proposals to modify, repeal or
adopt new laws and administrative regulations and policies. Neither the outcome
of these proceedings nor their impact on the Company can be predicted at this
time. The Company believes that it is in compliance in all material respects
with all federal, state and local regulations applicable to it. In some
instances, the Company has acquired businesses that did not comply with all
regulations applicable to them and it undertook to remediate such matters as
soon as practicable. See "Risk Factors -- Risks Associated with Acquisitions."
TELECOMMUNICATIONS REGULATION
The telecommunications services provided by the Company are subject to
regulation by federal, state and local government agencies. As the Company
implements its telecommunications strategy, which includes
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replacing many of its current PBX switches with networked central office
switches, the Company will increasingly become regulated as a CLEC. The FCC has
jurisdiction over interstate services and state regulatory commissions exercise
jurisdiction over intrastate services. Additionally, local authorities may
regulate limited aspects of the Company's business, such as the use of public
rights-of-way. The following subsections summarize the local, state and federal
regulations that pertain to the Company's current and projected
telecommunications services.
Competitive Local Exchange Carrier Regulation
The FCC historically has left the regulation of the intrastate aspects of
local exchange service to the states. It has, however, exercised its
jurisdiction over interstate matters and jurisdictionally mixed matters
respecting local telephone service. The Telecom Act expands the FCC's authority
to regulate local exchange service, and there can be no assurance that the FCC
will not exercise this authority aggressively.
State regulation of local exchange service traditionally has favored the
ILECs. The state laws have, with the exception of STS, generally prohibited
competition in the local exchange services market. The Telecom Act expressly
preempts such prohibitions. The Telecom Act declares that no state or local laws
or regulations may prohibit or have the effect of prohibiting the ability of any
entity to provide any interstate or intrastate telecommunications service.
States may, however, impose "competitively neutral" requirements regarding
universal service, public safety and welfare, service quality and consumer
protection. Local authorities may also require reasonable, competitively neutral
compensation for use of the public rights-of-way.
For purposes of the Telecom Act, CLECs and ILECs are subject to the same
basic set of requirements. However, certain additional obligations are imposed
on ILECs, but not on CLECs. Although the Company does not believe that the
regulatory burdens applicable to CLECs will have a material effect on its
business, no assurance can be given at this time regarding the extent or impact
of such regulation.
The Telecom Act requires all carriers, both CLECs and ILECs, to
interconnect with the facilities of other carriers, to resell their services, to
provide number portability, to provide dialing parity, to afford access to their
poles, ducts, conduits and rights-of-way and to establish reciprocal
compensation for the transport and termination of other LECs' telephone traffic.
All providers of telecommunications services are also subject to the Telecom
Act's requirements that they contribute to state and federal universal service
funds. ILECs are subject to certain additional requirements, such as a duty to
negotiate interconnection agreements in good faith, to unbundle elements of
their networks, to provide nondiscriminatory interconnection with their
networks, to comply with specific resale obligations, to provide notice of
changes to their networks and to allow collocation of other carriers' equipment
on their premises. The Company is not, however, considered an ILEC in any state.
The FCC and various state public utility commissions ("PUCs") are in the
process of defining the precise contours of the requirements that will govern
local exchange service in the future. Although the Telecom Act sets forth
certain standards, it also authorizes the states to adopt additional regulations
provided that such regulations do not conflict with the federal standards. It is
unclear at this time how the states will respond to the Telecom Act and what
additional regulations they may adopt. Moreover, the United States Court of
Appeals for the Eighth Circuit overturned portions of the FCC's First Report and
Order that had set forth pricing methodologies for unbundling, resale and
interconnection, and that had also set forth certain technical requirements,
such as obligations relating to quality of service and combination of unbundled
network elements. The Supreme Court has granted certiorari and agreed to review
the Eighth Circuit decision.
The FCC has pending a proceeding in which it will determine whether CLECs
that serve information service providers are entitled to reciprocal compensation
from other LECs for terminating Internet traffic that originates on other LEC's
networks. The vast majority of state PUCs that have addressed this issue have
concluded that CLECs are entitled to reciprocal compensation for traffic
terminated to an information service provider. If the FCC concludes otherwise,
the decision would have a negative effect on the Company's revenues.
It is not possible for the Company to predict the outcome of these or any
other proceedings relating to the Telecom Act. Nonetheless, at this time it is
clear that an increasing number of service providers will be seeking to compete
as CLECs in the local exchange markets and that state and federal regulations
will, to
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some extent, allow for such market entry. Although jurisdictional lines of
authority and basic implementation issues are being determined by the FCC and
the federal courts in accordance with the statutory provisions outlined above,
several states already have begun the process of opening the local exchange
market to competition.
Most states require companies seeking to compete in intrastate
telecommunications services to be certified to provide such services. These
certifications generally require a showing that the carrier has the financial,
managerial and technical resources to offer the proposed services consistent
with the public interest. State regulation of telecommunications services may
impose upon the Company additional regulatory burdens, including quality of
service obligations and universal service contributions.
Shared Tenant Services
The resale of STS is subject to the terms and conditions in the tariffs of
the telecommunications company whose services it resells and to regulation by
the states in which the Company resells such services. Historically, virtually
all such telecommunications company tariffs flatly prohibited resale of local
exchange service. However, in recent years several state legislatures and PUCs
determined that resale of local exchange service is in the public interest and
have directed telecommunications companies within their jurisdictions to allow
for resale of local exchange service, opening the way for STS operations.
Moreover, the Telecom Act requires such resale pursuant to interconnection
agreements with the ILEC. In some states, PUCs have issued detailed regulations
governing the provision of STS and other resale services. In other jurisdictions
where no formal requirements have been adopted, most telecommunications
companies have nonetheless modified their tariffs to provide for resale of local
exchange services.
The precise terms and conditions under which such resale services may be
provided varies from state to state, and from LEC to LEC, and may include
significant restrictions and limitations. These include: (i) a requirement to be
certified by the state PUC, (ii) restrictions with respect to the location and
ownership of MDUs to which STS service may be provided and the crossing of
public rights-of-way by STS operator facilities, (iii) regulations allowing
telecommunications companies to apply different local service rate structures
(e.g., measured use vs. flat rate) to STS providers and other subscribers, in
some cases lessening or even eliminating efficiencies which might otherwise be
realized through the use of the LECs' trunking facilities, (iv) regulations
providing for LEC access or rights-of-way to directly service individual
customers within an MDU and (v) in certain states, limits or prohibitions on
resale of intrastate long distance and local service at a profit.
None of the states in which the Company has significant operations has
adopted regulations governing the provision of STS services. The California PUC
has, however, adopted informal STS "guidelines." In addition, Florida requires
providers of STS services to be certified to resell local exchange services.
Other than the California "guidelines" and Florida's certification requirement,
the Company may provide STS services in each of its major markets, subject only
to individual telecommunications company tariff provisions. The tariffs of all
major LECs serving these jurisdictions provide for resale of local exchange
service pursuant to varying terms and conditions. Provision of STS service in
these states in the future will be subject to any regulations that ultimately
may be adopted by state authorities, and to changes in telephone company
tariffs.
Information Service Provider Regulation
Information service providers, including Internet access providers, are
largely unregulated at this time (apart from federal, state and local laws and
regulations applicable to business in general). However, there can be no
assurance that this business will not become subject to regulatory restraints.
For instance, although the FCC has rejected proposals to impose additional costs
and regulations on information service providers to the extent they use local
exchange telephone network facilities, it has suggested that certain
telephone-to-telephone services provided by information service providers using
the Internet backbone may be reclassified as "telecommunications services" and
subject to regulation as such. Any such change may affect demand for the
Company's Internet related services. In addition, the FCC has pending a
proceeding in which it will determine whether CLECs that serve information
service providers are entitled to reciprocal compensation
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from other LECs for terminating Internet traffic that originates on the other
LEC's network. An FCC determination that information service provider traffic
should not be included within reciprocal compensation calculations could have a
negative effect on the Company's revenues.
There also have been efforts at the federal and state level to impose taxes
and other burdens on information service providers and to regulate content
provided via the Internet and other information services. These efforts have not
generally been upheld when challenged in court. Nonetheless, the Company expects
that proposals of this nature will continue to be debated in Congress and state
legislatures in the future. No assurance can be given that changes in current or
future regulations adopted by the FCC or state regulators or other legislative
or judicial initiatives relating to Internet services would not have a material
adverse effect on OpTel. In addition, although there is a trend in the law away
from ISP liability for content posted or published on the Internet, there can be
no assurance that the Company's involvement in the provision of ISP services
will not subject it to liability for acts performed by third parties using the
Internet.
Long Distance Resale Regulation
Non-dominant IXCs, such as the Company, are subject to limited federal
regulation. Nonetheless, carriers are required by statute to offer their
services under rates, terms and conditions that are just, reasonable and not
unreasonably discriminatory, and to file tariffs for their international and
interexchange services. As a non-dominant carrier, the Company is permitted to
make tariff filings on a single day's notice and without cost support to justify
specific rates. The FCC generally does not exercise direct oversight over cost
justification and the level of charges for service of non-dominant carriers,
although it has the statutory power to do so. The FCC has jurisdiction to act
upon complaints brought by third parties, or on the FCC's own motion, against a
carrier for failure to comply with its statutory obligations.
Foreign Ownership Restrictions
Section 310(b) of the Communications Act limits the extent to which foreign
controlled companies may hold common carrier radio licenses. Under Section
310(b)(4) of the Communications Act, the FCC has discretion to permit common
carrier licensees to exceed some of these limits. To allow the Company to
provide common carrier telecommunications services using its networks, in the
event that the Company should desire to do so, the Company assigned
substantially all of its frequency licenses (the "Assigned Licenses") to
Transmission Holdings, Inc. ("THI"), a Delaware corporation owned by United
States citizens. To establish the terms of the Company's continued and
unencumbered use of the Assigned Licenses, the Company entered into a license
and services agreement pursuant to which THI agreed to provide to the Company
all the transmission capacity it requires or may in the future require and the
Company granted THI a non-exclusive license to use all of the Company's
facilities and related equipment, such as microwave transmitting and receiving
equipment, required to provide transmission capacity. The Company also obtained
an option to acquire the assets or equity of THI, subject to FCC approval.
In 1997, the United States agreed, as part of the World Trade Organization
("WTO") Basic Telecom Agreement, to allow foreign suppliers from WTO member
nations, including Canada, to provide a broad range of basic telecommunications
services in the United States. In light of those commitments, which became
effective in February 1998, and consistent with its authority under Section
310(b)(4) of the Communications Act, the FCC adopted a presumption favoring
grant of applications to exceed the limits on non-U.S. ownership of common
carrier licensees when the non-U.S. investment is from a WTO member nation.
Accordingly, the Company is in the process of reevaluating whether it should
hold FCC authorizations directly and, specifically, whether it should exercise
its option to purchase the assets or stock of THI. The Company has applied for
FCC consent for it to purchase the stock of THI.
REGULATION OF CABLE TELEVISION
Certain of the Company's networks are, for regulatory purposes, deemed to
be "Cable Systems." To constitute a Cable System, a multichannel television
system must use hard-wire or fiber optic cable that makes a tangible physical
crossing or use of a public right-of-way. All Cable Systems are required to
obtain a
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local franchise and are subject to state and local regulation as well as federal
Cable System regulation, including rate regulation in certain circumstances. The
Company's microwave and SMATV systems are not considered Cable Systems and thus
are not subject to local franchising requirements and are free from most Cable
System regulation. The Company's Houston system, a portion of its Fort Worth
system and certain other small systems are regulated as Cable Systems. However,
the Company's Houston, Fort Worth and other small franchise cable television
systems are exempt from federal rate regulation and the universal service
obligation, even though they are Cable Systems, because they are subject to
"effective competition" as discussed in greater detail below.
Set forth below is a discussion of the principal laws and regulations
governing the Company's private and franchise cable television operations.
Federal "Cable System" Regulation. The regulations imposed on Cable Systems
include requirements to (i) obtain a local franchise (which may require the
franchisee to pay franchise fees to local governments of up to 5% of yearly
gross revenues), (ii) delete certain programs from cablecasts, (iii) comply with
certain customer service standards, (iv) retransmit certain broadcast television
programming, (v) in most circumstances, conform subscriber service and equipment
rates to applicable federal regulations, (vi) comply with FCC equal employment
opportunity ("EEO") rules and policies, (vii) make available channels for
leased-access programmers at rates that are to be calculated on a formula
established by the FCC and (viii) offer customer service to all buildings passed
by its network. In addition, rates for basic cable service on Cable Systems not
subject to "effective competition" are regulated by local franchising
authorities. Rates for upper tier or "cable programming services" on such
systems are regulated by the FCC. The Telecom Act eliminates cable programming
service tier rate regulation effective March 31, 1999, for all Cable System
operators. The Company's networks that are Cable Systems are subject to these
requirements, which impose regulatory costs and reduce the speed and flexibility
with which the Company and its Cable System competitors can respond to
competitive challenges from other video distribution technologies. The Company's
Cable Systems, however, are exempt from rate regulation because they are, the
Company believes, subject to "effective competition."
Cable Systems are deemed to be subject to "effective competition" if any
of: (i) fewer than 30% of the households in the franchise area subscribe to the
service of the Cable System, (ii) the area is served by at least two
unaffiliated multichannel television operators, both of which are able to
provide service to at least 50% of the households in the franchise area, and the
number of households actually subscribing to all but the largest multichannel
television operator exceeds 15%, (iii) the local franchising authority itself
offers multichannel television to at least 50% of the households in the
franchise area, or (iv) a LEC or its affiliate offers multichannel television
directly to subscribers by any means (other than direct-to-home satellite
services) in the franchise area. No assurance can be given that the Company does
not, or will not in the future, constitute "effective competition" to any
franchise cable television operator with which it competes.
Copyright Licensing. Cable Systems and private cable television systems are
entitled to federal compulsory copyright licensing privileges. In order to
obtain a compulsory copyright, such systems must make semi-annual payments to a
copyright royalty pool administered by the Library of Congress. A compulsory
copyright provides a blanket license to retransmit the programming carried on
television broadcast stations. Non-broadcast programming, often referred to as
cable channel programming, is not subject to the compulsory copyright license.
The Company purchases this copyrighted programming from program suppliers (e.g.,
ESPN), which in turn obtain rights to the programming directly from the program
copyright owner pursuant to a private negotiated agreement. Bills have been
introduced in Congress over the past several years that would eliminate or
modify the cable compulsory license. The need to negotiate with the copyright
owners for each program carried on each broadcast station in the channel lineup
could increase the cost of carrying broadcast signals or could impair the
Company's ability to obtain programming.
Must-Carry and Retransmission Consent. The Communications Act grants local
television stations the right to elect either to force local Cable Systems to
"carry" the television station free of charge (a "must carry" right) or to
prohibit Cable Systems and private cable television systems from carrying the
local television station (a "retransmission consent" right). Under the
must-carry rules, a Cable System, subject to certain restrictions, generally
must carry, upon request by the station and depending on the number of usable
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activated channels on the system, all commercial television stations with
adequate signals that are licensed to the same market as the Cable System. Under
the retransmission consent rules, Cable Systems and private cable television
systems are precluded from carrying commercial broadcast stations that choose
not to exercise their must-carry rights, all "distant" commercial broadcast
stations (except for "superstations", i.e., commercial satellite-delivered
independent stations such as WTBS), commercial radio stations and certain low-
powered television stations, without obtaining those stations' explicit written
consent for the retransmission of their programming. Retransmission consent
agreements do not obviate a copyright license for the programming carried on the
broadcaster's signal. However, Cable Systems and private cable television
systems may obtain a compulsory copyright license for broadcast programming as
described above. To date, the "must carry/retransmission consent" regulations
have not had a significant impact on either the operations or profitability of
the Company. Nonetheless, there can be no assurance that broadcasters, in some
circumstances, will not withhold retransmission consent, require excessive
compensation for that consent or impose onerous conditions thereon which could
adversely affect the Company. Furthermore, it is unclear at this time the extent
to which Cable Systems will be required to carry multiple signals of digital
television broadcast stations or HDTV signals. The resolution of these
must-carry issues may have a significant impact on the programming carried on
the Company's systems.
Changes in the Definition of a "Cable System." Formerly, to avoid being
classified as a Cable System, private cable television systems were limited to
linking with hard wire only commonly owned or managed MDUs without crossing a
public right-of-way. The Telecom Act amended the definition of Cable System such
that systems which make no use of public streets or public rights-of-way no
longer are deemed to be Cable Systems, regardless of the type or ownership of
properties served by the system. Thus, for example, the Company's private cable
television systems now may serve mobile home parks and private communities
without a local franchise and free of most federal Cable System regulations.
Elimination of the Telco-Cable Cross-Ownership Restriction. The Telecom Act
repealed the LEC cable television cross-ownership restriction, which prohibited
LECs from providing multichannel television directly to subscribers in their
telephone service areas. This change may increase the level of competition in
the multichannel television market. LECs now have several options for entering
and competing in the multichannel television marketplace. LECs now may (i)
provide video programming to subscribers through radio communications under
Title III of the Communications Act, (ii) provide transmission of video
programming on a common carrier basis under Title II of the Communications Act
(i.e., provide a common carrier video platform), (iii) provide video programming
as a Cable System under Title VI of the Communications Act (franchise cable) or
(iv) provide video programming by means of an "open video system." Open video
systems are not required to comply with the full panoply of federal Cable System
regulation, but they are subject to certain additional programming selection
limitations. It is unclear at this time the extent to which any of these market
entry options will be used by LECs.
Rate Relief for Small Cable Operators. The Telecom Act deregulated the
rates charged for cable programming services in any Cable System operated by a
"small cable operator" that serves 50,000 or fewer subscribers. The law defines
a "small cable operator" as one which, in the aggregate, serves fewer than one
percent of all subscribers in the United States and which is not affiliated with
any entity with gross annual revenues in excess of $250 million. This provision
may provide increased pricing flexibility for certain of the Company's
competitors who qualify as "small cable operators."
The Uniform Rate Requirement. Prior to enactment of the Telecom Act, the
Communications Act generally provided that Cable Systems were required to have a
rate structure for the provision of cable service that was uniform throughout
its geographic area. The Telecom Act provides that this requirement is
applicable only where "effective competition" is absent. Further, the Telecom
Act exempts from the uniform rate requirement non-predatory bulk discounts
offered to MDUs. Consequently, the franchise cable television operators with
which the Company competes now have increased pricing flexibility with respect
to MDU bulk discounts.
Program Access. The program access provisions of the Communications Act
were intended to eliminate unfair competitive practices and facilitate
competition by providing competitive access to certain defined
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categories of programming. Generally, these restrictions are applicable to Cable
System operators, satellite cable programming vendors in which a Cable System
operator has an attributable interest and satellite broadcast programming
vendors. The programming access provisions prohibit these entities from charging
unfair, unreasonable or discriminatory prices for programming. Further, the
programming access provisions prohibit most exclusive dealing arrangements
pursuant to which Cable Systems obtain the exclusive right to distribute the
subject programming within their franchise areas. Such exclusive distribution
arrangements have been found to inhibit the ability of new entrants to compete
in the multichannel television market. The prohibition on exclusive contracts,
however, is scheduled to expire on October 5, 2002 unless the FCC determines,
during a proceeding that is to be conducted in 2001, that the prohibition
continues to be necessary to promote competition in the multichannel television
market. The Telecom Act amended the program access provisions by adding that the
provisions shall also apply to common carriers and their affiliates. Thus,
telecommunications companies entering the market will find it more difficult to
limit their competitors' access to programming.
Subscriber Access. The FCC has initiated a notice of proposed rulemaking
seeking comment on whether the FCC should adopt regulations restricting
exclusive contracts. The FCC has indicated that it seeks to ensure a level
competitive playing field in the emerging multichannel television market. One
possibility raised by the FCC is the establishment of a federal mandatory access
requirement or a limit on the duration of exclusive service agreements between
MDU owners and video programming providers. Although it is open to question
whether the FCC has statutory and constitutional authority to compel mandatory
access or restrict exclusive agreements, there can be no assurance that it will
not attempt to do so. Either such action would tend to undermine the exclusivity
provisions of the Company's Rights of Entry with MDU owners. The FCC also has
preempted state, local and private restrictions on over-the-air reception
antennas placed on rental properties or properties occupied by, but not within
the exclusive control of the viewer. This limits the extent to which MDU owners
and the Company may enforce certain aspects of the Company's Rights of Entry
agreements which otherwise would prohibit, for example, placement of DBS receive
antennae in MDU areas (such as apartment balconies or patios) under the
exclusive occupancy of a renter.
State and Local Cable System Regulation. Because Cable Systems use public
rights-of-way, they are subject to state and local regulation, typically imposed
through the franchising process. State and/or local officials often are involved
in the franchisee selection, system design and construction, safety, consumer
relations, billing and community-related programming and services among other
matters. Cable Systems generally are operated pursuant to nonexclusive
franchises, permits or licenses granted by a municipality or other state or
local government entity. Franchises generally are granted for fixed terms and in
many cases are terminable if the franchise operator fails to comply with
material provisions of the franchise.
Cable franchises typically contain provisions governing fees to be paid to
the franchising authority, length of the franchise term, renewal, sale or
transfer of the franchise, territory of the franchise, design and technical
performance of the system, use and occupancy of public rights-of-way and types
of cable services provided.
Although federal law contains certain procedural safeguards to protect
incumbent Cable Systems from arbitrary denials of franchise renewal, the renewal
of a cable franchise cannot be assured unless the franchisee has met certain
statutory standards. Moreover, even if a franchise is renewed, a franchising
authority may impose new requirements, such as the upgrading of facilities and
equipment or higher franchise fees. At least two states, Massachusetts and
Connecticut, have adopted legislation subjecting Cable Systems to regulation by
a centralized state government agency. There can be no assurance that other
states will not similarly adopt state level regulation.
The Company's Houston cable television franchise and its other limited
cable television franchises are subject to state and local franchise laws.
Moreover, although the Company's non-franchised private cable systems that use
microwave distribution technologies are not subject to local franchise laws,
state and local property tax and environmental laws are applicable to the
Company's business. For example, the Company has to comply with local zoning
laws and applicable covenants, conditions and restrictions when installing its
antennae and other microwave equipment.
In addition, a number of states have enacted mandatory access laws.
Although such laws differ in some respects from state to state, state mandatory
access laws generally require that, in exchange for just
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compensation, the owners of rental apartments (and, in some instances, the
owners of condominiums and manufactured housing parks) must allow the local
franchise cable television operator to have access to the property to install
its equipment and provide cable service to residents of the MDU. Such state
mandatory access laws effectively eliminate the ability of the property owner to
enter into an exclusive Right of Entry with a provider of cable or other video
programming services. Florida currently has a mandatory access statute for
condominiums, but the validity of that statute has been called into question
because an identical provision of Florida law that applied to rental properties
has been held to be unconstitutional. Virginia has an anti-compensation statute
that forbids an owner of an MDU from accepting compensation from whomever the
owner permits to provide cable or other video programming services to the
property. Such a statute limits the ability of a cable or other video
programming provider to enter into an exclusive Right of Entry with an owner of
an MDU because an owner usually is induced to enter an exclusive agreement
through financial incentives. These statutes have been and are being challenged
on constitutional grounds in various states.
The Company does not have significant operations in any mandatory access
state other than Florida (with respect to condominiums) and Illinois. When
operating in Illinois, the Company generally enters into bulk sales agreements
with MDU owners, whereby the MDU owner agrees to purchase cable television, at a
discount, for each unit in the MDU and provides the service to the MDU resident
as one of the amenities included in their rent.
MICROWAVE AND PRIVATE CABLE REGULATION
The Company uses microwave distribution networks, which typically operate
in the 18GHz band, to interconnect individual private cable systems with each
other and with head-end facilities. The FCC exercises jurisdiction over 18GHz
microwave and other transport technologies using the radio frequency spectrum
pursuant to Title III of the Communications Act, which vests authority in the
FCC to regulate radio transmissions and to issue licenses for radio stations.
The scope, content and meaning of existing laws, rules and regulations governing
all microwave technologies are subject to legislative, judicial and
administrative changes. There can be no assurance that future legislative or
regulatory actions will not adversely affect the Company's ability to deliver
video or telecommunications programming using the radio frequency spectrum or
raise the cost of such delivery.
The Company's microwave networks must comply with the FCC's licensing
procedures and rules governing a licensee's operations. Application to use
microwave "paths" and frequencies is made to the FCC and is subject to certain
technical requirements and eligibility qualifications. After microwave paths are
licensed to an applicant, the facilities must normally be constructed and fully
operational within 18 months of the grant. The facilities must be built in
strict accordance with the terms of the granted application. New licenses are
valid for ten years from the date of grant, after which the licensee must apply
to the FCC for license renewal. License renewal is not an automatic right,
although it is routinely granted if the licensee is in substantial compliance
with the FCC rules.
Licensing procedures include (i) obtaining an engineering report confirming
that the proposed path does not interfere with existing paths and (ii) filing
with the FCC a statement of eligibility and use, a system diagram and a
statement regarding compliance with the frequency coordination requirement. The
entire licensing procedure requires approximately 120 days.
The Company does not "own" the paths and frequencies granted by the FCC.
Rather, the Company is merely licensed or permitted to "use" the frequencies.
Moreover, the rights granted to the Company to use microwave frequencies are not
to the complete exclusion of other potential licensees. First, the Company's
rights only extend to the microwave paths identified in its application as
connecting the various points in its network. Other microwave users are
permitted to file applications and serve the same buildings as the Company (in
so far as the microwave licensing is concerned), but they may not interfere with
an incumbent user's licensed microwave paths. Second, the Company has no right
to the airspace over which the programming is transmitted. Obstructions could be
constructed in the line-of-sight of the microwave paths, precluding connection
of the Network Hubs with the various reception points to be served. The
microwave bands used by the Company also are authorized for use by other kinds
of users, including non-video, point-to-point microwave, mobile communications
and satellite transmissions. Although sharing these frequencies is
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technically feasible, it is possible that the Company will be unable to obtain
licenses for frequency paths it desires, or that it will be able to use only a
portion of the frequencies at certain locations because of pre-existing users.
The Company anticipates that in the future it will use 6GHz, 11GHz and
23GHz microwave frequencies, which are available for both private or common
carrier communications, to provide bi-directional telecommunications services.
The application and licensing procedures for authorizations to use the 6GHz,
11GHz and 23GHz frequencies are substantially the same as those described above.
Although the Company expects that 6GHz, 11GHz and 23GHz frequencies will be
available on its current paths and to meet its future needs, the Company has not
commenced frequency coordination, and there can be no assurance that the Company
will be able to obtain licenses for these frequencies on the paths it desires.
Recently the FCC, at the request of national defense agencies, restricted
the use of 18GHz frequencies in the greater Denver and Washington, D.C. areas.
This change could severely limit the Company's ability to use 18GHz microwave
technologies in these two markets. The Company has, however, received assurances
from the FCC that it will be permitted, subject to certain waiver and/or
rulemaking procedures, to use 12GHz microwave as a medium to deliver
multi-channel video programming and telecommunications services in Denver. The
Company believes that 12GHz microwave paths are an acceptable substitute for
18GHz microwave paths and that the change will not materially adversely affect
the Company's network plans in Denver. The 12GHz frequencies are not, however,
generally available to private microwave licensees. Nonetheless, based on the
assurances received from the FCC, the Company has commenced frequency
coordinations for 12GHz paths in Denver and obtained special temporary
authorization to use 12GHz frequencies on selected paths in Denver. There can be
no assurance that 12GHz paths will be available for the Company's future needs
in Denver or the Washington, D.C. area.
The FCC also has issued a Notice of Proposed Rulemaking seeking comment on
a proposal to make terrestrial microwave systems secondary to satellite
downlinks in 250 MHz of spectrum between 18.3 GHz and 18.55 GHz. The Company's
18 GHz networks currently use 440 MHz of spectrum in the frequencies between
18.140 GHz and 18.580 GHz. Under the proposal, terrestrial stations in existence
or applied for as of September 18, 1998, would be grandfathered as co-primary
with satellite services in the 18.3-18.55 GHz band, but terrestrial systems for
which applications are filed after that date would not be permitted to cause
harmful interference to satellite downlinks in the band.
If adopted, the proposal would severely limit the Company's use of the
18.3-18.55 GHz frequencies for new stations. In that event, the Company may seek
authority to use other portions of the microwave spectrum (e.g., the 17.7-18.3
GHz band). Such use, however, would require other FCC rule changes as to which
there can be no assurance. Further, there can be no assurance that migration to
another portion of the microwave spectrum is technically feasible, or that such
migration would not negatively affect the cost of the Company's microwave
systems or its costs of operations. See "Risk Factors -- Uncertainties Related
to the Availability of Radio Spectrum."
To reduce the Company's reliance on 18GHz microwave and to take advantage
of superior propagation characteristics of lower frequency microwave
transmissions, the Company has initiated two proceedings at the FCC that would,
if resolved in a manner satisfactory to the Company, make additional microwave
bands available for use by the Company on a nationwide basis. First, the Company
has filed a petition for rulemaking that proposes FCC rule changes to allow the
Company and other private microwave licensees to use 12GHz frequencies
nationwide for the delivery of video programming materials. These bands, which
the Company has obtained limited authority to use in the Denver market, normally
are not available for video distribution services by private microwave
licensees. Second, the Company has sought a nationwide waiver of a restriction
in the FCC's rules that prohibits non-common carrier microwave licensees from
transmitting video entertainment material in the 11GHz microwave bands. There
can be no assurance that either of these bands will be made generally available
to the Company on a nationwide basis. Further, the FCC has issued a Notice of
Proposed Rulemaking seeking comment on rule changes that would permit increased
use of both the 11 GHz and 12 GHz bands by satellite operators. There can be no
assurance that the FCC will not adopt rules in this proceeding that would
negatively affect the Company's proposed use of these bands.
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Radio frequency ("RF") emissions from microwave equipment may pose health
risks to humans. The FCC recently adopted new guidelines and methods for
evaluating the environmental effects of RF emissions from FCC-regulated
transmitters, including microwave equipment. The updated guidelines and methods
generally are more stringent than those previously in effect. The Company
expects that the microwave equipment to be provided by its vendors will comply
with applicable FCC guidelines.
Although private cable television operators are not subject to the full
range of regulation applicable to Cable Systems, they are subject to the
following federal regulations. First, private cable television operators are
entitled to the compulsory copyright license described above. Second, private
cable television operators benefit from the federal laws and regulations that
require certain programming providers to make cable programming available to all
multichannel video programming distributors on fair, reasonable and
nondiscriminatory terms. Third, as noted above, private cable television
operators are required to obtain retransmission consent from local broadcasters
in order to retransmit their signals. Finally, private cable television systems
are required to comply with the FCC's EEO rules and policies, although the
continuing validity of these rules and policies has been called into question by
a recent court of appeals decision overturning portions of the FCC's EEO rules
applicable to broadcast stations.
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RISK FACTORS
In addition to other information set forth elsewhere in this report, the
following risk factors should be considered.
LIMITED OPERATIONS OF CERTAIN SERVICES; HISTORY OF NET LOSSES AND NEGATIVE CASH
FLOW
OpTel's business commenced in 1993. Historically, substantially all of
OpTel's revenues were derived from providing cable television services. The
Company's telephone and Internet access services only recently have been
initiated or their availability only recently expanded in new market areas.
OpTel expects to increase substantially the size of these operations in the near
future. There is, therefore, limited historical financial information about
OpTel upon which to base an evaluation of OpTel's performance in the markets and
for the services that will be its principal focus in the future. Given OpTel's
limited experience operating telecommunications networks, there can be no
assurance that it will be able to compete successfully in the telecommunications
industry.
The development of OpTel's business and the expansion of its networks will
require substantial capital, operational and administrative expenditures, a
significant portion of which may be incurred before the realization of revenues.
These expenditures will result in negative cash flow until an adequate customer
base is established and revenues are realized. Although its revenues have
increased in each of the last three years, OpTel has incurred substantial
up-front operating expenses for marketing, customer operations, administration
and maintenance of facilities, general and administrative expenses and
depreciation and amortization in order to solicit and service customers in
advance of generating significant revenues. As a result of these factors, the
Company has generated operating losses of $28.2 million, $22.8 million and $12.6
million for fiscal 1998, fiscal 1997 and fiscal 1996, respectively, as its cable
television and telecommunications customer base has grown. The Company reported
positive EBITDA (see "Selected Financial Data") of $.3 million for fiscal 1998
as compared with negative EBITDA of $8.3 million and $3.9 million for fiscal
1997 and fiscal 1996, respectively. There can be no assurance that OpTel will
achieve or sustain profitability or positive EBITDA in the future. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations."
SUBSTANTIAL INDEBTEDNESS; INSUFFICIENCY OF EARNINGS TO COVER FIXED CHARGES;
ABILITY TO SERVICE DEBT
The Company's indebtedness is substantial in relation to its stockholders'
equity and cash flow. As of August 31, 1998, the Company had total consolidated
indebtedness of approximately $429 million and stockholders' equity of
approximately $161 million. The Company's earnings would have been insufficient
to cover its fixed charges by approximately $50.8 million for fiscal 1997 and
$77.2 million for fiscal 1998.
The indentures governing the Company's outstanding notes (the "Indentures")
impose certain restrictions on the operations and activities of the Company. The
Company's ability to make scheduled payments of principal of, or to pay interest
on, or to refinance, its indebtedness depends upon the success of its business
strategies and its future performance, which to a significant extent are subject
to general economic, financial, competitive, regulatory and other factors beyond
its control. There can be no assurance that the Company will be able to generate
the substantial increases in cash flow from operations that will be necessary to
service its indebtedness. In the absence of such operating results, the Company
could face substantial liquidity problems and might be required to raise
additional financing through the issuance of debt or equity securities. Further,
the Company expects that it may need to refinance the principal amount of its
outstanding notes at their respective maturities. There can be no assurance that
the Company will be successful in raising such financing when required or that
the terms of any such financing will be attractive. See "-- Significant Capital
Requirements and Need for Additional Financing" and "Management's Discussion and
Analysis of Financial Condition and Results of Operations -- Liquidity and
Capital Resources."
The degree to which OpTel is leveraged could have adverse consequences to
holders of its outstanding notes including the following: (i) a substantial
portion of OpTel's cash flow from operations will be dedicated to the payment of
the principal of and interest on its indebtedness thereby reducing funds
available for other purposes, (ii) OpTel's vulnerability to changes in general
economic conditions or increases in prevailing interest rates could be
increased, (iii) OpTel's ability to obtain additional financing for working
capital, capital
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expenditures, acquisitions, general corporate purposes or other purposes could
be impaired and (iv) OpTel may be more leveraged than certain of its
competitors, which may be a competitive disadvantage.
SIGNIFICANT CAPITAL REQUIREMENTS AND NEED FOR ADDITIONAL FINANCING
The Company will require substantial capital on a continuing basis to
finance cable television and telecommunications network expansion related to
subscriber and market growth, to upgrade existing facilities to desired
technical and signal quality standards and to finance any acquisitions of other
operators. The Company believes, based on its current business plan, that its
cash on hand, will provide the Company with sufficient financial resources to
fund its capital requirements through the first quarter of fiscal 2000. However,
the Company's future capital requirements will depend upon a number of factors,
including the Company's success in obtaining new Rights of Entry, the extent of
its telecommunications roll out, the size and timing of any acquisitions,
marketing expenses, staffing levels and customer growth, as well as other
factors that are not within the Company's control, such as competitive
conditions, changes in technology, government regulation and capital costs. The
Company expects to fund additional capital requirements through internally
generated funds and public or private debt and/or equity financing. There can be
no assurance, however, that OpTel will be successful in raising sufficient debt
or equity when required or on terms that it will consider acceptable. Moreover,
the terms of OpTel's outstanding indebtedness impose certain restrictions upon
OpTel's ability to incur additional indebtedness or issue additional stock. In
addition, both GVL and Capital Communications CDPQ Inc. ("CDPQ"), a wholly-owned
subsidiary of Caisse de depot et placement du Quebec ("Caisse"), have the power
to prevent the Company from obtaining additional debt or equity financing. See
"-- Control by GVL" and "Security Ownership of Certain Beneficial Owners and
Management -- Stockholders' Agreement." Failure to generate or raise sufficient
funds may require OpTel to delay or abandon some of its future expansion or
expenditures, which would have a material adverse effect on its growth and its
ability to compete in the cable television and telecommunications industries.
See "Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Liquidity and Capital Resources."
RISKS ASSOCIATED WITH ACQUISITIONS
OpTel expects to continue to make acquisitions of strategically important
businesses in the future when sufficiently attractive opportunities arise.
Acquisitions may divert the resources and management time of OpTel and will
require integration of the acquired operations with OpTel's existing networks
and services. There can be no assurance that any acquisition of assets,
operations or businesses, including the acquisition of the ICS Operations, will
be successfully integrated into OpTel's operations. The Company typically has
acquired businesses that were privately held by entrepreneurs, many of which
businesses were without the same regulatory compliance practices and internal
accounting controls and procedures as the Company. Accordingly, the Company
frequently is required to take remedial actions, which may include the
expenditure of funds and take extensive time to implement. In general, the
Company factors the costs associated with these matters into the terms of its
acquisitions, including, where practicable, through indemnification rights.
However, there can be no assurance that the Company's results of operations will
not be adversely affected by these or other matters arising from past or future
acquisitions. Consistent with its consolidation strategy, OpTel is currently
evaluating and often engages in discussions regarding various acquisition
opportunities. These acquisitions may be funded by cash on hand and/or through
the issuance of OpTel's debt and/or equity securities. It is possible that one
or more of such possible future acquisitions, if completed, could adversely
affect OpTel's cash flow, or increase OpTel's debt, or that such an acquisition
could be followed by a decline in the market value of OpTel's securities.
OpTel recently completed the acquisition of the ICS Operations subject to
the consummation of certain transfer conditions. A portion of the purchase price
paid for the acquisition of the ICS Operations was deposited in escrow subject
to release upon fulfillment of transfer conditions with respect to the
approximately 12,000 units for which, as of October 31, 1998, there remain
unsatisfied transfer conditions, including the receipt of third-party consents.
There can be no assurance that the Company will complete the transfer of all or
part of the balance of the ICS Operations. As of October 31, 1998, the
acquisition of approximately 87% of the ICS Operations had been completed.
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RISK ASSOCIATED WITH TELECOMMUNICATIONS STRATEGY
The Company is currently introducing central office switched
telecommunications services to MDUs served by its existing networks. The Company
believes that a successful introduction of these telecommunications services is
important to its long-term growth. Its success will be dependent upon, among
other things, the Company's ability to assess markets, design and install
telecommunications networks, including switches, obtain cooperation of the
ILECs, when needed, and obtain any required government authorizations and
permits, all in a timely manner, at reasonable costs and on satisfactory terms
and conditions, and the willingness of MDU residents to accept a new provider of
telecommunications services. There can be no assurance that the Company will be
able to successfully introduce central office switched telecommunications
services in each of its markets in a timely manner in accordance with its
strategic objectives and failure to do so could have a material adverse effect
on the Company. Specific risks associated with the Company's telecommunications
strategy include:
Switch Installation and Network Enhancement; Lack of Redundant Switches. An
essential element of the Company's telecommunications strategy is the provision
of switched local exchange service. The Company has recently commenced operating
central office switches in its Houston and Dallas-Fort Worth markets and intends
to implement central office switches in substantially all of its major markets
by the end of calendar year 1999. In connection with the implementation of
central office switches in additional markets, the Company will be reconfiguring
its microwave networks in such markets to carry bi-directional voice traffic.
The Company intends to use certain components of its existing infrastructure to
deliver bi-directional transmission utilizing microwave frequencies, principally
in the 23GHz band. While the Company believes this frequency and other required
frequencies are available for license on the paths that will be required, the
Company has not yet commenced frequency coordination in each of its markets and
there can be no assurance regarding path or frequency availability. In addition,
there can be no assurance that the installation of the required switches and the
reconfiguration of the network will be completed on schedule. The failure of the
Company to successfully reconfigure its microwave networks and to have its
switches operational on a timely basis could have a material adverse effect upon
the Company's ability to expand its telecommunications services. In addition,
the Company intends initially to install only one switch in each market. As a
result, a switch failure which disables both the primary and redundant
capabilities of a Company switch may have a material adverse effect on the
Company's ability to provide telecommunications services in the affected market
which may continue for an indefinite period. The Company may seek to enter into
contracts with other telecommunications service providers to provide backup
capabilities in the event of a switch failure. However, there can be no
assurance that the Company will be able to successfully negotiate such
agreements or that such agreements will be available on favorable terms. See
"Business -- Network Architecture."
Reliance On Third Parties. As part of its telecommunications configuration,
the Company may transport telephone traffic across municipal boundaries or LATAs
which may require the Company to have multiple interconnection agreements. While
the Company has entered into interconnection agreements with ILECs serving
portions of its markets, the Company is currently negotiating agreements for the
interconnection of its networks with the network of other ILECs in certain of
the metropolitan areas the Company serves. There can be no assurance that the
Company will be able to successfully negotiate interconnection agreements with
the ILEC or any other LEC in each market where the Company plans to offer
central office switched telecommunications services or that it will be able to
do so on favorable terms. In addition, the Company has experienced delays and
difficulties accessing inside wiring used or owned exclusively by the ILEC even
in circumstances where it has a Right of Entry. The failure to negotiate the
necessary interconnection agreements or gain access to inside wiring used or
owned exclusively by the ILEC could have a material adverse effect upon the
Company's ability to expand its telecommunication services. Currently, the
Company provides local telephone service as an STS provider in most of its
markets. STS providers generally use the ILEC's facilities (although in many
states CLECs can now supply STS operators with facilities) to provide local
telephone service as a reseller, subject to state regulation. If LECs were no
longer required to provide tariffed services to STS providers or if STS-type
service classifications were to be eliminated, the Company's telephone
operations could be materially adversely affected. The Company relies on the
services of a third-
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party vendor to provide certain carrier-to-carrier billing services. The failure
by such vendor to accurately bill IXCs access charges could have a material
adverse effect on the Company.
Uncertainties Related to Reciprocal Compensation. The Telecom Act requires
ILECs to provide reciprocal compensation to other carriers for local traffic
terminated on such other carrier's network. Notwithstanding this requirement, a
number of ILECs have taken the position that traffic terminated to ISPs is not
local traffic. Competitive carriers generally have been successful in
challenging this position before the PUCs in several states. However, this issue
is under consideration and subject to review at the FCC, various state PUCs and
state and federal courts. There can be no assurance that traffic terminated to
an ISP will not ultimately be held to be exempt from the reciprocal compensation
requirements.
Uncertainties Related to Access Charges. The Company charges IXCs "access
charges" for the right to terminate and originate traffic on the Company's local
network. The Company depends in substantial part upon these access charges to
defray the costs of its network build-out. At least one IXC has questioned the
reasonableness of the Company's access rate and has refused to pay any access
rate greater than that charged by the ILEC in the same local calling area. There
can be no assurance that the Company's access rates will not now, or in the
future, be found to be unreasonable, or that regulatory or market forces will
not compel the Company to lower its access rates, which could, in either case,
materially adversely affect the profitability or the speed of deployment of the
Company's local telephone network.
Potential 911, E-911 and Intrusion Alarm Liability. The Company delivers
local exchange service, including access to emergency ("911") services, to MDU
residents through either its central office switches or PBX switches installed
by the Company at each property. Mechanical or electrical defects, power
failures or catastrophic events may temporarily disrupt operation of the
Company's switches, preventing, delaying or impeding access to 911 service. In
many jurisdictions, telecommunications carriers are required to implement
services which permits a 911 operator to immediately identify the location of
the caller ("E-911 service"). To provide E-911 service at an MDU, the
telecommunications service provider or its agent must maintain a database with
certain information relating to the MDU residents. The failure of the Company or
its agent to maintain such database in a timely and accurate manner could
prevent, delay or impede the operation of E-911 service. In addition, because of
the configuration of the Company's telecommunications networks, the Company's
telecommunications traffic may cross more than one E-911 jurisdiction. This will
require the Company to coordinate among these various jurisdictions. There can
be no assurance that the Company will not be liable for damage to property or
personal injuries that may directly or indirectly result from any failure of 911
or E-911 service to operate properly. Moreover, the Company may provide 911,
E-911 or operator services by contracting such services from other carriers in
its markets. The providers of these services will generally require the Company
to indemnify them for any losses or liability incurred in connection with such
services except for those caused exclusively by the gross negligence or
malfeasance of the carrier. In addition, the Company currently provides certain
intrusion alarm services through subcontractors. There can be no assurance that
the Company will not be liable for any property damage or personal injuries that
may result from intrusion alarm malfunctions or from a subcontractor's failure
to appropriately monitor the intrusion alarm systems under contract.
RISKS ASSOCIATED WITH RIGHTS OF ENTRY
The Company's business depends upon its ability to enter into and exploit
favorable new long-term Rights of Entry for demographically attractive MDUs and
to exploit and renew its existing Rights of Entry. Its success in doing so may
be affected by a number of factors, including (i) the extent of competition in
the provision of multichannel television and telecommunications services, (ii)
its ability to identify suitable MDUs and contract with their owners, (iii) the
continuing demographic attractiveness of the markets in which the Company has
chosen to focus its business, (iv) occupancy rates in the MDUs to which it
provides services, (v) its ability to maintain superior levels of customer
service, (vi) the absence of material adverse regulatory developments and (vii)
the enforceability of the material terms of its Rights of Entry, including
exclusivity provisions. Although the Company does not believe that any of its
existing arrangements will be cancelled or will not be renewed as needed in the
near future, cancellation or non-renewal of certain of such arrangements could
materially adversely affect the Company's business in any such affected area. In
addition,
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the failure by the Company to enter into and maintain any such arrangements for
a particular network which is already under development may affect the Company's
ability to acquire or develop that network. See "Business -- Competition" and
"-- Regulation."
The Company's Rights of Entry generally provide that the Company will have
the exclusive right to provide residents within the applicable MDU with
multichannel television services and, where Rights of Entry extend to
telecommunications services, an undertaking by the MDU owner to promote OpTel as
the preferred telecommunications alternative to the ILEC. While the Company
believes that the exclusivity provisions in its cable television Rights of Entry
are now generally enforceable under applicable law, current trends at the state
and federal level suggest that the future enforceability of these provisions may
be uncertain. Certain states in which the Company operates, including Illinois
and Florida (for condominiums only), and certain cities and municipalities in
states in which the Company operates, have adopted "mandatory access" laws that
provide that no resident of an MDU may be denied access to programming provided
by incumbent franchise cable systems, regardless of any rights granted by an MDU
owner to another multichannel television operator. Texas has adopted a
"mandatory access" law for state certified telecommunications service providers.
In addition, Virginia prohibits private cable television operators from entering
into revenue sharing or up front incentive payment arrangements with MDU owners.
The ICS Operations included several MDUs located in Virginia. Further, the FCC
has initiated a notice of proposed rule making seeking comment on whether the
FCC should adopt regulations restricting exclusive contracts. While the
constitutionality of present "mandatory access" laws is uncertain, there can be
no assurance that such laws will not be adopted elsewhere or upheld as
constitutional which may have a material adverse effect on the Company's
business. Broad mandatory access would likely increase the Company's capital
costs associated with new Rights of Entry if installing duplicate wiring were
required and result in competitive services being offered at MDUs where the
Company presently has exclusive rights of entry. See "-- Regulation."
In a number of instances individual Rights of Entry are subordinate by
their terms to indebtedness secured by the MDU, with the effect that enforcement
of the security interest or default under such indebtedness could result in
termination of such Right of Entry. Bankruptcy of an MDU owner could also result
in rejection of a Right of Entry as an "executory contract." Moreover, the terms
of a number of the Company's Rights of Entry require it to remain competitive
with other competitors in that market in general or competitive in terms of
price of offering, technology, number of programming channels and levels of
service. To meet these requirements, the Company could be required to upgrade
its networks and equipment, which would require capital expenditures. The
failure to remain competitive under any of these standards in a market could
result in a loss or cancellation of the related Right of Entry. Such losses or
cancellations could, in the aggregate, have a material adverse effect on the
Company's business. See "Business -- Strategic Relationships with MDU Owners."
UNCERTAINTIES RELATED TO THE AVAILABILITY OF RADIO SPECTRUM
The Company relies upon use of the radio spectrum, principally 18 GHz
microwave radio, in its network architecture. The 18 GHz point-to-point
microwave paths that the Company uses, and the other microwave frequencies that
the Company uses or intends to use, are licensed by the FCC. The FCC has issued
a Notice of Proposed Rulemaking seeking comment on a proposal to make
terrestrial microwave users, like the Company, secondary to satellite downlinks
in portions of the 18 GHz band that currently are used by the Company. Under the
proposal, terrestrial stations existing on September 18, 1998, and those for
which an application was already on file with the FCC as of that date, will
retain their status as co-primary in the 18 GHz band, but new stations would not
be permitted to cause harmful interference to satellite downlinks in the band.
If adopted, the proposal would severely limit the Company's use of the 18
GHz microwave band and potentially strand some of the Company's investment in
network facilities serving stations licensed after September 18, 1998 designed
to use 18 GHz. If the proposal is adopted, the Company would seek authority to
use other portions of the radio spectrum, but such use will likely require other
FCC rule changes, as to which there can be no assurance, and there can be no
assurance that migration by the Company to other bands is
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technically feasible or that such migration would not negatively affect the cost
of the Company's networks. See, "Business -- Regulation -- Microwave and Private
Cable Regulation."
DISTANCE AND WEATHER LIMITATIONS; LINE OF SIGHT; AVAILABILITY OF TRANSMISSION
SITES
Point-to-point microwave transmission requires a direct line of sight
between two dishes comprising a link and is subject to distance and rain
attenuation. The Company expects that its average coverage radius of Network
Hubs will be approximately five miles, depending on local conditions, and it is
expected that the Company's Network Hubs will utilize power control to increase
signal strength and mitigate the effects of rain attenuation. In areas of heavy
rainfall, transmission links are engineered for shorter distances and greater
power to maintain transmission quality. The reduction of path link distances to
maintain transmission quality may increase the cost of service coverage. While
these increased costs may not be significant in all cases, such costs may render
point-to-point microwave transmissions uneconomical in certain circumstances.
Due to line of sight limitations, the Company currently plans to install
its dishes and antennas on the rooftops of buildings and on other tall
structures. The Company expects generally to be able to construct intermediate
links or use other means to resolve line of sight and distance issues. However,
these limitations may render point-to-point links uneconomical in certain
locations.
The Company's microwave network expansion plans require the Company to
lease or otherwise obtain permission to install equipment at rooftop and tower
transmission sites in substantially all of its markets. The availability of
these sites is subject to market conditions and may be subject to zoning and
other municipal restrictions. The Company believes that as additional wireless
video and telecommunications providers emerge, competition for such transmission
sites will continue to increase. There can be no assurance that the necessary
sites will be available or that the terms upon which access to such sites may be
obtained will be acceptable.
RAPID TECHNOLOGICAL CHANGES AND UNCERTAIN MARKET DEVELOPMENT
The multichannel television and telecommunications industries are subject
to rapid and significant changes in technology and frequent service innovations.
The effect on the business of the Company of future technological changes, such
as changes relating to emerging transmission technologies, cannot be predicted.
The Company believes that its future success will depend on its ability, as to
which no assurance can be given, to enhance its existing systems or implement
new systems to respond to new technologies and to develop and introduce in a
timely fashion new products and services on a competitive basis.
The markets in which the Company competes are constantly evolving. The
convergence of traditional telecommunications services and multichannel
television services is a recent trend in the industries within which the Company
competes. As part of this trend, many telecommunications and cable television
operators are attempting to integrate network components. For example, video
distribution equipment is being considered for voice and data telecommunications
and vice versa. The convergence of these traditional services towards integrated
multimedia services presents both opportunity and material risk to companies
such as OpTel. The Company will face enhanced competition from competitors with
greater financial, technical, marketing and other resources. Many of these
competitors may offer packages of services that are more extensive than the
services which the Company plans to offer. There can be no assurance that the
Company will be able to predict accurately the direction of this evolving market
or be able to respond effectively to the highly competitive environment. See
"-- Competition" and "Business -- Competition."
INFORMATION SYSTEMS AND AUTOMATION
The Company has ordered a new customer management information system which
is to be implemented during fiscal 1999 and which the Company expects to be an
important factor in its operations. If the customer management information
system is not implemented in a timely manner, or is not implemented at all or if
it fails or is unable to perform as expected, it could have a material adverse
effect on the Company. Furthermore, as the Company's business expands, problems
may be encountered with higher processing volumes or with additional automation
features, in which case the Company might experience system
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breakdowns, delays and additional unbudgeted expense to remedy the defect or to
replace the defective system with an alternative system.
MANAGEMENT OF GROWTH AND DEPENDENCE ON QUALIFIED PERSONNEL
The Company is highly dependent upon the efforts of its senior management,
the loss of any of whom could impede the achievement of service delivery and
marketing objectives and could have a material adverse effect on the Company.
The Company has undertaken a rapid expansion of its networks and services. This
growth has increased the operating complexity of the Company as well as the
level of responsibility for both existing and new management personnel. The
Company's ability to manage its expansion effectively will require it to
continue to implement and improve its operational and financial systems and to
expand, train and manage its employee base and attract and retain highly skilled
and qualified personnel. Any failure by the Company to effectively manage its
growth and attract and retain qualified personnel could have a material adverse
effect on its business.
COMPETITION
Substantially all markets for voice and video services are highly
competitive and the Company expects that competition will intensify. See
"Business -- Competition." In each of its markets, the Company faces significant
competition from larger companies with greater access to capital, technology and
other competitive resources. The Company's switched local exchange services
compete with ILECs, other STS providers, CLECs and CAPs and will compete with
long distance telephone companies and franchise cable television operators as
they begin to enter the local telephone business. The Company's long distance
service competes with established IXCs and resellers. In addition, recent
telecommunications offerings, including PCS, and future offerings may increase
competition in the telecommunications industry. The Company's private cable
television services compete with incumbent franchise cable television operators
as well as wireless cable television operators, other private cable television
operators, DBS operators and stand-alone satellite service providers. Recent and
future legislative, regulatory and technological developments likely will result
in additional competition, as telecommunications companies enter the cable
television market and as franchise cable television operators and IXCs begin to
enter the local telephone market. See "Business -- Regulation." Similarly,
mergers, joint ventures and alliances among franchise, wireless or private cable
television operators, RBOCs and IXCs may result in providers capable of offering
bundled cable television and telecommunications services in direct competition
with the Company.
The Company competes with multichannel television operators and
telecommunications service providers to obtain Rights of Entry and to enroll
subscribers. In most markets serviced by the Company, franchise cable television
operators now offer revenue sharing and access fee arrangements to MDU owners.
There can be no assurance that these payments will not increase in the future as
competition increases for access to the higher quality MDUs. Another basis of
competition is the breadth of programming and range of services offered.
Although the Company as a matter of course investigates new sources of
programming and technologies that may increase its range of services, other
larger and more diversified competitors may attract the targeted MDUs based on
their increased menu of services. There can be no assurance that the Company
will be able to compete successfully with existing competitors or new entrants
in the market for such services. See "Business -- Competition."
Competition also may be enhanced by technological developments that allow
competitors of the Company to bypass property owners altogether and market their
services directly to the tenants of MDUs. Although the Company's Rights of Entry
prohibit tenants from installing receiving equipment on the exterior of the
building, these provisions are not always enforced and do not prohibit tenants
from utilizing other services and technologies. For example, the Rights of Entry
do not prevent a resident from using cellular telephone service offered by
another provider. While the Company believes that the exclusivity provisions of
its Rights of Entry provide it with competitive advantages, such advantages may
be significantly diminished by technological, regulatory and other developments
beyond the control of the Company. Such developments may impact the Company's
strategies and may require it to expend funds beyond the levels currently
contemplated.
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As an emerging CLEC in each of its markets, OpTel faces significant
competition for the local exchange services it offers from ILECs which currently
dominate their local telecommunications markets. ILECs have longstanding
relationships with their customers, which relationships may create competitive
barriers. Furthermore, ILECs may have the potential to subsidize competitive
service from monopoly service revenues. OpTel believes that various legislative
initiatives, including the Telecom Act have removed most of the remaining
legislative barriers to local exchange competition. Nevertheless, in light of
the passage of the Telecom Act, regulators also are likely to provide ILECs with
increased pricing flexibility as competition increases. If ILECs are permitted
to lower their rates substantially or engage in excessive volume or term
discount pricing practices for their customers, the net income or cash flow of
ICPs and CLECs, including OpTel, could be materially adversely affected. In
addition, while OpTel currently competes with AT&T, MCI Telecommunications
Corporation ("MCI") and others in the interexchange services market, recent
federal legislation permits the RBOCs to provide interexchange services once
certain criteria are met. Once the RBOCs begin to provide such services, they
will be in a position to offer single source telecommunications service similar
to that being offered by OpTel. In addition, AT&T and MCI have entered, and
other IXCs have announced their intent to enter, the local exchange services
market, which is facilitated by the Telecom Act's resale and unbundled network
element provisions. OpTel cannot predict the number of competitors that will
emerge as a result of existing or new federal and state regulatory or
legislative actions. Competition from the RBOCs with respect to interexchange
services or from AT&T, MCI or others with respect to local exchange services
could have a material adverse effect on OpTel's business. In addition, a
continuing trend toward business combinations and alliances in the
telecommunications industry may create significant new competitors for OpTel.
Many of OpTel's existing and potential competitors have financial, personnel and
other resources significantly greater than those of OpTel.
DEPENDENCE UPON PROGRAM MATERIAL
The Company has fixed-term contracts with various program suppliers. The
average term of such contracts is approximately five years and such contracts
are typically renewed upon expiration. If the contracts were terminated or not
renewed, the Company would be required to seek program material from other
sources, which could place the Company at a competitive disadvantage. Although
federal law and FCC regulations require that vertically integrated franchise
cable television system operators and cable television programmers sell
programming to other video distributors, such as the Company, on fair and
non-discriminatory terms, the Company has been denied certain popular sports
programming by certain providers who claim that the programming is not required
to be licensed to the Company. These denials have adversely impacted, and any
such denials in the future could adversely impact, the Company's activities in
the affected markets. There can be no assurance that the equal program access
laws and regulations will not be invalidated, changed or repealed, which could
limit the Company's ability to obtain programming or raise the cost of
programming. In addition, one aspect of the equal program access laws, the
prohibition on the sale of exclusive distribution rights by certain programmers,
is scheduled to expire on October 5, 2002, unless the FCC finds, during a
proceeding to be conducted in 2001, that the prohibition continues to be
necessary to promote competition in the multichannel television market. See
"Business -- Regulation."
REGULATION
The cable television and telecommunications industries are subject to
extensive regulation at the federal, state and local levels. Many aspects of
regulation at the federal, state and local levels currently are subject to
judicial review or are the subject of administrative or legislative proposals to
modify, repeal, or adopt new laws and administrative regulations and policies,
the results of which the Company is unable to predict. The United States
Congress and the FCC have in the past, and may in the future, adopt new laws,
regulations and policies regarding a wide variety of matters, including
rulemakings arising as a result of the Telecom Act, that could, directly or
indirectly, affect the operation of the Company's business. The business
prospects of the Company could be materially adversely affected (i) by the
application of current FCC rules or policies in a manner leading to the denial
of applications by the Company for FCC licenses or a change in the regulatory
status of the Company's private cable television and telecommunications
operations, (ii) by the adoption of new laws, policies or regulations, (iii) by
changes in existing laws, policies or regulations, including changes to their
31
<PAGE> 34
interpretations or applications, that modify the present regulatory environment
or (iv) by the failure of certain rules or policies to change in the manner
anticipated by the Company. See "Business -- Regulation."
The Company believes that its exclusive Rights of Entry are now generally
enforceable under applicable law; however, current trends at the state and
federal level suggest that the future enforceability of these provisions may be
uncertain. The FCC is seeking comment on whether such exclusive contracts should
be limited to a maximum period of seven years and whether such an amount of time
is reasonably necessary to recover the capital costs of providing service to
that MDU. Although it is open to question whether the FCC has statutory and
constitutional authority to compel mandatory access there can be no assurance
that it will not attempt to do so. Any such action would tend to undermine the
exclusivity provisions of the Company's Rights of Entry. See "-- Risks
Associated with Rights of Entry." The FCC also has issued a rule preempting
state, local and private restrictions on over-the-air reception antennas placed
on rental properties or properties not within the exclusive control of the
viewer. There can be no assurance that future state or federal laws or
regulations will not restrict the ability of the Company to offer revenue
sharing or access payments, limit MDU owners from receiving revenue sharing or
prohibit MDU owners from entering into exclusive access agreements, any of which
could have a material adverse effect on the Company's business. See "Business --
Sales and Marketing," "-- Strategic Relationships with MDU Owners" and
"-- Regulation."
The Company uses a substantial number of point-to-point microwave paths
which are licensed by the FCC. There can be no assurance that the Company will
be able to acquire licenses for the microwave paths that it seeks in the future,
or that changes in the FCC's regulations will not limit the Company's ability to
use desirable frequencies for the distribution of its services, or otherwise
impair the Company's microwave licenses. See "-- Uncertainties Related to the
Availability of Radio Spectrum." If the Company cannot license the necessary
paths on the desired frequencies, it may be necessary to utilize other
frequencies for signal transport or other means of signal transport. There can
be no assurance that the cost of such alternate means of transport will not
exceed those associated with the desired microwave frequency. Further, even if
the FCC grants the desired licenses, the Company may not have the financial
resources to construct the necessary facilities within the time permitted by the
license. In addition, state and local zoning and land use laws may impede the
efficient deployment of the Company's microwave antennas. Any of the foregoing
developments could have a material adverse effect on the Company's business. See
"Business -- Network Architecture."
As an emerging CLEC, OpTel is subject to varying degrees of federal, state
and local regulation. OpTel is not currently subject to price cap or rate of
return regulation at the state or federal level. OpTel is, however, generally
subject to certification or registration and tariff or price list filing
requirements for intrastate services by state regulators. Although passage of
the Telecom Act should result in increased opportunities for companies that are
competing with the ILECs, no assurance can be given that changes in current or
future regulations adopted by the FCC or state regulators or other legislative
or judicial initiatives relating to the telecommunications industry would not
have a material adverse effect on OpTel. Moreover, while the Telecom Act reduces
regulation to which non-dominant LECs are subject, it also reduces the level of
regulation that applies to the ILECs and increases their ability to respond
quickly to competition from OpTel and others. In addition, the Telecom Act will
permit RBOCs, for the first time, to offer long distance service in the regions
where they provide local exchange service upon demonstrating to the FCC and
state regulatory agencies that they have complied with the FCC's interconnection
regulations designed to foster local exchange competition. While the FCC has not
approved the applications to provide in-region long distance service filed to
date, it may do so in the future.
In addition, the FCC has put in place access charge reform rules which may
over time result in a net decrease in the access charges paid by IXCs to LECs
for originating or terminating long distance traffic. To the extent ILECs are
afforded increased pricing flexibility or access charges are reduced, the
ability of the Company to compete with ILECs for certain services may be
adversely affected.
The majority of states currently permit STS services with relatively few
regulatory barriers. However, several states require certification and place
some conditions or restraints on the provision of STS services. Additionally,
STS providers must comply with the conditions of service set forth in the LEC's
tariffs under which STS providers receive service. There can be no assurance
that the regulatory environment will continue
32
<PAGE> 35
to be favorable for STS providers or that regulatory changes will not slow or
stop the Company's planned migration from an STS provider into a CLEC in each of
its markets. Although the current regulatory environment enables competition for
local exchange services, there is no assurance that the Company will be able to
compete successfully against established providers and new entrants in that
marketplace. In addition, various state and federal laws and regulations limit
the Company's ability to enforce exclusivity provisions of Rights of Entry so as
to exclude other telecommunications providers from an MDU.
CONTROL OF LICENSES BY UNAFFILIATED COMPANY
The Telecom Act prohibits any corporation directly or indirectly controlled
by any other corporation of which more than 25 percent of the capital stock is
owned or voted by non-U.S. citizens from holding a common carrier radio station
license absent a finding by the FCC that the grant of such a license to such a
licensee would serve the public interest. In 1997, the United States agreed, in
the context of the WTO Basic Telecom Agreement, to allow foreign suppliers from
WTO member nations, including Canada, to provide a broad range of basic
telecommunications services in the United States. Those commitments became
effective in February 1998. In light of those commitments, the FCC has
determined that it will adopt an "open entry standard" for suppliers of
telecommunications services from WTO member nations, including Canada. In
conjunction with its new open entry policies, the FCC has adopted a presumption
favoring grant of applications to exceed the 25 percent limit on non-U.S.
ownership described above when the non-U.S. investment is from a WTO member
nation. GVL, the Company's principal stockholder, is a Canadian corporation.
Prior to the recent developments described above, the Company assigned
substantially all of its frequency licenses to THI, an entity controlled by
United States citizens, to permit the Company to use its frequency licenses to
provide "common carrier" telecommunications services in the event that the
Company should desire to do so. The Company has an option to purchase the assets
(or the stock) of THI, exercisable at any time, subject to FCC approval. THI is
not an affiliate of the Company. While the Company is in the process of
reevaluating whether it should hold FCC authorizations directly and,
specifically, whether it should exercise its option to purchase the assets or
stock of THI, the current ownership of these licenses by THI is subject to a
number of risks, including the risk that acts or omissions of THI or its
stockholders could result in the revocation of such licenses or the
unavailability of such licenses to the Company and the risk that THI may be
subject to bankruptcy or similar proceedings which could result in the rejection
or termination of the arrangements between THI and the Company with respect to
the use of such licenses. While THI and its stockholders have made various
affirmative and negative covenants intended to limit the risk to the Company,
there can be no assurance that such covenants will not be violated or will be
adequate to protect the Company. See "Certain Relationships and Related
Transactions -- License Holding Company."
USE OF THE NAME OPTEL
On April 27, 1998, an action was commenced against the Company in the
United States District Court for the Northern District of California by Octel
Communications Corp. ("Octel"), charging the Company with trademark
infringement, trade name infringement, trademark dilution, and unfair
competition (the "Civil Action") based on its use of the name "OpTel" and
seeking to enjoin the Company from using the name and trademark "OpTel." The
Civil Action follows a now-suspended administrative proceeding in the United
States Patent and Trademark Office ("PTO"), pending since November 7, 1995,
relating to registration of the "OpTel" mark by the Company. The PTO found the
Company's application for registration to be allowable; however, Octel commenced
an opposition proceeding claiming that the Company's mark is confusingly similar
to the "Octel" mark used by that party in a related field, and claiming that the
Company's application had procedural deficiencies. During the course of the PTO
proceeding, the Company acquired rights to the marks "Optel" and "Optel
Communications" in the telecommunications field which are believed to predate
the rights of Octel to its trademark, and the Company commenced two further
proceedings against Octel in the PTO seeking cancellation of two trademark
registrations held by Octel. The various proceedings in the PTO between the
Company and Octel were consolidated and thereafter suspended on May 15, 1998, in
view of the commencement of the Civil Action. The Company believes it has
meritorious counterclaims in the Civil
33
<PAGE> 36
Action and intends to vigorously defend against Octel's claims. Although the
Company does not believe that its use of the name "OpTel" infringes on the
trademark rights or trade name rights of Octel or any other person, there can be
no assurance as to the outcome of the Civil Action or the proceedings in the PTO
(if reinstated) or that any such outcome would not materially adversely affect
the Company.
LATE FEES CLASS ACTION LITIGATION
On April 9, 1998, a purported class action complaint was filed in the
District Court of Harris County, Texas by Gavin Stewart Clarkson, individually
and on behalf of all cable subscribers in the U.S. that have paid late fees to
either the group of affiliated entities known as Phonoscope (collectively,
"Phonoscope") or the Company. The plaintiff, who formerly subscribed to cable
television services provided by Phonoscope, alleges that Phonoscope's charging
pre-established late fees for delinquent payments of cable subscription charges
constitutes an illegal collection of a penalty and that cable service providers
should only be entitled to their actual collection costs. The plaintiff seeks to
enjoin Phonoscope and OpTel from collecting, or attempting to collect, such late
fees. The case is in its very early stages, and no assurance can be given as to
its ultimate outcome or that any such outcome will not materially adversely
affect the Company. OpTel believes that it has meritorious factual and legal
defenses, and intends to defend vigorously against these claims.
CONTROL BY GVL
General. VPC, an indirect wholly-owned subsidiary of GVL, owns 1,923,559
shares of the Company's Class B Common Stock, par value $.01 per share (the
"Multi-Vote Common"), representing approximately 81% of the voting rights of the
Company. Accordingly, VPC can elect a majority of the Board of Directors of the
Company (the "Board") and control the vote on matters submitted to the vote of
the Company's stockholders.
Potentially Competing Ventures. In addition to its investment in the
Company, GVL, through other subsidiaries, currently holds interests in wireless
cable systems or licenses to operate wireless cable systems in a number of U.S.
markets including San Francisco, San Diego and Victorville, California and
Tampa, Florida. These subsidiaries employ wireless cable systems, SMATV systems
or hard wire franchise cable television systems. As a result, affiliates of GVL
may compete with the Company in markets where their services overlap. In
addition, an affiliate of GVL has recently announced its intention to deliver
high speed Internet access in the San Francisco area. These services may compete
with the Company's high speed Internet offering.
GVL Indenture. GVL is party to an indenture which limits the aggregate
amount of indebtedness which can be incurred by GVL and its subsidiaries,
including the Company, taken as a whole (based upon a ratio of total
consolidated indebtedness to consolidated operating cash flow). As a result,
GVL's strategies and the operating results of its subsidiaries other than the
Company may affect the ability of the Company to incur additional indebtedness.
As of August 31, 1998, GVL was able to incur approximately Cdn $550 million
(approximately $355 million based on an exchange rate of $1.00 = Cdn $1.5474 as
reported by the Wall Street Journal on November 20, 1998) of indebtedness under
its indenture. There can be no assurance that this number may not decrease
substantially in the future. There can be no assurance that GVL will not
restrain the Company's growth or limit the indebtedness incurred by the Company
so as to ensure GVL's compliance with the terms of its debt instruments.
Stockholders' Agreement. GVL, VPC, CDPQ, a subsidiary of Caisse, a Quebec
financial institution and minority shareholder of GVL, and the Company are
parties to a Stockholders' Agreement, dated as of August 15, 1997 (the
"Stockholders' Agreement"), pursuant to which, among other things, CDPQ was
granted veto rights with respect to certain material transactions (including
material acquisitions and the incurrence of certain additional indebtedness),
the right to elect certain directors of OpTel, preemptive rights to acquire new
securities issued by the Company subject to certain exceptions (including a
registered public offering) and tag along rights upon the sale by VPC of its
interest in OpTel. In addition, CDPQ agreed to certain restrictions on the
transfer of its shares of Multi-Vote Common. See "Security Ownership of Certain
Beneficial Owners and Management -- Stockholders' Agreement."
34
<PAGE> 37
CHANGE OF CONTROL UNDER THE INDENTURES
A transfer by VPC of its interest in OpTel or a transfer by GVL of its
interest in VPC or an election by VPC to convert its Multi-Vote Common into
shares of Class A Common Stock may result in a "Change of Control" as defined
under the Indentures, which would require the Company to offer to purchase its
outstanding notes.
There can be no assurance that the Company would have the financial
resources to meet its obligations in the event of a "Change of Control." The
occurrence of a "Change of Control" may also result in the acceleration of or an
event of default in respect of other indebtedness of the Company and,
consequently, the lenders or holders thereof may have the right to require
repayment of such indebtedness in full.
Neither VPC nor GVL is under any obligation to prevent a "Change of
Control." The occurrence of a "Change of Control" could have a material adverse
effect on the Company, including the loss of GVL's strategic involvement with
the Company.
YEAR 2000 RISK
OpTel has implemented a Year 2000 program to ensure that its computer
systems and applications will function properly beyond 1999.
Embedded Technology. As the first phase of its program, OpTel has conducted
an inventory of the equipment that it either uses to deliver its
telecommunications services or utilizes in its corporate headquarters and
regional offices. While OpTel believes that its equipment inventory is complete,
much of the equipment utilized by OpTel resides outside the Company's
headquarters and there can be no assurance that mission critical equipment has
not been overlooked. As the second phase of its Year 2000 program, OpTel has
begun contacting its vendors to determine whether the inventoried equipment is
Year 2000 compliant or must be upgraded or replaced. While certain of OpTel's
equipment vendors have indicated that their equipment is Year 2000 compliant,
others have indicated that software upgrades are required. The Company has begun
to schedule the installation of the necessary software upgrades, however, there
can be no assurance that it will successfully implement all of the necessary
upgrades in a timely manner. OpTel also intends to conduct a risk assessment to
identify those systems whose failures would be expected to present the highest
risk to the Company. Although OpTel intends to conduct tests to ensure that its
equipment is Year 2000 compliant, such tests will focus principally on those
systems whose failure would pose the greatest risk to the Company. OpTel will
likely not test all of its equipment and will rely upon vendor representations
where tests are not conducted. In addition, OpTel has not yet received responses
from all of its equipment vendors. There can be no assurance that OpTel will
receive responses from all of its vendors in a timely manner or that such
responses will be accurate or complete. There can be no assurance that the
failure of OpTel to adequately address Year 2000 problems embedded in currently
utilized equipment will not have a material adverse effect on OpTel's business,
financial condition, cash flows and results of operations.
Information Technology. OpTel also has begun upgrading, replacing and
testing certain components of its networks and information processing systems.
OpTel believes that it has allocated adequate resources for this purpose and
expects its Year 2000 conversion program for its information processing systems
to be successfully completed on a timely basis. However, successful completion
of the Year 2000 conversion program is substantially dependent upon successful
implementation of the Company's new customer management information system and,
as a result, on the third party vendor meeting the delivery and implementation
schedule it has proposed to OpTel. In addition, the Company's financial
accounting system has not been upgraded to eliminate potential Year 2000 related
malfunctions. The Company has selected a new financial accounting system and
plans to have the new system implemented within the next 12 months. There can be
no assurance that the new customer management information system and financial
accounting system will be implemented on schedule or that other components of
the Year 2000 conversion program will be completed in a timely manner. See
"-- Information Systems and Automation." Other than expenses relating to the
acquisition of the customer management information system and the financial
accounting system, OpTel does not expect to incur significant expenditures to
address its Year 2000 compliance issues.
35
<PAGE> 38
However, the failure of the Company to become Year 2000 compliant on a timely
basis could have a material adverse effect on the Company's business, financial
condition, cash flows and results of operations.
Third Party Interfaces. OpTel also has taken an inventory of its third
party service or content providers. While OpTel believes that its inventory of
third party service and content providers is complete, there can be no assurance
that mission critical providers have not been overlooked. Many of the Company's
third party providers have indicated that they are, or will be, Year 2000
compliant. The Company, however, has not undertaken an in-depth evaluation of
such providers in relation to the Year 2000 issue and the ability of third
parties with which OpTel transacts business to adequately address their Year
2000 issues is outside of OpTel's control. There can be no assurance that the
failure of OpTel or such third parties to adequately address their respective
Year 2000 issues will not have a material adverse effect on OpTel's business,
financial condition, cash flows and results of operations.
FORWARD LOOKING STATEMENTS
The statements contained in this report that are not historical facts are
"forward-looking statements" (as such term is defined in the Private Securities
Litigation Reform Act of 1995), which can be identified by the use of
forward-looking terminology such as "estimates," "projects," "anticipates,"
"expects," "intends," "believes" or the negative thereof or other variations
thereon or comparable terminology or by discussions of strategy that involve
risks and uncertainties. Management wishes to caution the reader that these
forward-looking statements are only estimates or predictions. No assurance can
be given that future results will be achieved. Actual events or results may
differ materially as a result of risks facing OpTel or actual events differing
from the assumptions underlying such statements. All forward-looking statements
made in connection with this report which are attributable to OpTel or persons
acting on its behalf are expressly qualified in their entirety by these
cautionary statements.
EMPLOYEES
As of October 31, 1998, the Company had a total of 749 full-time employees.
The Company believes that its continued success will depend in large part on its
ability to attract and retain highly skilled and qualified personnel. The
Company has nondisclosure agreements with all of its senior executive officers.
From time to time, the Company also uses the services of contract technicians
for installation and maintenance services. The Company relies principally on
outside contractors for network construction. None of the Company's employees is
currently represented by a collective bargaining agreement. The Company believes
that its relationships with its employees are good.
ITEM 2: PROPERTIES
The Company's executive offices are located in Dallas, Texas and house its
national call center and its corporate, engineering, sales and marketing and
corporate administrative services groups. The original lease provides for
approximately 52,000 square feet of space and has a ten-year term expiring
November 30, 2005. The Company has an option to extend the lease term for an
additional five-year term at the then market rental rate. The Company leased an
additional 17,000 square feet in the same building, for a term of one year
expiring in September, 1999, to provide for needed expansion. The Company pays
approximately $71,000 per month for the space in its headquarters building. The
Company has the right to acquire additional space at its current location when
such space becomes available.
In October 1997, the Company purchased a building proximate to its
executive offices in Dallas, Texas. The Company has installed the central office
switch for the Dallas-Fort Worth market in the building and intends to relocate
its Dallas regional operations to the same building by the end of January 1999.
The Company also leases facilities in each of the fourteen cities in which it
has established regional operations.
The Company owns substantially all of the telecommunications and cable
television equipment essential to its operations. The Company's major fixed
assets are telecommunications switches, cable television head
36
<PAGE> 39
ends, microwave transmitters and receivers, SMATV receivers, PBX switches and
coaxial fiber optic cable. Such properties do not lend themselves to description
by character and location of principal units. Substantially all of this
equipment (other than fiber optic cable laid under public rights of way) resides
on or under the MDUs served by the Company or in leased facilities in various
locations throughout the metropolitan areas served by the Company.
ITEM 3: LEGAL PROCEEDINGS
The Company is not a party to any legal proceedings except for those
described below and those arising in the ordinary course of business. The
Company does not believe that any legal proceeding to which it is a party will
have a material adverse impact on the Company's financial condition or results
of operations.
On April 27, 1998, the Civil Action was commenced against the Company in
the United States District Court for the Northern District of California by
Octel, charging the Company with trademark infringement, trade name
infringement, trademark dilution and unfair competition based on its use of the
name "OpTel" and seeking to enjoin the Company from using the name "OpTel." The
Civil Action follows a now-suspended administrative proceeding in the PTO,
pending since November 7, 1995, relating to registration of the "OpTel" mark by
the Company. The PTO found the Company's application for registration to be
allowable; however, Octel commenced the PTO proceeding claiming that the
Company's mark is confusingly similar to the "Octel" mark used by that party in
a related field, and claiming that the Company's application had procedural
deficiencies. During the course of the PTO proceeding, the Company acquired
rights to the marks "Optel" and "Optel Communications" in the telecommunications
field which are believed to predate the rights of Octel to its trademark, and
the Company commenced two further proceedings against Octel in the PTO seeking
cancellation of two of the trademark registrations owned by Octel. The various
proceedings in the PTO between the Company and Octel were consolidated and
thereafter suspended on May 15, 1998, in view of the commencement of the Civil
Action. The Company believes it has meritorious counterclaims in the Civil
Action and intends to vigorously defend against Octel's claims. Although the
Company does not believe that its use of the name "OpTel" infringes on the
trademark or trade name rights of Octel or any other person, there can be no
assurance as to the outcome of the Civil Action or the proceedings in the PTO
(if reinstated) or that any such outcome would not materially adversely affect
the Company. See "Risk Factors -- Use of the Name OpTel."
On April 9, 1998, a purported class action complaint was filed in the
District Court of Harris County, Texas by Gavin Stewart Clarkson, individually
and on behalf of all cable subscribers in the U.S. that have paid late fees to
either the group of affiliated entities known as Phonoscope ("Phonoscope") or
the Company. The plaintiff, who formerly subscribed to cable television services
provided by Phonoscope, alleges that Phonoscope's charging pre-established late
fees for delinquent payments of cable subscription charges constitutes an
illegal collection of a penalty and that cable service providers should only be
entitled to their actual collection costs. The plaintiff seeks to enjoin
Phonoscope and OpTel from collecting, or attempting to collect, such late fees.
The case is in its very early stages and no assurance can be given as to its
ultimate outcome or that any such outcome will not materially adversely affect
the Company. OpTel believes that it will have meritorious factual and legal
defenses and intends to defend vigorously against these claims. See "Risk
Factors -- Late Fees Class Action Litigation."
ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
37
<PAGE> 40
PART II
ITEM 5: MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
The Company's capital stock is not registered or listed on any exchange and
there is no established market for these securities. The Company has not
declared any dividend on its capital stock and does not intend to do so in the
foreseeable future. The terms of the Company's outstanding indebtedness restrict
the ability of the Company to declare or pay dividends on its capital stock. It
is expected that any future working capital financing will also contain similar
restrictions.
As of October 31, 1998, all of the outstanding shares of the Company's
Multi-Vote Common were held by VPC and CDPQ and all of the outstanding shares of
Class A Common Stock were held by ICS. See "Risk Factors -- Control by GVL."
RECENT SALES OF UNREGISTERED EQUITY SECURITIES
On April 13, 1998, in connection with the initial closing of the
acquisition of the ICS Operations and the payment of the purchase price thereof,
the Company issued 164,271.54 shares of Class A Common Stock and 991.1039 shares
of the Series B Preferred. Such issuances were made in reliance on the exemption
from registration provided by Section 4(2) of the Securities Act as transactions
by an issuer not involving a public offering. All of the securities were
acquired by the recipients thereof for investment and with no view toward the
sale or redistribution thereof. The sales were made without any public
solicitation; the stock certificates bear restrictive legends and appropriate
stop transfer instructions have been or will be given to the transfer agent.
Effective March 1, 1998, VPC exchanged $139.2 million principal amount of
the GVL Notes, constituting all of the GVL Notes, for 6,962.21365 shares of the
Series A Preferred. The issuance of the shares of Series A Preferred in exchange
for the GVL Notes was made in reliance on the exception from registration
provided by Section 3(a)(9) of the Securities Act for securities exchanged by an
issuer with its existing security holders exclusively. No commissions or other
remuneration was paid or given for soliciting such exchange.
During fiscal 1998, the Company granted options and warrants to purchase a
total of 43,657 shares of Class A Common Stock to certain employees and a former
employee of the Company as part of their compensation or severance packages.
Such issuances were made in reliance on the exemption from registration provided
by Section 4(2) of the Securities Act as transactions by an issuer not involving
a public offering. All of the securities were acquired by the recipients thereof
for investment and with no view toward the sale or redistribution thereof. The
securities were acquired without any public solicitation; the securities bear
restricted legends, and appropriate stop transfer instructions have been or will
be given to the transfer agent.
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<PAGE> 41
ITEM 6: SELECTED FINANCIAL DATA
The following selected historical consolidated financial data have been
derived from the audited consolidated financial statements of the Company. In
1995, the Company changed its fiscal year end to August 31 to match that of its
majority stockholder. As a result of the change in fiscal year and the Company's
history of growth through acquisitions the Company's historical financial
results are not directly comparable from period to period, nor are they
indicative of future results of operations in many respects. The following
information should be read in conjunction with "Management's Discussion and
Analysis of Financial Condition and Results of Operations," "Business" and the
Consolidated Financial Statements of the Company and the notes thereto,
appearing elsewhere in this report.
<TABLE>
<CAPTION>
PERIOD FROM
APRIL 20, 1993 EIGHT MONTH
(DATE OF INCEPTION) YEAR ENDED PERIOD ENDED YEAR ENDED AUGUST 31,
TO DECEMBER 31, DECEMBER 31, AUGUST 31, --------------------------------------
1993 1994 1995 1996 1997 1998
------------------- ------------ ------------ ---------- ---------- ------------
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<S> <C> <C> <C> <C> <C> <C>
CONSOLIDATED OPERATIONS DATA
Revenues:
Cable television................... $ 12 $ 240 $ 8,783 $ 25,893 $ 36,915 $ 61,081
Telecommunications................. -- 202 788 1,711 2,922 3,882
----- ------- -------- -------- -------- --------
Total revenues..................... 12 442 9,571 27,604 39,837 64,963
Operating expenses:
Programming, access fees and
revenue sharing................. 6 470 4,558 11,868 19,202 28,825
Customer support, general and
administrative.................. 304 7,733 12,055 19,636 28,926 35,847
Depreciation and amortization...... 8 117 2,420 8,676 14,505 28,481
----- ------- -------- -------- -------- --------
Total operating expenses............. 318 8,320 19,033 40,180 62,633 93,153
----- ------- -------- -------- -------- --------
Loss from operations................. (306) (7,878) (9,462) (12,576) (22,796) (28,190)
Interest expense, net(1)............. (1) (66) (1,169) (5,854) (25,739) (39,564)
----- ------- -------- -------- -------- --------
Loss before income taxes and
extraordinary item................. (307) (7,944) (10,631) (18,430) (48,535) (67,754)
Net loss(2).......................... $(307) $(7,944) $(10,161) $(18,430) $(48,535) $(74,398)
===== ======= ======== ======== ======== ========
Basic and diluted loss per share of
Common Equity(3)................... N/A N/A $ (6.89) $ (8.30) $ (19.98) $ (31.45)
</TABLE>
<TABLE>
<CAPTION>
DECEMBER 31, AUGUST 31,
-------------- -----------------------------------------
1993 1994 1995 1996 1997 1998
---- ------- -------- -------- -------- --------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
BALANCE SHEET DATA
Cash and cash equivalents........................ $ 41 $ 5,019 $ 2,036 $ 1,677 $ 87,305 $123,774
Restricted investments........................... -- -- -- -- 67,206 63,207
Property, plant and equipment, net............... 509 11,379 48,060 103,800 160,442 268,044
Intangible assets................................ -- 16,189 55,443 65,876 82,583 160,370
Total assets..................................... 588 33,820 108,072 175,978 403,416 627,170
Convertible notes due stockholder................ -- 15,000 17,950 89,414 129,604 --
Notes payable and long-term obligations.......... 52 7,675 9,023 8,963 228,573 429,278
Total liabilities................................ 206 31,007 39,527 116,700 383,051 466,394
Stockholders' equity............................. 382 2,813 68,545 59,279 20,365 160,776
</TABLE>
39
<PAGE> 42
<TABLE>
<CAPTION>
PERIOD FROM
APRIL 20, 1993
(DATE OF EIGHT MONTH
INCEPTION) YEAR ENDED PERIOD ENDED YEAR ENDED AUGUST 31,
TO DECEMBER 31, DECEMBER 31, AUGUST 31, -----------------------------------
1993 1994 1995 1996 1997 1998
--------------- ------------ ------------ ---------- ---------- ---------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
OTHER FINANCIAL DATA
Net cash flows used in operating
activities............................ $(183) $ (3,332) $ (3,494) $ (453) $ (15,935) $ (26,268)
Net cash flows used in investing
activities............................ (517) (10,576) (72,144) (72,037) (143,125) (121,532)
Net cash flows provided by financing
activities............................ 741 18,886 72,655 72,131 244,688 184,269
Capital expenditures(4)................. 517 9,278 22,170 62,121 71,505 85,643
EBITDA(5)............................... (298) (7,761) (7,042) (3,900) (8,291) 291
</TABLE>
<TABLE>
<CAPTION>
AS OF AUGUST 31,
------------------------------------------
1995 1996 1997 1998
------- ------- ------- -------
<S> <C> <C> <C> <C>
OPERATING DATA(6)
CABLE TELEVISION
Units under contract(7)..................................... 173,324 241,496 295,149 432,955
Units passed(8)............................................. 170,336 225,433 254,032 399,210
Basic subscribers........................................... 75,944 114,163 132,556 216,249
Basic penetration(9)........................................ 44.6% 50.6% 52.2% 54.2%
Premium units(10)........................................... 39,753 60,641 95,150 182,788
Pay-to-basic ratio(10)(11).................................. 52.3% 53.1% 71.8% 84.5%
Average monthly revenue per basic subscriber(12)............ $ 22.84 $ 22.70 $ 24.94 $ 27.95
TELECOMMUNICATIONS
Units under contract(9)..................................... 10,322 20,945 39,831 94,338
Units passed(10)............................................ 9,116 12,364 16,572 35,671
Lines(13)................................................... 2,650 4,126 6,185 9,244
Line penetration(14)........................................ 29.1% 33.4% 37.3% 25.9%
Average monthly revenue per line(15)........................ $ 36.86 $ 42.10 $ 47.23 $ 46.62
</TABLE>
- ---------------
(1) Interest expense, net is reflected net of interest income and interest
capitalized in property, plant and equipment. Includes interest expense on
the GVL Notes of approximately $919,000, $5,342,000, $15,204,000,
$10,671,000 and $9,640,000 for the eight month period ended August 31,
1995, the years ended August 31, 1996, 1997 and 1998, respectively.
(2) The Company had no taxable income for the periods reported. The Company
reported an income tax benefit of approximately $470,000 in the eight month
period ended August 31, 1995. In addition, the Company incurred an
extraordinary loss of $6,644,000 in the year ended August 31, 1998.
(3) Loss per share is not presented for the periods the Company was organized
as a partnership. Loss per share has been restated to reflect the adoption
of statement of Financial Accounting Standards No. 128, "Earnings Per
Share." Basic and diluted loss per share are computed in the same manner
since common stock equivalents have an antidilutive effect.
(4) Capital expenditures include expenditures on property, plant and equipment
together with intangible assets excluding expenditures for business
acquisitions.
(5) EBITDA represents earnings before interest expense (net of interest income
and amounts capitalized), income tax benefits, depreciation and
amortization. EBITDA is not intended to represent cash flow from operations
or an alternative to net loss, each as defined by generally accepted
accounting principles. In addition, the measure of EBITDA presented herein
may not be comparable to other similarly titled measures by other
companies. The Company believes that EBITDA is a standard measure commonly
reported and widely used by analysts, investors and other interested
parties in the cable television and telecommunications industries.
Accordingly, this information has been disclosed herein to permit a more
complete comparative analysis of the Company's operating performance
relative to other companies in its industry.
(6) Operating data for 1993 and 1994 is not available because such information
was not tracked prior to the acquisition of the Company by VPC. The Company
does not believe that the operating statistics for 1993 and 1994, if they
were available, would be material because the Company's revenues during
such periods were minimal.
(7) Units under contract represents the number of units currently passed and
additional units with respect to which the Company has entered into Rights
of Entry for the provision of cable television and telecommunications
services, respectively, but which the Company has not yet passed and which
the Company expects to pass within the next five years. At this time
substantially all units under contract for telecommunications are also
under contract for cable television.
(8) Units passed represents the number of units with respect to which the
Company has connected its cable television and telecommunications systems,
respectively. The difference between units under contract and units passed
represents units for which Rights of Entry have been entered into, but
which are not yet connected for cable television and telecommunications
services, respectively.
40
<PAGE> 43
(9) Basic penetration is calculated by dividing the total number of basic
subscribers at such date by the total number of units passed.
(10) Beginning with the year ended August 31, 1997, to be consistent with most
other cable television providers, the Company has revised the method of
reporting premium penetration to include all premium units in the
calculation. Historically the calculation excluded premium channels that
were provided to customers as part of an expanded basic line up or other
special arrangements. Prior years have not been restated. For comparative
purposes, the premium units and the pay-to-basic ratios as of August 31,
1997 and 1998, presented under the previous method of reporting are 84,875
and 136,863, respectively, and 64.0% and 63.3%, respectively.
(11) Pay-to-basic ratio is calculated by dividing the total number of premium
units by the total number of basic subscribers.
(12) Represents average monthly revenue per the average number of basic
subscribers for the fiscal periods ended as of the date shown.
(13) Lines represent the number of telephone lines currently being provided to
telecommunications subscribers. A telecommunications subscriber can
subscribe for more than one line. The Company has revised its method of
reporting lines to reflect only one line in service where multiple
customers share a single line. The Company has restated the number of lines
previously reported to reflect this change.
(14) Line penetration is calculated by dividing the total number of
telecommunications lines at such date by the total number of units passed.
(15) Represents average monthly revenue per the average number of lines for the
fiscal period ended as of the date shown.
41
<PAGE> 44
ITEM 7: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion should be read in conjunction with the
Consolidated Financial Statements and notes thereto appearing elsewhere in this
Report on Form 10-K.
OVERVIEW
OpTel is a leading network based provider of integrated communications
services, including local and long distance telephone and cable television
services, to residents of MDUs in the United States. The Company was organized
in April 1993 to build, acquire and operate private cable television and
telecommunications systems. The Company seeks to capitalize on opportunities
created by the Telecom Act to become the principal competitor in the MDU market
to the ILEC and the incumbent franchise cable television operator. The Company
has commenced offering central office switched telecommunications services in
Houston and Dallas-Fort Worth and expects to offer such services in
substantially all of its major markets by the end of calendar 1999.
Since inception, the Company has experienced substantial growth. This
growth has been achieved through a combination of acquisitions of other
operators, many of which operated SMATV systems, and the negotiation of new
Rights of Entry. In general, the conduct of the acquired operations prior to
acquisition was materially different from the conduct of operations following
acquisition. Among the changes made in many of the businesses after acquisition
were (i) commencing conversion of SMATV systems to 18GHz or fiber optic
networks, (ii) delivering customer service from a more advanced national call
center in Dallas, (iii) increasing the number of programming channels, (iv)
improving technical and field service and system reliability, (v) improving
regulatory and financial controls and (vi) initiating telecommunications
services offerings.
On April 13, 1998, OpTel completed the acquisition of the ICS Operations,
subject to the consummation of certain transfer conditions. As of October 31,
1998, OpTel had received consents and accepted transfer of legal title to
approximately 78,000 of the ICS cable television and telecommunications units
under contract (or approximately 87% of the approximately 90,000 ICS units under
contract to be acquired). The Company has included the 100% of the assets and
operating results of the ICS Operations in its consolidated financial statements
since April 13, 1998 because (i) although the transfer of legal title to the
Rights of Entry relating to the remaining MDUs is subject to the receipt of
certain third party consents, the Company may elect to waive the consent
conditions, (ii) under the terms of a management agreement, the Company services
the approximately 12,000 units with respect to which, as of October 31, 1998,
there remained unsatisfied transfer conditions and, in connection therewith,
during the period that ICS has to secure the necessary consents, the Company
receives all the economic benefit of (including all the revenues associated
with) and incurs the costs and economic risks associated with these units and
(iii) the entire purchase price was paid (although a portion of the purchase
price is being held in escrow for the protection of the Company, subject to the
receipt of the necessary consents). While the Company expects the transfer of
the remaining units to be completed over the next few months, the transfer of
these units is subject to certain conditions, including the receipt of third
party consents, and there can be no assurance that the transfer of all or part
of the balance will be completed. See "Risk Factors -- Risks Associated with
Acquisitions."
As of August 31, 1998, the Company had 399,210 and 35,671 units passed for
cable television and telecommunications, respectively. As of such date, OpTel
had 216,249 cable television subscribers and 9,244 telecommunication lines in
service.
OpTel believes that by utilizing a single advanced network infrastructure
it can be the first to market a competitive integrated package of voice and
video services in its serviced markets. As of March 31 and August 31, 1998,
respectively, the Company's networks delivered cable television services to
approximately 229,935 and 258,190 units representing approximately 72% and 65%
of the Company's units passed for cable television. The decrease in the
percentage of units passed served by the Company's networks is a direct result
of the acquisition of the ICS Operations on April 13, 1998. OpTel expects to
connect substantially all of the MDUs currently served by SMATV systems to 18GHz
or fiber optic networks by the end of calendar 2000. Once an MDU is brought onto
the Company's networks, gross profit per subscriber at the MDU generally
42
<PAGE> 45
increases. In addition, networks provide OpTel with the infrastructure necessary
to deliver an integrated package of communications services to subscribers at
the MDU.
The Company's telecommunications revenue is comprised of monthly recurring
charges, usage charges and initial non-recurring charges. Monthly recurring
charges include fees paid by subscribers for line rental and additional
features. Usage charges consist of fees paid by end users for long distance,
fees paid by the ILEC for terminating intraLATA traffic to the Company's network
and access charges paid by carriers for long distance traffic originated and
terminated to and from local customers. Initial non-recurring charges include
fees paid by subscribers for installation.
The Company's cable television revenue is comprised of monthly recurring
charges paid by subscribers, monthly recurring charges paid by MDU owners for
bulk services and fees paid by subscribers for premium services and some
non-recurring charges. The Company offers its cable services under either retail
or bulk agreements. Under retail agreements, the Company contracts directly with
MDU residents. Under bulk agreements, the Company contracts directly with MDU
owners for basic cable to be provided to all units in a particular MDU, but
generally at lower prices than under retail agreements. This lower per unit rate
is generally offset by the 100% penetration achieved by bulk agreements. Premium
services are contracted for directly by subscribers under both types of
agreements and include fees paid for premium channels and pay-per-view. The
Company anticipates that its overall revenue per subscriber will increase as the
number of bulk contracts declines as a percentage of the Company's Rights of
Entry. Additionally, the Company believes that its revenue per subscriber will
increase as it migrates its SMATV properties onto the Company's networks. See
"Business -- Network Architecture."
The line item programming, access fees and revenue sharing with respect to
the Company's telecommunications services consists of leased transport
facilities, terminating access charges from ILECs, fees paid to IXCs for long
distance and revenue sharing. Leased transport facility costs may include the
rental of T-1's to connect the MDUs to the ILEC and may include costs associated
with connecting the Company's Network Hubs to each other and to its central
office switch. Terminating access charges are fees paid to the ILEC for
intraLATA calls which are originated by OpTel's subscribers and terminated on
the ILECs network. Fees paid to IXCs for long distance include costs associated
with terminating toll calls initiated by OpTel's subscribers. Revenue sharing
costs include a commission type payment to owners of MDUs for marketing the
Company's telephone product.
The line item programming, access fees and revenue sharing with respect to
the Company's cable television services consists of programming costs, franchise
fees and revenue sharing. Programming costs include those fees paid to obtain
the rights to broadcast certain video programming. Revenue sharing costs include
a commission type payment to owners of MDUs.
The Company's customer support, general and administrative expenses include
selling and marketing costs, customer service, engineering, facilities and
corporate and regional administration.
Through August 31, 1998, the Company had invested approximately $469
million primarily in its cable television and telecommunications assets. The
Company's revenues have grown from $0.4 million for the year ended December 31,
1994 to $65.0 million for fiscal 1998. While pursuing its investment and
development strategy, the Company has incurred substantial up-front operating
expenses for marketing, customer operations, administration and maintenance of
facilities, general and administrative expenses and depreciation and
amortization in order to solicit and service customers in advance of generating
significant revenues. As a result of these factors, the Company has generated
operating losses of $28.2 million, $22.8 million, $12.6 million, and $9.5
million for the years ended August 31, 1998, 1997, 1996 and the eight months
ended August 31, 1995, respectively, as its cable television and
telecommunications customer base has grown. The Company reported positive EBITDA
of $.3 million for the year ended August 31, 1998 as compared with negative
EBITDA of $8.3 million and $3.9 million for the years ended August 31, 1997 and
1996, respectively. The Company expects that the incremental operating costs
associated with the addition of new customers in its existing markets will be
principally limited to customer operations and marketing expenses and,
therefore, that its EBITDA will improve significantly. There can be no assurance
that the Company will generate operating profits or continue to generate
positive EBITDA in the future.
43
<PAGE> 46
FACTORS AFFECTING FUTURE OPERATIONS
The principal operating factors affecting the Company's future results of
operations are expected to include (i) changes in the number of MDUs under
Rights of Entry, (ii) penetration rates for its services, (iii) the terms of its
arrangements with MDU owners, including revenue sharing and length of contract,
(iv) the prices that it charges its subscribers, (v) normal operating expenses,
which in the cable television business principally consist of programming
expenses and in the telecommunications business principally consist of fees paid
to long distance carriers, the cost of trunking services and other LEC charges,
as well as, in each case, billing and collection costs, technical service and
maintenance expenses and customer support services, and (vi) capital
expenditures as the Company commences offering central office switched
telecommunication services in additional markets and completes its conversion of
SMATV systems. The Company's results of operations may also be impacted by
future acquisitions.
The Company anticipates that it will continue to have higher churn than is
typical of an incumbent franchise cable television operator due to the frequent
turnover of MDU tenants. This churn generally does not result in a reduction in
overall penetration rates since the outgoing subscriber is generally quickly
replaced by a new tenant in the unit. This may result in average installation
revenue per subscriber that is higher than for a franchise cable television
operator. Although this may also require higher installation expenses per
subscriber, because of the layout of MDUs and the Company's ability to obtain
"permission to enter" from the MDU owner, installations can often be completed
when the subscriber is not home, limiting the expense of installation.
Accordingly, the Company does not believe that churn is as significant an
operating statistic as would be the case for franchise cable television
operators. With respect to the Company's telecommunications services, the
Company believes that its best opportunity for a sale arises when a subscriber
first signs a lease and takes occupancy in an MDU. Accordingly, the Company
believes that during the early stages of the roll out its central office
switched telecommunications services in a market it benefits from the high rate
of MDU resident turnover.
RESULTS OF OPERATIONS
All of the Company's acquisitions have been accounted for by the purchase
method of accounting. As a result of the Company's growth through acquisitions
and the change in fiscal year, the Company's historical financial results are
not directly comparable from period to period, nor are they indicative of future
results of operations in many respects.
The following table sets forth, for the periods indicated, certain
operating and financial information relating to the Company.
<TABLE>
<CAPTION>
AS OF AUGUST 31,
---------------------------
1996 1997 1998
------- ------- -------
<S> <C> <C> <C>
OPERATING DATA
CABLE TELEVISION
Units passed(1)............................................. 225,433 254,032 399,210
Basic subscribers........................................... 114,163 132,556 216,249
Basic penetration(2)........................................ 50.6% 52.2% 54.2%
Average monthly revenue per basic subscriber(3)............. $ 22.70 $ 24.94 $ 27.95
TELECOMMUNICATIONS
Units passed(1)............................................. 12,364 16,572 35,671
Lines(4).................................................... 4,126 6,185 9,244
Line penetration(5)......................................... 33.4% 37.3% 25.9%
Average monthly revenue per line(6)......................... $ 42.10 $ 47.23 $ 46.62
</TABLE>
44
<PAGE> 47
<TABLE>
<CAPTION>
YEAR ENDED AUGUST 31,
-------------------------------
1996 1997 1998
-------- --------- --------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
FINANCIAL DATA
Revenues:
Cable television.......................................... $ 25,893 $ 36,915 $ 61,081
Telecommunications........................................ 1,711 2,922 3,882
-------- --------- --------
Total revenues.................................... $ 27,604 $ 39,837 $ 64,963
EBITDA(7)................................................... $ (3,900) $ (8,291) $ 291
Net cash flows used in operating activities................. $ (453) $ (15,935) $(26,268)
Net cash flows used in investing activities................. (72,037) (143,125) (121,532)
Net cash flows provided by financing activities............. 72,131 244,688 184,269
</TABLE>
- ---------------
(1) Units passed represents the number of units with respect to which the
Company has connected its cable television and telecommunications systems,
respectively.
(2) Basic penetration is calculated by dividing the total number of basic
subscribers at such date by the total number of units passed.
(3) Represents average monthly revenue per the average number of basic
subscribers for the fiscal periods ended as of the date shown.
(4) Lines represent the number of telephone lines currently being provided to
telecommunications subscribers. A telecommunications subscriber can
subscribe for more than one line. The Company has revised its method of
reporting lines to reflect only one line in service where multiple customers
share a single line. The Company has restated the number of lines previously
reported to reflect this change.
(5) Line penetration is calculated by dividing the total number of
telecommunications lines at such date by the total number of units passed.
(6) Represents average monthly revenue per the average number of lines for the
fiscal period ended as of the date shown.
(7) EBITDA represents income (loss) from operations before interest (net of
interest income and amounts capitalized), income taxes and depreciation and
amortization. EBITDA is not intended to represent cash flow from operations
or an alternative to net loss, each as defined by generally accepted
accounting principles. In addition, the measure of EBITDA presented herein
may not be comparable to other similarly titled measures by other companies.
The Company believes that EBITDA is a standard measure commonly reported and
widely used by analysts, investors and other interested parties in the cable
television and telecommunications industries. Accordingly, this information
has been disclosed herein to permit a more complete comparative analysis of
the Company's operating performance relative to other companies in its
industry.
Fiscal year ended August 31, 1998 compared to fiscal year ended August 31,
1997
Total revenues. Total revenues for the fiscal year ended August 31, 1998
increased by $25.1 million or 63% to $64.9 million compared to revenues of $39.8
million for the fiscal year ended August 31, 1997.
Cable television. Compared to fiscal 1997, cable television revenues
increased by $24.2 million, or 66%, to $61.1 million from $36.9 million,
reflecting both a 63% increase in the number of subscribers and a 12% increase
in the average monthly revenue per basic subscriber which rose from $24.94 for
fiscal 1997 to $27.95 for fiscal 1998. The increase in revenue per subscriber
resulted from a combination of rate increases following property upgrades,
annual rate increases and increased premium revenues as the Company's pay to
basic ratio improved from 72% to 85% over the course of the year. The Company
continued to grow basic penetration which increased by 2% over the year.
Telecommunications. Compared to fiscal 1997, telecommunications revenues
increased by $1.0 million, or 33%, to $3.9 million from $2.9 million. This
increase is mainly due to the increase in the number of lines served by the
Company and higher revenues per line associated with the lines served by the
Company's central office switches.
Programming, Access Fees and Revenue Sharing. Programming, access fees and
revenue sharing was $28.8 million for fiscal 1998 compared to $19.2 million for
fiscal 1997. Substantially all of the increased cost is attributable to the
subscriber growth mentioned above.
Customer Support, General and Administrative. Customer support, general and
administrative expenses were $35.8 million for fiscal 1998 compared to $28.9
million for fiscal 1997. The increase in expenses was largely due to an increase
in personnel associated with the expansion of the Company's operations and
45
<PAGE> 48
recruitment for the roll out of the Company's telecommunications services in
advance of the expected revenues.
EBITDA. The Company's EBITDA increased from negative $8.3 million to
positive $.3 million over the year. There can be no assurance that the Company
will be able to achieve or sustain positive EBITDA in the future.
Depreciation and Amortization. Depreciation and amortization was $28.5
million for fiscal 1998 compared to $14.5 million in fiscal 1997. This increase
is primarily attributable to an increase in cable and telephone systems and
intangible assets resulting from continued purchases and construction of such
systems and from acquisitions of businesses.
Interest Expense, Net. Interest expense (net of amounts capitalized) was
$48.5 million for fiscal 1998, an increase of $17.1 million over interest
expense of $31.4 million for fiscal 1997, reflecting the increase in the
Company's debt incurred principally to fund the build out of its networks.
Interest Income and Other Income. Interest income and other income was $8.9
million for fiscal 1998, an increase of $3.2 million over interest income and
other income of $5.7 million for fiscal 1997. The increase in interest and other
income was largely due to an increase in cash and cash equivalents and
restricted investments resulting from the proceeds of the offering of $225
million of 13% Senior Notes due 2005 (the "1997 Notes") in February 1997, and
from the proceeds of the offering of the 1998 Notes in July 1998.
Income tax benefit. The Company has experienced net operating losses for
the years ended August 31, 1998 and 1997. Realization of deferred tax assets is
dependent on generating sufficient taxable income prior to expiration of the
loss carryforwards. The Company is unable to determine whether these accumulated
losses will be utilized; accordingly, a valuation allowance has been provided
and no benefit has been recognized.
Extraordinary Loss. The Company incurred an extraordinary loss of $6.7
million in 1998. This loss can be directly attributed to the repayment of the
Senior Credit Facility, which was retired in July of 1998. Included in the
extraordinary loss are $5.4 million for write off of debt issue costs and $1.3
million associated with the prepayment penalty.
Fiscal year ended August 31, 1997 compared to fiscal year ended August 31,
1996
Total revenues. Total revenues for the fiscal year ended August 31, 1997
increased by $12.2 million or 44% to $39.8 million compared to revenues of $27.6
million for the fiscal year ended August 31, 1996.
Cable television. Compared to fiscal 1996, cable television revenues
increased by $11.0 million, or 42%, to $36.9 million from $25.9 million,
reflecting both a 16% increase in the number of subscribers and a 10% increase
in the average monthly revenue per basic subscriber which rose from $22.70 for
fiscal 1996 to $24.90 for fiscal 1997. The increase in revenue per subscriber
resulted from a combination of rate increases following property upgrades,
annual rate increases and increased premium revenues as the Company's pay to
basic ratio improved from 53% to 72% over the course of the year. The Company
continued to grow basic penetration which increased by 1.6% over the year.
Telecommunications. The Company's strategy is to roll out central office
switched local exchange services in each of the major markets in which it
operates. Until recently the Company served certain properties as an STS
provider, reselling telephone service using PBXs situated at the MDU properties.
The Company has not historically promoted such STS service because it was not in
line with its strategy to offer central office switched telecommunications
services to its subscribers. Despite not promoting telecommunications services
during the year, telecommunications contributed $2.9 million of revenue compared
to $1.7 million in the preceding year, mainly as a result of increased
penetration and a 34% increase in the number of units where telephone service is
offered from 12,364 at the end of fiscal 1996 to 16,572 at the end of fiscal
1997.
Programming, Access Fees and Revenue Sharing. Programming, access fees and
revenue sharing was $19.2 million for fiscal 1997 compared to $11.9 million for
fiscal 1996. Such costs are generally variable based on the number of
subscribers or gross revenues. Overall, programming, access fees and revenue
sharing as a
46
<PAGE> 49
percentage of total revenues increased over the year from 43.0% to 48.2%,
largely due to costs associated with the increase in the number of subscribers
served by PBX telephone service, the increase in premium cable penetration which
has lower associated margins and, to a lesser extent, an increase in the
proportion of the Company's portfolio under revenue sharing arrangements with
property owners. The PBX costs represent the costs of interconnecting individual
properties with the ILEC's central office switch. These costs will be
substantially reduced once the Company is able to utilize its own networks to
pass telephone traffic to Company owned central office switches.
Customer Support, General and Administrative. Customer support, general and
administrative expenses were $28.9 million for fiscal 1997 compared to $19.6
million for fiscal 1996. The increase in expenses was largely due to an increase
in personnel associated with the expansion of the Company's operations and
recruitment for the roll out of the Company's telecommunications services in
advance of the expected revenues. In addition, the Company incurred a one time
reorganization charge of $1.4 million associated with the restructuring of
certain senior management positions during the year which was included in such
expenses.
EBITDA. The Company's EBITDA decreased from negative $3.9 million to
negative $8.3 million over the year, largely due to the reduced gross margins
and the expansion of the Company's operations in anticipation of the roll out of
telecommunications services. The increase in negative EBITDA was largely within
expectations given that the Company increased its personnel in the middle of
fiscal 1997 in anticipation of two significant events that occurred after the
end of the fiscal year: the launch of the Houston central office switch and the
consummation of the acquisition of certain residential cable television and
associated fiber optic network assets also in Houston.
Depreciation and amortization. Depreciation and amortization was $14.5
million for fiscal 1997 compared to $8.7 million in fiscal 1996. This increase
is primarily attributable to an increase in cable and telephone systems and
intangible assets resulting from continued purchases and construction of such
systems and from acquisitions of businesses.
Interest Expense, Net. Interest expense (net of amounts capitalized) was
$31.4 million for fiscal 1997, an increase of $25.4 million over interest
expense of $6.0 million for fiscal 1996, reflecting the increase in the
Company's debt incurred principally to fund the build out of its network.
Interest income and other income. Interest income and other income was $5.7
million for fiscal 1997, an increase of $5.6 million over interest income and
other income of $0.1 million for fiscal 1996. The increase in interest income
and other income was largely due to an increase in cash and cash equivalents and
restricted investments resulting from the proceeds of the offering of the 1997
Notes in February 1997.
Income tax benefit. The Company has experienced net operating losses for
the years ended August 31, 1997 and 1996. Realization of deferred tax assets is
dependent on generating sufficient taxable income prior to expiration of the
loss carryforwards. The Company is unable to determine whether these accumulated
losses will be utilized; accordingly, a valuation allowance has been provided
and no benefit has been recognized.
LIQUIDITY AND CAPITAL RESOURCES
The development of OpTel's business and the expansion of its network have
required substantial capital, operational and administrative expenditures, a
significant portion of which have been incurred before the realization of
revenues. These expenditures will continue to result in negative cash flow until
an adequate customer base is established and revenues are realized. Although its
revenues have increased in each of the last three years, OpTel has incurred
substantial up-front operating expenses for marketing, customer operations,
administration and maintenance of facilities, general and administrative
expenses and depreciation and amortization in order to solicit and service
customers in advance of generating significant revenues. As a result of these
factors, the Company has generated operating losses of $28.2 million, $22.8
million and $12.6 million for the years ended August 31, 1998, 1997, and 1996,
respectively, as its cable television and telecommunications customer base has
grown. The Company reported net losses of $74.4 million for the year ended
August 31, 1998 as compared with net losses of $48.5 million and $18.4 million
for the years ended August 31, 1997 and 1996, respectively.
47
<PAGE> 50
During the past year, the Company has required external funds to finance
capital expenditures associated with the completion of acquisitions in strategic
markets, expansion of its networks and operating activities. Net cash used in
building the Company's cable television and telecommunications networks and
related business activities was $129.0 million for fiscal 1998 (including $36.5
million for the acquisition of Phonoscope) compared to $78.2 million for fiscal
1997.
From inception and until the issuance of the 1997 Notes, the Company relied
primarily on investments from GVL, its principal stockholder, in the form of
equity and convertible notes to fund its operations. Effective March 1, 1998,
GVL converted all of the outstanding GVL Notes, including accrued interest, into
shares of Series A Preferred with an aggregate liquidation preference of
approximately $139.2 million. The Series A Preferred earns dividends at the
annual rate of 9.75%, initially payable in additional shares, and is convertible
under certain circumstances and at certain prices at the option of the holder
into shares of Multi-Vote Common. None of the Company's stockholders or
affiliates is under any contractual obligation to provide additional financing
to the Company.
In February 1997, the Company issued the 1997 Notes along with 225,000
shares of Class C common stock, par value $.01 per share ("Non-Voting Common")
for aggregate net proceeds of $219.2 million. Of this amount, approximately
$79.6 million was placed in an escrow account in order to cover the first six
semi-annual interest payments due on the 1997 Notes. At August 31, 1998,
approximately $41.4 million remained in such escrow account.
In December 1997, the Company obtained the Senior Credit Facility which
consisted of a $125 million term loan bearing interest at LIBOR plus 3.5% and a
$25 million revolving credit commitment. The Senior Credit Facility was
terminated on July 7, 1998. To comply with certain covenants of the Senior
Credit Facility and to reduce the impact of changes in interest rates on the
Senior Credit Facility, the Company entered into interest rate swap agreements
with total notional amounts of $75 million in which the Company agreed to
receive a variable rate equal to LIBOR and pay fixed rates ranging from 5.96% to
6.00%. The swap agreements were terminated on July 17, 1998 in exchange for cash
payments of $578,000. The Company expensed the costs associated with the
termination of the swap agreement in July 1998.
On July 7, 1998, the Company issued $200 million principal amount of 1998
Notes. The net proceeds of the 1998 Notes were approximately $193.5 million. Of
this amount, approximately $126.3 million was used to effect the Senior Credit
Facility Retirement and approximately $22.0 million was placed in an escrow
account to fund the first two interest payments on the 1998 Notes. In October
1998, the Company commenced an exchange offer in connection with the 11.5%
Senior Notes. On November 19, 1998, $200 million principal amount of the 11.5%
Senior Notes were exchanged for Registered Notes.
The Company's future results of operations will be materially impacted by
its ability to finance its planned business strategies. The Company expects that
it will spend approximately $650 million on capital expenditures over the next
five years. Additionally, the Company will incur approximately $325 million in
cash interest expense over the next five years. The Company currently has
approximately $63 million of short-term investments restricted for scheduled
interest payments over the next eighteen months. The Company expects it will
need approximately $250 million in additional financing over the next five years
in order to achieve its business strategy within its targeted markets. A
considerable portion of the Company's capital expenditure requirements is
scaleable dependent upon the number of Rights of Entry that the Company signs.
The foregoing estimates are based on certain assumptions, including the timing
of the signing of Rights of Entry, the conversion of MDUs currently served by
SMATV systems to networks and the telecommunications roll out, each of which may
vary significantly from the Company's plan. The capital expenditure requirements
will be larger or smaller depending upon whether the Company is able to achieve
its expected market share among the potential MDUs in its markets. The Company
plans to finance its future capital requirements through additional public or
private equity or debt offerings. There can be no assurance that the Company
will be successful in obtaining any necessary financing on reasonable terms or
at all.
In addition, both GVL and CDPQ have the power to prevent the Company from
obtaining additional debt or equity financing. See "Risk Factors -- Control by
GVL" and "Security Ownership of Certain Beneficial Owners and
Management -- Stockholders' Agreement." GVL is party to an indenture which
limits
48
<PAGE> 51
the aggregate amount of indebtedness which can be incurred by GVL and its
subsidiaries, including the Company, taken as a whole (based upon a ratio of
total consolidated indebtedness to consolidated operating cash flow). As a
result, GVL's strategies and the operating results of its subsidiaries other
than the Company may affect the ability of the Company to incur additional
indebtedness. As of August 31, 1998, GVL was able to incur approximately Cdn.
$550 million (approximately $355 million based on an exchange rate of $1.00 =
Cdn. $1.5474 as reported by the Wall Street Journal on November 20, 1998) of
indebtedness under its indenture. There can be no assurance that this number may
not decrease substantially in the future. There can be no assurance that GVL
will not restrain the Company's growth or limit the indebtedness incurred by the
Company so as to ensure GVL's compliance with the terms of its debt instruments.
The Company benefits from the fact that it does not require a substantial
capital investment in its cable television and telecommunications networks in
advance of connecting subscribers to its networks since a significant proportion
of the costs comprises the internal wiring and the erection of microwave
transmitting and receiving equipment specific to the MDU. These expenditures
are, to a large extent, "success-based" and will only be incurred when new
properties are brought into service or when existing properties serviced by
SMATV or PBX systems are connected to the networks. When a new Right of Entry is
signed, it takes approximately four months of construction work to activate
signal at the property. Once the property is activated, penetration rates
increase rapidly. The balance of the budgeted capital expenditures is for
infrastructure assets not related to individual MDUs. These assets include
central office switches, cable television head ends, computer hardware and
software and capitalized construction costs. The Company, can to some degree,
control the timing of the infrastructure capital expenditures by controlling the
timing of the telecommunications roll out and the scope of its expansion.
In order to accelerate the achievement of the Company's strategic goals,
the Company is currently evaluating and often engages in discussions regarding
various acquisition opportunities. The Company also engages from time to time in
preliminary discussions relating to possible investments in the Company by
strategic investors. There can be no assurance that any agreement with any
potential acquisition target or strategic investor will be reached nor does
management believe that any thereof is necessary to achieve its strategic goals.
YEAR 2000 COMPLIANCE
OpTel has implemented a Year 2000 program to ensure that its computer
systems and applications will function properly beyond 1999.
Embedded Technology. As the first phase of its program, OpTel has conducted
an inventory of the equipment that it either uses to deliver its
telecommunications services or utilizes in its corporate headquarters and
regional offices. While OpTel believes that its equipment inventory is complete,
much of the equipment utilized by OpTel resides outside the Company's
headquarters and there can be no assurance that mission critical equipment has
not been overlooked. As the second phase of its Year 2000 program, OpTel has
begun contacting its vendors to determine whether the inventoried equipment is
Year 2000 compliant or must be upgraded or replaced. While certain of OpTel's
equipment vendors have indicated that their equipment is Year 2000 compliant,
others have indicated that software upgrades are required. The Company has begun
to schedule the installation of the necessary software upgrades, however, there
can be no assurance that it will successfully implement all of the necessary
upgrades in a timely manner. OpTel also intends to conduct a risk assessment to
identify those systems whose failure would be expected to present the highest
risk to the Company. Although OpTel intends to conduct tests to ensure that its
equipment is Year 2000 compliant, such tests will focus principally on those
systems whose failure would pose the greatest risk to the Company. OpTel will
likely not test all of its equipment and will rely upon vendor representations
where tests are not conducted. In addition, OpTel has not yet received responses
from all of its equipment vendors. There can be no assurance that OpTel will
receive responses from all of its vendors in a timely manner or that such
responses will be accurate or complete. There can be no assurance that the
failure of OpTel to adequately address Year 2000 problems embedded in currently
utilized equipment will not have a material adverse effect on OpTel's business,
financial condition, cash flows and results of operations. See "Risk
Factors -- Year 2000 Risk -- Embedded Technology."
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<PAGE> 52
Information Technology. OpTel also has begun upgrading, replacing and
testing certain components of its networks and information processing systems.
OpTel believes that it has allocated adequate resources for this purpose and
expects its Year 2000 conversion program for its information processing systems
to be successfully completed on a timely basis. However, successful completion
of the Year 2000 conversion program is substantially dependent upon successful
implementation of the Company's new customer management information system and,
as a result, on the third party vendor meeting the delivery and implementation
schedule it has proposed to OpTel. In addition, the Company's financial
accounting system has not been upgraded to eliminate potential Year 2000 related
malfunctions. The Company has selected a new financial accounting system and
plans to have the new system implemented within the next 12 months. There can be
no assurance that the new customer management information system and financial
accounting system will be implemented on schedule or that other components of
the Year 2000 conversion program will be completed in a timely manner. See "Risk
Factors -- Information Systems and Automation." Other than costs estimated at
between $0.5 million and $1.0 million to bring personal computers and facilities
systems into compliance and expenses relating to the acquisition of the customer
management information system and the financial accounting system, which are
currently expected to be approximately $4 million in the aggregate, OpTel does
not expect to incur significant expenditures to address its Year 2000 compliance
issues. However, the failure of the Company to become Year 2000 compliant on a
timely basis could have a material adverse effect on the Company's business,
financial condition, cash flows and results of operations. See "Risk
Factors -- Year 2000 Risk -- Information Technology."
Third Party Interfaces. OpTel also has taken an inventory of its third
party service or content providers. While OpTel believes that its inventory of
third party service and content providers is complete, there can be no assurance
that mission critical providers have not been overlooked. Many of the Company's
third party providers have indicated that they are, or will be, Year 2000
compliant. The Company, however, has not undertaken an in-depth evaluation of
such providers in relation to the Year 2000 issue and the ability of third
parties with which OpTel transacts business to adequately address their Year
2000 issues is outside of OpTel's control. There can be no assurance that the
failure of OpTel or such third parties to adequately address their respective
Year 2000 issues will not have a material adverse effect on OpTel's business,
financial condition, cash flows and results of operations. See "Risk
Factors -- Year 2000 Risk -- Third Party Interfaces."
Contingency Plans. OpTel intends to develop appropriate contingency plans
to address situations in which various systems of the Company, or of third party
providers, are not Year 2000 compliant. In addition, the Company will
participate in industry wide efforts to address Year 2000 issues, the goal of
which is to develop contingency plans which address not only the Company's
issues but those of the industry as a whole.
RECENTLY ISSUED ACCOUNTING PRINCIPLES
Statement of Financial Accounting Standards ("SFAS") No. 128, "Earnings Per
Share," is effective for earnings per share calculations and disclosures for
periods ending after December 15, 1997, including interim periods, and requires
restatement of all prior period earnings per share data that is presented. SFAS
No. 128 supersedes Accounting Principles Board Opinion No. 15, "Earnings Per
Share," and provides reporting standards for calculating "Basic" and "Diluted"
earnings per share. The Company has adopted SFAS No. 128 which did not have a
significant impact upon the Company's reported earnings per share and its
earnings per share computations have been restated for all prior periods.
The Financial Accounting Standards Board ("FASB") issued, in February 1997,
SFAS No. 129, "Disclosure of Information about Capital Structure," which
establishes standards for disclosing information about an entity's capital
structure and is effective for financial statements for periods ending after
December 15, 1997. The Company's financial statements comply with the
requirements of SFAS No. 129 and there was no impact on the Company's results of
operations or financial position.
In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive
Income," which establishes standards for the reporting and display of
comprehensive income and its components in the financial statements. SFAS No.
130 is effective for fiscal years beginning after December 15, 1997. The Company
has evaluated the requirements of SFAS No. 130 and will begin disclosing the
appropriate information in the first
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<PAGE> 53
quarter of fiscal 1999. The Company believes that the adoption of SFAS No. 130
will not have any impact on the Company's results of operations or financial
position.
The FASB also issued, in June 1997, SFAS No. 131, "Disclosures about
Segments of an Enterprise and Related Information," which establishes standards
for the way public companies disclose information about operating segments,
products and services, geographic areas and major customers. SFAS No. 131 is
effective for financial statements for fiscal years beginning after December 15,
1997. The Company is currently evaluating the applicability of the requirements
of SFAS No. 131. Depending on the outcome of the Company's evaluation,
additional disclosure may be required beginning in fiscal 1999. The Company
believes that the adoption of SFAS No. 131 will not have any impact on the
Company's results of operations or financial position.
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities," which establishes standards for accounting
and reporting for derivative instruments. SFAS No. 133 is effective for fiscal
years beginning after June 15, 1999; however, earlier application is permitted.
Management is currently not planning on early adoption of this statement and has
not completed an evaluation of the impact of the provisions of this statement on
the Company's consolidated financial statement.
INFLATION
The Company does not believe that inflation has had a material effect on
its results of operations to date. However, there can be no assurance that the
Company's business will not be adversely affected by inflation in the future.
ITEM 7A: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company's only use of derivative financial instruments was interest
rate swap agreements that were required to comply with certain covenants of the
Senior Credit Facility. See "-- Liquidity and Capital Resources." In exchange
for a cash payment of $578,000, which was expensed in fiscal 1998, the swap
agreements were terminated on July 17, 1998.
At August 31, 1998, no derivative financial instruments existed.
Furthermore, substantially all of the Company's indebtedness bears a fixed
interest rate. Therefore, the Company is not sensitive to changes in market
interest rates.
ITEM 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The information required by Item 8 is set forth on pages F-1 through F-22
of this Form 10-K. The Company is not required to provide the supplementary
financial information required by Item 302 of Regulation S-K.
ITEM 9: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
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<PAGE> 54
PART III
ITEM 10: DIRECTORS AND EXECUTIVE OFFICERS
The following table sets forth certain information regarding the directors
and executive officers of the Company as of November 30, 1998:
<TABLE>
<CAPTION>
NAME POSITION AGE
- ---- -------- ---
<S> <C> <C>
Andre Chagnon.................. Chairman of the Board and Director 70
Louis Brunel................... Director; President and Chief Executive Officer 57
Frederick W. Benn.............. Director 64
Christian Chagnon.............. Director 42
William O. Hunt................ Director 64
R. Douglas Leonhard............ Director 62
Lynn McDonald.................. Director 38
Alain Michel................... Vice Chairman of the Board and Director 49
Bertrand Blanchette............ Chief Financial Officer 41
Stephen Dube................... Chief Operating Officer 42
John Czapko.................... Vice President, Sales and Marketing 57
James Greene................... Vice President, Telephone 52
Michael E. Katzenstein......... Vice President, Legal Affairs and General Counsel 39
Thomas Watson.................. Vice President, Engineering and Information Services 43
Lynn Zera...................... Vice President, Human Resources 50
</TABLE>
Andre Chagnon has served as Chairman of the Board and as a Director since
October 1998. Since October 1998, Mr. Chagnon has served as Chairman of the
Board, President and Chief Executive Officer of GVL; prior thereto he was its
Chairman of the Board and Chief Executive Officer. Mr. Chagnon is also a
director at Toronto Dominion Bank and Cable Television Laboratories, Inc.
Louis Brunel has served as a Director since March 1995 and as President and
Chief Executive Officer since April 1996. Since 1988, Mr. Brunel has held
various positions at GVL and its subsidiaries, including, immediately prior to
joining OpTel, Vice-Chairman and Chief Executive Officer of Videotron Holdings
Plc ("VHP"), a recently divested United Kingdom based cable and telephone
subsidiary of GVL. While at VHP, Mr. Brunel was the chief architect of VHP's
cable television/telecommunications business. From 1988 to 1990, he served as
Vice President, Corporate Development of GVL. In addition, he served as
President of Videotron International Ltee from September 1994 through December
1996.
Frederick W. Benn was appointed as a Director in November, 1998. From 1987
until retirement at the end of 1995, Mr. Benn was a partner with the law firm of
Smith Lyons in Toronto, Canada. Mr. Benn serves as a director of both GVL and
its affiliate Videotron Ltee.
Christian Chagnon has served as a Director since March 1997 and has been
Senior Vice President, Strategic Planning and Technology of GVL since September
1994. Prior to August 1994, Mr. Chagnon was also President of Videotron Services
Informatiques Ltee. Mr. Chagnon also serves as a Director of GVL. Mr. Christian
Chagnon is the son of Mr. Andre Chagnon.
William O. Hunt was appointed as a Director in June 1998. Since December
1992, Mr. Hunt has served as Chairman of the Board, Chief Executive Officer and
President of Intellicall, Inc. ("Intellicall"), a manufacturer of network and
customer premise equipment. From June 1986 to July 1992, Mr. Hunt was Chairman
and Chief Executive Officer of Alliance Telecommunications Corporation, a
wireless telecommunications company. Mr. Hunt also serves as a Director of The
Allen Group Inc., American Homestar Corporation, DSC Communications Corporation
and Dr. Pepper Bottling Company of Texas.
R. Douglas Leonhard was appointed as a Director in November, 1998. From
1986 until retirement in 1997, Mr. Leonhard was Senior Vice President of the
LaCantera Development Company, a wholly owned subsidiary of United Services
Automobile Association, a large financial services company that provides an
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<PAGE> 55
array of services including property and casualty insurance, personal financial
service products, and travel and personal banking services. Mr. Leonhard serves
on the board of Continental Mortgage and Equity Trust, Income Opportunity Realty
Investors, Inc., and Transcontinental Realty Investors, Inc., each a publicly
traded REIT.
Lynn McDonald was appointed as a Director in June 1998. Since 1996, Ms.
McDonald has been a Manager with CDPQ, a subsidiary of Caisse that actively
manages private placements in communications companies. Prior to joining CDPQ,
Ms. McDonald worked at the Fonds de Solidarite des Travailleurs du Quebec, a
leading venture capital fund. Previously, Ms. McDonald was a special situations
equity analyst at BBN James Capel, a Canadian stock brokerage firm. Ms. McDonald
is also a Director of Fundy Communications Inc., Telexis Corporation, Les
Systemes Proxima Ltee and Regional Vision Inc. Ms. McDonald was designated as
Director by CDPQ pursuant to the terms of the Stockholders' Agreement. See
"Security Ownership of Certain Beneficial Owners and Management -- Stockholders'
Agreement."
Alain Michel has served as a Director since April 1997. Since July 1992,
Mr. Michel has held various management positions at GVL, including, since July
1994, Senior Vice President and Chief Financial Officer. Mr. Michel is also a
Director of NB Capital, Inc., a publicly traded Delaware real estate investment
trust, Microcell Telecommunications Inc., a Canadian public company which
provides telecommunications services and in which GVL holds a minority interest,
and Groupe Goyette Inc., a Canadian private company which provides
transportation and storage services.
Bertrand Blanchette was appointed Chief Financial Officer in September
1996. From September 1995 to December 1996, Mr. Blanchette served as Chief
Financial Officer of VHP. From June 1994 to December 1995, he was Vice
President, Control of GVL. From October 1986 to May 1994, Mr. Blanchette was
Vice President, Finance of Heroux, Inc., a Canadian public company which
manufactures airplane parts.
Stephen Dube was appointed Chief Operating Officer in October 1998. Since
July 1995 Mr. Dube has held various senior management positions at OpTel,
including Vice President, Operations and Vice President, Marketing and Corporate
Development. From July 1995 to March 1997, Mr. Dube served as a Director of
OpTel. From January 1992 to April 1995, Mr. Dube was Senior Vice President of
Laurentian Financial Inc., a financial services company.
John Czapko was appointed Vice President, Sales in March 1997 and Vice
President, Sales and Marketing in July 1998. From September 1993 to February
1997, Mr. Czapko was Director of Indirect Distribution of Metrocel Cellular
Telephone Company ("Metrocel"). From June 1991 to September 1993, he was
Director of Direct Distribution of Metrocel.
James Greene was appointed Vice President, Telephone in April 1998. From
June 1997 to April 1998, Mr. Greene was an independent consultant and advised
the Company on the launch of its first central office switch in Houston, Texas
and the commencement of CLEC services. Mr. Greene consulted for OpTel on an
exclusive basis from November 1997 until his appointment as Vice President. From
1993 to November 1997, Mr. Greene was a consultant for several state and local
regulatory bodies and worked principally with the State of Oregon.
Michael E. Katzenstein was appointed Vice President, Legal Affairs and
General Counsel in November 1995. Prior to joining OpTel, Mr. Katzenstein was a
partner at Kronish Lieb Weiner & Hellman LLP. Mr. Katzenstein received his J.D.
from Boston University School of Law in 1985.
Thomas Watson was appointed Vice President, Information Services in
September 1996. In August 1997, he also assumed the role of Vice President,
Engineering. From January 1992 to September 1996, Mr. Watson held various
positions at GTE Telephone Operations, an ILEC, including Group Product Manager,
Group Manager Engineering and Senior Program Manager.
Lynn Zera was appointed Vice President, Human Resources in November 1995.
From July 1994 to October 1995, Ms. Zera was Executive Director of Keystone
Consulting. From July 1993 to July 1994, she was Executive Director of Human
Resources of Intellicall. From March 1978 to January 1993, she held various
management and marketing positions with Oryx Energy, a company involved with the
production and exploration of oil and gas.
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<PAGE> 56
Pursuant to the Company's Bylaws, Directors are elected annually and serve
in such capacity until the earlier of their removal or resignation or the
election of their successors.
ITEM 11: EXECUTIVE COMPENSATION
SUMMARY COMPENSATION TABLE
The following table sets forth certain information concerning compensation
awarded to or paid to the Company's Chief Executive Officer and the four most
highly compensated executive officers (collectively, the "Named Executive
Officers") for the fiscal years ended August 31, 1998, 1997 and 1996.
<TABLE>
<CAPTION>
ANNUAL COMPENSATION LONG-TERM COMPENSATION
------------------------------------ ------------------------------
SECURITIES
FISCAL OTHER ANNUAL UNDERLYING ALL OTHER
NAME AND PRINCIPAL POSITION YEAR SALARY BONUS* COMPENSATION OPTIONS COMPENSATION(13)
--------------------------- ------ -------- ------- ------------ ---------- ----------------
<S> <C> <C> <C> <C> <C> <C>
Louis Brunel........................ 1998 $309,600 $25,000 $ 89,179(6) 10,204.55 --
President and Chief 1997 $269,623 -- $ 66,062(7) 16,034.79 --
Executive Officer 1996 $ 35,095(1) -- -- -- --
Michael E. Katzenstein.............. 1998 $182,000 $30,000 $ -- -- $4,184
Vice President, Legal Affairs 1997 $175,000 $57,500 $ 65,196(8) 9,137.61 $2,820
and General Counsel 1996 $135,346(2) $40,000 $103,756(9) -- $3,334
Bertrand Blanchette................. 1998 $158,000 $17,500 $ -- -- --
Vice President and 1997 $129,702(3) $ 5,000 $ 33,961(10) 4,373.12 --
Chief Financial Officer 1996 -- -- -- -- --
Stephen Dube........................ 1998 $170,775 $30,000 $ 24,172(11) 2,915.50 $3,006
Vice President and Chief Operating 1997 $119,139 $15,000 $ 63,514(12) 3,381.88 $2,844
Officer 1996 $ 36,542(4) -- -- -- --
John Czapko......................... 1998 $150,000 -- $ -- 3,265.31 $ 346
Vice President, Sales and 1997 $ 70,000(5) $10,000 -- -- --
Marketing 1996 -- -- -- -- --
</TABLE>
- ---------------
* In fiscal 1999, bonuses in respect of fiscal 1998 services have been paid
as follows: Mr. Brunel $135,000; Mr. Katzenstein $45,500; Mr. Blanchette
$39,500; Mr. Dube $41,000; and Mr. Czapko $37,500. These bonuses are not
reflected in the schedule.
(1) During fiscal 1996, Mr. Brunel was paid primarily by GVL. Beginning June 1,
1996, a portion of Mr. Brunel's salary was allocated to the Company.
Effective November 1, 1996, Mr. Brunel accepted the position of President
and Chief Executive Officer on a full-time basis.
(2) Mr. Katzenstein commenced employment with the Company in November 1995.
(3) Mr. Blanchette commenced employment with the Company as Chief Financial
Officer in September 1996. During the period September 1996 through
December 1996, Mr. Blanchette continued to act as Chief Financial Officer
of VHP, a subsidiary of GVL which was divested in December 1996. During
such period, Mr. Blanchette's salary was paid by VHP and a portion of such
salary was allocated to the Company. Mr. Blanchette commenced full-time
employment with the Company effective January 1, 1997.
(4) During fiscal 1996, Mr. Dube was paid primarily by GVL. Beginning June 1,
1996, a portion of Mr. Dube's salary was allocated to the Company.
Effective January 1, 1997, Mr. Dube became a full-time employee of the
Company.
(5) Mr. Czapko commenced employment with the Company in March 1997.
(6) $51,960 represents temporary housing and commuting reimbursements.
(7) $39,790 represents temporary housing and commuting reimbursements and
$21,680 represents an automobile allowance.
(8) $49,823 represents tax reimbursements resulting from relocation.
(9) $93,706 represents relocation payments.
(10) $29,161 represents relocation payments.
(11) $22,179 represents tax reimbursements resulting from relocation payments.
(12) $54,288 represents relocation payments.
(13) Represents 401(k) matching fund contributions by the Company.
54
<PAGE> 57
OPTION GRANTS IN FISCAL 1998
The following table sets forth options to purchase shares of the Class A
Common Stock granted to the Named Executive Officers during fiscal 1998.
<TABLE>
<CAPTION>
POTENTIAL REALIZED VALUE AT
NUMBER OF % OF TOTAL ASSUMED ANNUAL RATES OF
SECURITIES OPTIONS STOCK PRICE APPRECIATION FOR
UNDERLYING GRANTED TO OPTION TERM
OPTIONS EMPLOYEES IN EXERCISE EXPIRATION -----------------------------
NAME GRANTED FISCAL YEAR PRICE DATE 5% 10%
- ---- ---------- ------------ -------- ------------- ------------ --------------
<S> <C> <C> <C> <C> <C> <C>
Louis Brunel.................... 10,204.55 31.06% $85.75 March, 2008 $676,359.26 $1,483,015.76
Stephen Dube.................... 1,399.46 4.26% $85.75 January, 2008 $ 92,756.44 $ 203,381.95
1,516.04 4.62% $85.75 April, 2008 $100,483.38 $ 220,324.39
John Czapko..................... 3,265.31 9.94% $85.75 March, 2007 $216,425.29 $ 474,543.82
</TABLE>
AGGREGATED OPTION EXERCISES IN FISCAL 1998 AND FISCAL YEAR END 1998 OPTION
VALUES
The following table shows the values of options held by the Named Executive
Officers as of the end of fiscal 1998. No options were exercised by the Named
Executive Officers during fiscal 1998.
<TABLE>
<CAPTION>
NUMBER OF SECURITIES VALUE OF UNEXERCISED
UNDERLYING UNEXERCISED IN-THE-MONEY
OPTIONS AT FISCAL YEAR-END OPTIONS AT FISCAL YEAR-END
1998(#) 1998($)(1)
--------------------------- ---------------------------
NAME EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
- ---- ----------- ------------- ----------- -------------
<S> <C> <C> <C> <C>
Louis Brunel........................ 6,559.91 19,679.74 $80,358.90 $241,076.82
Michael E. Katzenstein.............. 2,284.40 6,853.21 $53,866.15 $161,598.69
Bertrand Blanchette................. -- 4,373.12 -- $ 53,570.72
Stephen Dube........................ 1,195.34 5,102.13 $14,642.92 $ 62,501.08
John Czapko......................... -- 3,265.41 -- $ 40,001.27
</TABLE>
- ---------------
(1) Based on an assumed fair market value of $98.00 per share of Class A Common
Stock.
EMPLOYMENT AGREEMENTS
Louis Brunel is employed as President and Chief Executive Officer of the
Company pursuant to an at will employment agreement. Under the employment
agreement, Mr. Brunel currently receives an annual base salary of $350,000, a
Company automobile and a housing allowance. In addition, Mr. Brunel is entitled
to participate in the Company's Incentive Stock Plan (as described below) and
Bonus Plan (as described below). If Mr. Brunel's employment is terminated by the
Company for other than cause, Mr. Brunel will receive a severance payment equal
to two years base salary.
Michael E. Katzenstein is employed as Vice President, Legal Affairs and
General Counsel of the Company pursuant to an employment agreement expiring in
November 2000. Under the employment agreement, Mr. Katzenstein currently
receives an annual base salary of $194,000 and a Company automobile. In
addition, Mr. Katzenstein is entitled to participate in the Company's Incentive
Stock Plan and Bonus Plan.
Bertrand Blanchette is employed as Vice President and Chief Financial
Officer of the Company pursuant to an at will employment agreement. Under the
employment agreement, Mr. Blanchette currently receives an annual base salary of
$175,000 and a monthly automobile allowance. In addition, Mr. Blanchette is
entitled to participate in the Company's Incentive Stock Plan and Bonus Plan.
Stephen Dube is employed as Chief Operating Officer of the Company pursuant
to an at will employment agreement. Under the employment agreement, Mr. Dube
currently receives an annual base salary of $200,000 and a monthly automobile
allowance. In addition, Mr. Dube is entitled to participate in the Company's
Incentive Stock Plan and Bonus Plan.
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<PAGE> 58
John Czapko is employed as Vice President, Sales and Marketing of the
Company pursuant to an at will employment agreement. Under the employment
agreement, Mr. Czapko currently receives an annual base salary of $150,000 and a
monthly automobile allowance. In addition, Mr. Czapko is entitled to participate
in the Company's Incentive Stock Plan and Bonus Plan.
Upon termination by the Company of any of its most senior executives
without cause, the Company has in the past offered severance equal to one year's
base salary.
INCENTIVE STOCK PLAN
In fiscal 1997, the Company adopted an Incentive Stock Plan. In fiscal
1998, the Company adopted amendments to such plan, certain of which will become
effective, subject to stockholder approval, on the date, if any, an IPO is
consummated and certain of which will become effective immediately upon
stockholder approval (as so amended, the "Plan"). As of August 31, 1998, options
to purchase 88,557.98 shares of Class A Common Stock have been granted under the
Plan, none of which have been exercised, at a weighted average exercise price of
$84.58 per share of Class A Common Stock. The Plan authorizes the Board to issue
incentive stock options ("ISOs") as defined in Section 422(b) of the Internal
Revenue Code of 1986, as amended (the "Code") and stock options that do not
conform to the requirements of that Code section ("Non-ISOs").
The Board has discretionary authority to determine the types of options to
be granted, the persons to whom options shall be granted (provided that options
shall only be granted to directors, senior executives and other employees
designated by the Board), the number of shares to be subject to each option
granted (provided that no single participant in the Plan shall be entitled to
receive more than 40,000 shares of Class A Common Stock pursuant to the Plan)
and the terms of the stock option agreements. Unless otherwise specifically
provided in the option agreement, (i) the exercise price of an option will not
be less than the fair market value, as determined by the Board, of the Class A
Common Stock on the date of the grant and (ii) the options shall become
exercisable in equal installments on each of the second, third, fourth and fifth
anniversaries of the effective date of grant. In the event of a "change of
control," all options shall vest and become immediately exercisable. At the
discretion of the Board, the exercise price may be paid by personal check, bank
draft, money order, or money transfers, through the delivery of shares of the
Class A Common Stock, pursuant to a broker-assisted "cashless exercise" program
if established by the Company or by such other method as the Board may deem
appropriate.
Subject to certain exceptions, during the period of 45 days after the
termination of an executive's employment with the Company, the Company shall
have the right to purchase all, but not less than all, of the shares of Class A
Common acquired by such executive pursuant to the exercise of options issued
under the Plan at the fair market value of such shares as of the date on which
such executive's employment was terminated (the "Call") and the executive shall
have the right to sell to the Company all, but not less than all, of the shares
of Class A Common acquired by such executive pursuant to the exercise of options
issued under the Plan at the fair market value of such shares as of the date on
which such executive's employment was terminated (the "Put"). Both the Call and
the Put shall expire on the date of an initial public offering of the equity
securities of OpTel (the "IPO Date").
Prior to the IPO Date, holders of Class A Common shares issued upon the
exercise of options issued under the Plan may not transfer or sell any of such
shares except pursuant to a bona fide written offer to purchase such shares for
an all cash purchase price ("third party offer") and only after such shares have
first been offered to the Company. The Company shall have the option to purchase
all (but not less than all) of the Class A Common shares subject to the third
party offer at the price per share set forth in the third party offer.
If an IPO is consummated, (i) five percent of the Class A Common Stock
outstanding, on a fully diluted basis, on the date the IPO is consummated, will
be issuable under the terms of the Plan, (ii) the number of shares issuable
under the Plan will be adjusted on each January 1 to 5% of the then outstanding
Class A Common Stock, on a fully diluted basis, if such adjustment would
increase the number of shares, (iii) the Board will be authorized to issue
certain other types of stock based awards, and (iv) the Plan will terminate on
the tenth anniversary of the date the IPO is consummated.
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STOCK PURCHASE PLAN
In fiscal 1998, the Company adopted the 1998 Employee Stock Purchase Plan
(the "Stock Purchase Plan") which will become effective, subject to stockholder
approval, on the date, if any, an IPO is consummated. One percent of the Class A
Common Stock outstanding, on a fully diluted basis, on the date an IPO is
consummated will be issuable under the terms of the Stock Purchase Plan.
ANNUAL BONUS PLAN
The Company has adopted an Annual Bonus Plan (the "Bonus Plan") pursuant to
which the Board is authorized to grant cash bonuses to certain employees of the
Company. Bonuses are payable only if the Company achieves certain performance
targets approved by the Compensation Committee at the beginning of the fiscal
year.
401(k) PLAN
The Company has implemented an employee savings and retirement plan (the
"401(k) Plan") covering certain of the Company's employees who have at least
three months of service with the Company and have attained the age of 21.
Pursuant to the 401(k) Plan, eligible employees may elect to reduce their
current compensation by up to the lesser of 15% of such compensation or the
statutorily prescribed annual limit and have the amount of such reduction
contributed to the 401(k) Plan. The Company has made, and may in the future
make, contributions to the 401(k) Plan on behalf of eligible employees.
Employees become 100% vested in these Company contributions after one year of
service. The 401(k) Plan is intended to qualify under Section 401 of the Code so
that contributions by employees or by the Company to the 401(k) Plan, and income
earned on the 401(k) Plan contributions, are not taxable to employees until
withdrawn from the 401(k) Plan, and so that contributions by the Company, if
any, will be deductible by the Company when made. The trustee under the 401(k)
Plan, at the direction of each participant, invests the 401(k) Plan employee
salary deferrals in selected investment options.
COMMITTEES OF THE BOARD OF DIRECTORS
The Board has an Audit Committee and a Compensation Committee. The
functions of the Audit Committee include recommending to the Board the retention
of independent public accountants, reviewing the scope of the annual audit
undertaken by the Company's independent public accountants and the progress and
results of their work and reviewing the financial statements of the Company and
its internal accounting and auditing procedures. The Audit Committee is composed
of Andre Chagnon, William O. Hunt, Lynn McDonald and Alain Michel. The chairman
of the Audit Committee is Mr. Hunt. The function of the Compensation Committee
is to supervise the Company's compensation policies, administer the employee
incentive plans, review officers' salaries and bonuses, approve significant
changes in employee benefits and consider other matters referred to it by the
Board. The Compensation Committee is composed of Andre Chagnon, William O. Hunt,
Lynn McDonald and Alain Michel. The Chairman of the Compensation Committee is
Mr. Chagnon.
COMPENSATION OF DIRECTORS
Directors of the Company who are neither employees of the Company nor
designees of the Company's significant stockholders will receive an annual fee
of $15,000, a fee of $1,000 per in person meeting of the Board and an annual fee
of $1,500 if they serve as the chairperson of a committee of the Board. Each
such Director will also receive options to purchase 1,000 shares of Class A
Common Stock with an exercise price equal to the fair market value on the date
of grant as determined by the Board (or at the initial public offering price if
an IPO is consummated). The options will become exercisable in equal
installments on each of the second, third, fourth and fifth anniversaries of the
effective date of the grant. Directors who are either employees of the Company
or designees of the Company's significant stockholders will not be compensated
for their services. However, all Directors will be reimbursed for actual
out-of-pocket expenses incurred by them in connection with their attending
meetings of the Board or any committees of the Board.
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COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
During fiscal 1997 and part of fiscal 1998, Mr. Brunel served as a member
of the Compensation Committee. Effective May 19, 1998, Mr. Brunel resigned from
the Compensation Committee.
LIMITATION OF LIABILITY; INDEMNIFICATION; INSURANCE
The Company's Certificate of Incorporation provides that the Company shall,
to the fullest extent permitted by the Delaware General Corporation Law (the
"DGCL"), indemnify all persons which it may indemnify pursuant thereto (i.e.,
directors and officers) and shall advance expenses incurred in defending any
proceeding for which such right to indemnification is applicable, provided that,
if the DGCL so requires, the indemnitee provides the Company with an undertaking
to repay all amounts advanced if it is determined by a final judicial decision
that such person is not entitled to indemnification pursuant to this provision.
The Company's Certificate of Incorporation also contains a provision eliminating
the personal liability of the Company's directors for monetary damages for
breach of any fiduciary duty. By virtue of this provision, under the DGCL, a
director of the Company will not be personally liable for monetary damages for
breach of his fiduciary duty as a director, except for liability for (i) any
breach of the director's duty of loyalty to the Company or its stockholders,
(ii) acts or omissions not in good faith or which involve intentional misconduct
or a knowing violation of law, (iii) dividends or stock purchases or redemptions
that are unlawful under the DGCL and (iv) any transaction from which a director
derives an improper personal benefit. However, this provision of the Company's
Certificate of Incorporation pertains only to breaches of duty by directors as
directors and not in any other corporate capacity such as officers, and limits
liability only for breaches of fiduciary duties under the DGCL and not for
violations of other laws, such as the federal securities laws. As a result of
the inclusion of such provision, stockholders may be unable to recover monetary
damages against directors for actions taken by them that constitute negligence
or gross negligence or that are in violation of their fiduciary duties, although
it may be possible to obtain injunctive or other equitable relief with respect
to such actions. The inclusion of this provision in the Company's Certificate of
Incorporation may have the effect of reducing the likelihood of derivative
litigation against directors, and may discourage or deter stockholders or
management from bringing a lawsuit against directors for breach of their duty of
care, even though such an action, if successful, might otherwise have benefitted
the Company and its stockholders.
Insofar as indemnification for liabilities arising under the Securities Act
may be permitted to directors, officers or persons controlling OpTel pursuant to
the foregoing provisions, OpTel has been informed that in the opinion of the
Commission such indemnification is against public policy as expressed in the
Securities Act and is therefore unenforceable. In the event that a claim for
indemnification against such liabilities (other than the payment by the Company
of expenses incurred or paid by a director, officer or controlling person of the
Company in the successful defense of any action, suit or proceeding) is asserted
by such director, officer or controlling person in connection with the
securities being registered, the Company will, unless in the opinion of its
counsel the matter has been settled by controlling precedent, submit to a court
of appropriate jurisdiction the question whether such indemnification by it is
against public policy as expressed in the Securities Act and will be governed by
the final adjudication of such issue.
The directors and officers of the Company are insured (subject to certain
exceptions and deductions) against liabilities that they may incur in their
capacity as such, including liabilities under the Securities Act, under a
liability insurance policy carried by GVL. Such policy provides coverage in an
aggregate amount of $50 million (subject to a $250,000 deductible) and expires
in October 1999.
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ITEM 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
The following table sets forth certain information, as of October 31, 1998,
regarding the beneficial ownership of the Common Stock by (i) each Director of
the Company who beneficially owns any Common Stock, (ii) each Named Executive
Officer, (iii) each person known by the Company to beneficially own 5% or more
of the outstanding shares of any class of Common Stock and (iv) all directors
and executive officers of the Company as a group.
<TABLE>
<CAPTION>
PERCENT OF
AMOUNT AND PERCENT OF TOTAL
NATURE OF PERCENT OF TOTAL SHARES VOTING
BENEFICIAL OWNER TITLE OF CLASS OWNERSHIP(1)(2) CLASS(2) OUTSTANDING(2) POWER(2)
- ---------------- -------------------- --------------- ---------- -------------- ----------
<S> <C> <C> <C> <C> <C>
Le Groupe Videotron Ltee........... Multi-Vote Common 1,923,559.00(3) 81.73% 70.13% 81.17%
Andre Chagnon...................... Multi-Vote Common 1,923,559.00(3) 81.73% 70.13% 81.17%
Caisse de depot et placement du
Quebec........................... Multi-Vote Common 429,939.00(4) 18.27 15.68 18.14
Interactive Cable Systems, Inc..... Class A Common Stock 164,271.54(5) 100.00 5.99 *
James A. Kofalt.................... Class A Common Stock 24,992.00(6) 13.20 * *
Rory Cole.......................... Class A Common Stock 9,406.36(7) 5.42 * *
Louis Brunel....................... Class A Common Stock 13,119.67(8) 7.40 * *
Michael E. Katzenstein............. Class A Common Stock 4,568.80(9) 2.71 * *
Bertrand Blanchette................ Class A Common Stock 1,093.28(10) * * *
Stephen Dube....................... Class A Common Stock 2,390.67(11) 1.43 * *
John Czapko........................ Class A Common Stock --(12) * * *
All directors and officers as a
group (15 persons)............... Class A Common Stock 22,979.98(13) 12.27 * *
</TABLE>
- ---------------
(1) Except as otherwise indicated in the other footnotes to this table, each
person named in the table has sole voting and dispositive power with
respect to the shares of Common Stock beneficially owned by such person.
(2) "*" indicates less than one percent. In accordance with the Commission's
rules, each beneficial owner's holdings have been calculated assuming the
full exercise of warrants and options and the conversion of all shares of
convertible preferred stock held by such holder which are currently
exercisable or convertible or which will become exercisable or convertible
within 60 days after the date of this Form 10-K and no exercise of warrants
and options or conversion of preferred stock held by any other person.
(3) Such shares are owned by VPC, an indirect wholly-owned subsidiary of GVL.
Andre Chagnon, the founder of GVL, indirectly controls approximately 72% of
GVL's outstanding voting rights. All such shares are fully convertible into
Class A Common Stock on a one-for-one basis at the option of the holder
and, upon the occurrence of certain events, automatically. See
"-- Stockholders' Agreement" and "-- GVL Shareholders' Agreement" for the
terms of certain agreements governing the voting and disposition of the
shares of Common Stock held by VPC and GVL. Excludes 6,962.21 shares of
Series A Preferred which will be convertible into Multi-Vote Common should
an IPO be consummated. GVL's address is 300 Avenue Viger East, Montreal,
Quebec, H2X 3W4.
(4) Such shares are owned by CDPQ, a wholly-owned subsidiary of Caisse. All
such shares are fully convertible into Class A Common Stock on a
one-for-one basis at the option of the holder and, upon the occurrence of
certain events, automatically. See "--Stockholders' Agreement" and "-- GVL
Shareholders' Agreement" for the terms of certain agreements covering the
voting and disposition of the shares of Common Stock held by Caisse and
CDPQ. In addition, Caisse holds $20.0 million of 1998 Series A Notes which
it purchased from the initial purchasers of the offering. Caisse's address
is 1981, Avenue McGill College, Montreal, Quebec, H3A 3C7.
(5) See "-- ICS Stockholders' Agreement and ICS Registration Rights Agreement"
for the terms of certain agreements governing the disposition of such
shares of Common Stock. Includes shares currently held in escrow pending
the satisfaction of transfer conditions with respect to the balance of the
acquisition of the ICS Operations. Excludes shares of Series B Preferred
held by ICS which will be convertible into Class A Common Stock should an
IPO be consummated. ICS's address is 1901 N. Glenville Drive, Suite 800,
Richardson, Texas 75081.
(6) Represents a presently exercisable warrant to purchase 24,992 shares of
Class A Common Stock. Mr. Kofalt's address is 50209 Manly, Chapel Hill,
North Carolina 27514.
(7) Represents a presently exercisable warrant to purchase 9,406.36 shares of
Class A Common Stock. Mr. Cole's address is 4339 Beverly Drive, Dallas,
Texas 75205.
(8) Includes 13,119.67 shares of Class A Common Stock underlying presently
exercisable options. Excludes 13,119.67 shares of Class A Common Stock
underlying options which are not exercisable until at least 60 days after
the date set forth above.
(9) Includes 4,568.80 shares of Class A Common Stock underlying presently
exercisable options. Excludes 4,568.81 shares of Class A Common Stock
underlying options which are not exercisable until at least 60 days after
the date set forth above.
(10) Includes 1,093.28 shares of Class A Common Stock underlying presently
exercisable options. Excludes 3,279.84 shares of Class A Common Stock
underlying options which are not exercisable until at least 60 days after
the date set forth above.
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(11) Includes 2,390.67 shares of Class A Common Stock underlying presently
exercisable options. Excludes 3,906.71 shares of Class A Common Stock
underlying options which are not exercisable until at least 60 days after
the date set forth above.
(12) Excludes 3,265.31 shares of Class A Common Stock underlying options which
are not exercisable until at least 60 days after the date set forth above.
(13) With respect to executive officers who are not Named Executive Officers,
includes 1,807.55 shares of Class A Common Stock underlying presently
exercisable options and excludes 7,405.23 shares of Class A Common Stock
underlying options which are not exercisable until at least 60 days after
the date set forth above.
ICS STOCKHOLDERS' AGREEMENT AND ICS REGISTRATION RIGHTS AGREEMENT
In connection with the Company's acquisition of the ICS Operations, ICS,
Nomura Holding America, Inc. ("Nomura"), MCI (ICS, Nomura, and MCI, together,
the "ICS Group"), VPC, GVL and the Company entered into a Stockholders'
Agreement (the "ICS Stockholders' Agreement") dated as of April 9, 1998 and the
Company, ICS, Nomura and MCI entered into a Registration Rights Agreement (the
"ICS Registration Rights Agreement") dated as of April 9, 1998.
Under the ICS Stockholders' Agreement, (i) the transfer of the shares of
Class A Common Stock and Series B Preferred owned by the ICS Group
(collectively, the "ICS Shares") is restricted, subject to certain exceptions,
(ii) the ICS Shares are subject to drag-along rights if VPC (or GVL through the
sale of its interests in VPC) elects to sell equity interests representing 50%
or more of the voting power of the outstanding capital stock of the Company or
50% or more of the equity interests held by VPC and (iii) the transfer of the
ICS Shares are subject to certain first offer rights of the Company and VPC. In
addition, the ICS Group has certain tag-along rights in connection with sales by
VPC of outstanding shares of the Company's Common Stock.
Pursuant to the ICS Registration Rights Agreement, following the
consummation of an initial public offering of the Company's common equity, the
ICS Group has piggyback registration rights, on three occasions, in registration
statements filed by the Company for the sale of its equity securities, subject
to certain conditions, including customary allocation and holdback provisions.
The ICS Group also has certain demand registration rights in the event that the
Company has not consummated an initial public offering of its common equity
prior to April 9, 2002.
STOCKHOLDERS' AGREEMENT
In August 1997, CDPQ purchased the minority interest in the Company from
Vanguard Communications L.P. ("Vanguard"). In connection with the sale by
Vanguard of its minority stock position in the Company to CDPQ, the Company, VPC
and CDPQ entered into the Stockholders' Agreement and the Company and CDPQ
entered into a related Registration Rights Agreement (the "Registration Rights
Agreement"), under which CDPQ has certain rights and obligations relating to the
Company and VPC. CDPQ is also a party to the GVL Shareholders' Agreement
described below. The following is a summary of certain provisions of the
Stockholders' Agreement and the Registration Rights Agreement.
Designation of Directors. Under the Stockholders' Agreement, for as long as
CDPQ holds at least 5% of the Company's voting stock, CDPQ may designate a
number of Directors of the Company and each of its subsidiaries, and each
committee of the Board and each of its subsidiaries, which is proportionate (in
relation to the total number of Directors or committee members) to CDPQ's
percentage ownership of the Company's voting stock, but in no event less than
one Director and one committee member. This agreement supersedes the rights of
Caisse to designate a Director of the Company pursuant to the GVL Shareholders'
Agreement; however, such rights are subject to reinstatement in the event CDPQ
ceases to be a stockholder of the Company. Pursuant to the terms of the
Stockholders' Agreement, CDPQ has designated Lynn McDonald as a Director of the
Company.
Approval of Certain Actions by CDPQ. Pursuant to the Stockholders'
Agreement, until the consummation of an initial public offering of the Company's
voting common stock, CDPQ has the right to approve certain corporate actions
including: (i) any amendment to the certificate of incorporation or bylaws of
the Company or any subsidiary; (ii) any change in the capital stock of the
Company or any subsidiary; (iii) the
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acquisition or disposition by the Company or any subsidiary of assets or
securities in excess of $10 million in any single transaction or $40 million in
the aggregate in any fiscal year; (iv) a merger or other business combination
involving the Company or any subsidiary if the consideration paid for such
merger or business combination is in excess of $10 million in any single
transaction or $40 million in the aggregate in any fiscal year; and (v) the
incurrence by the Company or certain subsidiaries of indebtedness not permitted
under the terms of certain of its outstanding indebtedness.
Rights in Connection with Other Financings; Tag-Along Rights. Pursuant to
the Stockholders' Agreement, VPC is obligated to cause the Company to afford
CDPQ rights equivalent to those afforded other purchasers of the Company's
capital stock to the extent they are more advantageous than the rights held by
CDPQ. Subject to certain exceptions (including a public offering of the
Company's equity securities) and waiver by CDPQ at VPC's request in connection
with certain events, the Company is obligated to afford CDPQ preemptive rights
to purchase equity securities which the Company proposes to sell in proportion
to CDPQ's ownership of the total outstanding equity securities of the Company
prior to the sale. In addition, pursuant to the Stockholders' Agreement, CDPQ
has certain tag-along rights in connection with sales by VPC of outstanding
shares of the Company's voting stock.
Registration Rights. Pursuant to the Registration Rights Agreement, nine
months after the consummation of an initial public offering of the Company's
equity securities and, subject to certain conditions, CDPQ has the right, on two
occasions, to require the Company to register under the Securities Act shares of
Class A Common Stock issued to CDPQ upon the conversion of the Multi-Vote
Common. In addition, CDPQ has piggyback registration rights, on three occasions,
to include Common Stock held by it in registration statements filed by the
Company for the sale of its equity securities, subject to certain conditions,
including customary allocation and holdback provisions.
GVL SHAREHOLDERS' AGREEMENT
Caisse, CDPQ, Sojecci Ltee and Sojecci (1995) Ltee, the principal
shareholders of GVL, and Andre Chagnon (the founder of GVL) are parties to an
amended and restated shareholders agreement, dated as of May 10, 1995 (the "GVL
Shareholders' Agreement"), which provides, among other things, that for so long
as GVL controls the Company, Caisse will be allowed to select one of GVL's
nominees to the Board and to have one representative on the Audit Committee of
the Company. While this right has been superseded by the Stockholders'
Agreement, it is subject to reinstatement in the event CDPQ ceases to be a
stockholder of the Company or the Stockholders' Agreement ceases to be
enforceable. See "-- Stockholders' Agreement."
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ITEM 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
CONVERTIBLE NOTES AND SERIES A PREFERRED
The Company has financed a large portion of its capital needs by borrowing
from its majority stockholder, VPC. The Company borrowed approximately $17.8
million, $73.4 million and $23.7 million from VPC in the form of the GVL Notes
during the eight month period ended August 31, 1995, fiscal 1996 and fiscal
1997, respectively. The GVL Notes bore interest at a rate of 15% per annum,
payable concurrently with the payment of principal. Interest was added to
principal on an annual basis. Effective March 1, 1998, VPC exchanged all of the
GVL Notes for 6,962.21365 shares of the Series A Preferred. In the event of an
IPO, VPC has advised the Company that it intends to convert all of its shares of
Series A Preferred into Multi-Vote Common upon the consummation of an IPO.
LICENSE HOLDING COMPANY
The Company has assigned substantially all of its frequency licenses to THI
in exchange for a $1.0 million secured promissory note with interest at 8% due
on February 14, 2007 (the "License Note"). The License Note contains covenants
which restrict THI from, among other things, incurring indebtedness other than
to the Company or in the ordinary course of business, and merging or
consolidating with another entity.
Section 310(b) of the Communications Act prohibits any corporation of which
more than one-fifth of the capital stock is owned or voted by non-U.S. citizens
from holding a common carrier radio station license. In addition, under Section
310(b)(4) of the Communications Act, the FCC may, if it finds that it would
serve the public interest, deny or revoke a common carrier license if the
applicant or licensee is controlled directly or indirectly by any other
corporation of which more than one-fourth of the capital stock is owned or voted
by non-U.S. citizens. GVL, the Company's indirect principal stockholder, is a
Canadian corporation. Consequently, THI was created to permit the Company to use
the Assigned Licenses, modified as necessary, to provide "common carrier"
telecommunications services in the event that the Company should desire to do so
in the future. Russell S. Berman, Henry Goldberg and Thomas Watson, each U.S.
citizens, each own one-third of the outstanding equity interests in THI. Russell
S. Berman is a partner at Kronish Lieb Weiner & Hellman LLP which represents
both the Company and THI with respect to various legal matters. Henry Goldberg
is a partner at Goldberg, Godles, Wiener & Wright which represents both the
Company and THI with respect to certain federal regulatory matters. Mr. Watson
is Vice President, Engineering and Information Services of OpTel.
To establish the terms of the Company's continued and unencumbered use of
the Assigned Licenses, the Company and THI entered into a license and services
agreement (the "THI Agreement") pursuant to which THI agreed to provide to the
Company all the transmission capacity it requires or may in the future require
and the Company granted THI a nonexclusive license to use all of the Company's
facilities and related equipment, such as microwave transmitting and receiving
equipment, required to provide such transmission capacity. THI will obtain
future licenses necessary to provide the Company with the transmission capacity
it requires. The THI Agreement provides for payments from the Company to THI
which are expected to approximate the monthly interest due on the License Note
plus an allowance for the anticipated expenses of THI. The Company may also
advance funds to THI to the extent necessary to enable THI to fulfill its
obligations under the THI Agreement. All amounts of such advances will be added
to the principal of the License Note. It is not expected that payments made by
the Company to THI will have a material impact on the Company's cash flows or
results of operations.
In connection with the above described transaction, the Company received an
option from THI (the "THI Option") to purchase all or, in certain circumstances,
some of the assets of THI and a separate option from each stockholder of THI
(each, an "Individual Option") to purchase all of such person's shares of
capital stock of THI. The exercise price of the THI Option is equal to the
current principal of, plus the accrued interest on, the License Note on the
closing date, which may be paid by tendering to THI the License Note plus an
amount equal to the lesser of (i) the book value of the assets being purchased
or (ii) the initial capitalization of THI plus a 10% premium compounded
annually. The exercise price of each Individual Option is equal to the lesser of
(x) the book value of the shares being purchased and (y) the price paid for
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such shares plus a 10% premium compounded annually. The THI Option and the
Individual Options are exercisable at any time prior to February 14, 2007,
subject to FCC approval.
In 1997, the United States agreed, in the context of the WTO Basic Telecom
Agreement, to allow foreign suppliers from WTO member nations, including Canada,
to provide a broad range of basic telecommunications services in the United
States. Those commitments became effective in February 1998. In light of those
commitments, the FCC has determined that it will adopt an "open entry standard"
for suppliers of telecommunications services from WTO member nations. In
conjunction with its new open entry policies, the FCC has adopted a presumption
favoring grant of applications to exceed the 25 percent limit on non-U.S.
ownership contained in Section 310(b)(4) of the Communications Act when the
non-U.S. investment is from a WTO member nation. Accordingly, the Company is in
the process of reevaluating whether it should hold FCC authorizations directly
and, specifically, whether it should exercise its option to purchase the assets
or stock of THI. The Company has applied for FCC consent to allow it to purchase
the stock of THI.
INSURANCE
The Company purchases certain insurance coverage through GVL, including
directors' and officers' liability insurance. The Company paid an aggregate of
approximately $456,000 to GVL for this insurance coverage in fiscal 1998.
SERVICE AGREEMENTS
Pursuant to the terms of the Stockholders' Agreement, VPC and certain of
its affiliates provide certain strategic planning and treasury support services
to the Company and perform internal audits of the Company's operations.
Additional services may be provided as and when requested by the Company. The
Company is charged for such services based on an estimate of the actual cost of
the personnel engaged and materials used to provide such services (without an
allowance for profit). The cost for such services in fiscal 1998 was $310,000.
In addition, OpTel provides certain customer support and billing services
to certain affiliates of GVL which operate wireless cable systems. OpTel charges
such affiliates based on the actual cost of the personnel engaged and materials
used to provide such services.
SHARED LITIGATION EXPENSES
GVL, the Company and certain other affiliates of GVL were named as
defendants in a lawsuit by a former employee of the Company. GVL and the Company
agreed to joint representation by a single law firm and to share the associated
expenses. The litigation was settled and neither the settlement costs or the
associated expenses are material.
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PART IV
ITEM 14: EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
(a) The following documents are filed as part of this report:
1. Financial Statements. The following consolidated financial
statements of the Company and the report of the independent auditors
thereon, are included in this Form 10-K on pages F-1 through F-22.
Independent Auditors' Report
Consolidated Balance Sheets at August 31, 1997 and 1998
Consolidated Statements of Operations for the years ended August 31,
1996, 1997 and 1998
Consolidated Statements of Stockholders' Equity for the years ended
August 31, 1996, 1997 and 1998
Consolidated Statements of Cash Flows for the years ended August 31,
1996, 1997 and 1998
Notes to the Consolidated Financial Statements
2. Financial Statement Schedules. The following financial statement
schedule of the Company and the report of the independent auditors thereon,
for the years ended August 31, 1996, 1997 and 1998 are included in this
Form 10-K on pages S-1 and S-2.
<TABLE>
<CAPTION>
SCHEDULE NO. DESCRIPTION PAGE NO.
------------ ----------- --------
<S> <C> <C>
Schedule II Valuation and Qualifying Accounts S-2
</TABLE>
All other financial statement schedules have been omitted because they
are inapplicable or the required information is included or incorporated by
reference elsewhere herein.
3. Exhibits. The Company will furnish to any eligible stockholder,
upon written request of such stockholder, a copy of an exhibit listed below
upon payment of a reasonable fee equal to the Company's expenses in
furnishing such exhibit.
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
------- -----------
<C> <S>
2.1 -- Purchase Agreement (the "ICS Purchase Agreement") among
OpTel, ICS and ICS Licenses, Inc., dated as of March 4,
1998.(4)
2.2 -- Amendment Number One to the ICS Purchase Agreement, dated
as of March 4, 1998.(4)
2.3 -- Purchase Agreement (the "Phonoscope Purchase Agreement"),
dated as of August 13, 1997, among OpTel, Phonoscope,
Ltd., Phonoscope Management L.C., Lee Cook, Alton Cook
and Lee Cook Family Trust.(2)
2.4 -- Amendment Number One to the Phonoscope Purchase
Agreement, dated as of August 13, 1997.(4)
2.5 -- Amendment Number Two to the Phonoscope Purchase
Agreement, dated as of August 13, 1997.(4)
3.1 -- Restated Certificate of Incorporation of OpTel, together
with all amendments thereto.(7)
3.2 -- Bylaws of OpTel.(1)
3.3 -- Certificate of Designation of Voting Power, Designations,
Preferences, Limitations, Restrictions and Relative
Rights of the Series A Preferred.(4)
3.4 -- Certificate of Designation of Voting Power, Designations,
Preferences, Limitations, Restrictions and Relative
Rights of the Series B Preferred.(4)
4.1 -- 1997 Notes Purchase Agreement, dated February 7, 1997,
between OpTel and Salomon Brothers Inc and Merrill Lynch,
Pierce, Fenner & Smith Incorporated.(1)
4.2 -- Registration Agreement, dated as of February 14, 1997,
between OpTel and Salomon Brothers Inc and Merrill Lynch,
Pierce, Fenner & Smith Incorporated.(1)
</TABLE>
64
<PAGE> 67
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
------- -----------
<C> <S>
4.3 -- Indenture, dated as of February 14, 1997, between OpTel
and U.S. Trust Company of Texas, N.A., as Trustee.(1)
4.4 -- Form of 1997 Note (included in Exhibit 4.3).(1)
4.5 -- Escrow Agreement, dated as of February 14, 1997, between
OpTel and U.S. Trust Company of Texas, N.A., as Trustee
and Escrow Agent.(1)
4.6 -- 1998 Notes Purchase Agreement, dated as of June 29, 1998,
between OpTel, Salomon Brothers Inc, Goldman, Sachs & Co.
and CIBC Oppenheimer.(6)
4.7 -- Registration Agreement, dated as of July 7, 1998, between
OpTel and Salomon Brothers Inc, Goldman, Sachs & Co. and
CIBC Oppenheimer.(6)
4.8 -- Indenture, dated as of July 7, 1998, between OpTel and
U.S. Trust Company of Texas, N.A., as Trustee.(6)
4.9 -- Form of 1998 Note (included in Exhibit 4.8).(6)
4.10 -- Escrow Agreement, dated as of July 7, 1998, between OpTel
and U.S. Trust Company of Texas, N.A., as Trustee and
Escrow Agent.(6)
10.1 -- Amendment, dated as of February 17, 1997, between
Vanguard, General Partner, Pacific, VPC, OpTel and
GVL.(1)
10.2 -- Form of Convertible Note (included as Exhibit B to the
Amendment referenced as Exhibit 10.1 hereto) and a list
of the issue dates and principal amounts of all
outstanding Convertible Notes (included as Schedule 1 to
the Amendment referenced as Exhibit 10.1 hereto).(1)
10.3 -- Stockholders' Agreement, dated as of August 15, 1997, by
and among VPC, CDPQ and OpTel.(3)
10.4 -- Stockholders' Agreement, dated as of April 9, 1998, among
OpTel, Nomura, MCI, GVL and ICS.(4)
10.5 -- Lease Agreement, dated July 25, 1995, between Space
Center Dallas, Inc. and OpTel.(1)
10.6 -- First Amendment to Lease Agreement, dated August 8, 1996,
between Space Center Dallas, Inc. and OpTel. (1)
10.7 -- Restated Incentive Stock Plan of OpTel, dated November
12, 1996.(1)
10.8 -- Restated Incentive Stock Plan of OpTel, dated June 4,
1998.(7)
10.9 -- Annual Bonus Plan of OpTel.(1)
10.10 -- Employment Agreement between Stephen Dube and OpTel,
dated November 19, 1996.(7)
10.11 -- Employment Agreement between Bertrand Blanchette and
OpTel, dated June 17, 1996.(7)
10.12 -- Employment Agreement between Lynn Zera and OpTel, dated
November 7, 1995.(7)
10.13 -- Employment Agreement between Louis Brunel and OpTel,
dated November 15, 1996.(1)
10.14 -- Employment Agreement between Rory Cole and OpTel, dated
January 3, 1997.(1)
10.15 -- Employment Agreement between Michael Katzenstein and
OpTel, dated January 14, 1998.(7)
10.16 -- Separation and Consulting Agreement, dated as of
September 1, 1996, between OpTel and James A. Kofalt.(1)
10.17 -- Warrant Agreement, dated as of September 1, 1996, between
OpTel and James A. Kofalt.(1)
10.18 -- Separation Agreement, dated as of July 11, 1997, between
OpTel and Rory O. Cole.(4)
</TABLE>
65
<PAGE> 68
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
------- -----------
<C> <S>
10.19 -- Warrant Agreement, dated as of July 11, 1997, between
OpTel and Rory O. Cole.(2)
10.20 -- Assignment Agreement, dated as of February 14, 1997,
among TVMAX, Sunshine Television Entertainment, Inc.,
Richey Pacific Cablevision, Inc., IRPC Arizona, Inc. and
THI.(1)
10.21 -- Equipment License and Services Agreement, dated as of
February 14, 1997, between TVMAX and THI.(1)
10.22 -- Form of Shareholders Option Agreement, dated as of
February 14, 1997, between TVMAX and each of the
shareholders of THI, together with a list of the
shareholders of THI.(1)
10.23 -- Option Agreement, dated as of February 14, 1997, between
TVMAX and THI.(1)
10.24 -- Common Stock Registration Rights Agreement, dated as of
February 14, 1997, among OpTel, VPC, GVL and Salomon
Brothers Inc and Merrill Lynch, Pierce, Fenner & Smith
Incorporated and U.S. Trust Company of Texas, N.A.(1)
10.25 -- Registration Rights Agreement, dated as of August 15,
1997, between OpTel and CDPQ.(2)
10.26 -- Registration Rights Agreement dated as of April 9, 1998,
between OpTel, ICS, Nomura and MCI.(4)
10.27 -- City of Houston, Texas, Ordinance No. 89-338 dated March
29, 1989 granting to PrimeTime Cable Partners I, Ltd. the
right to operate for 15 years a Community Antenna
Television System, and subsequent ordinances consenting
to assignment of rights to EagleVision and to TVMAX
Communications (Texas), Inc.(1)
10.28 -- City of Houston, Texas, Ordinance No. 97-285 dated March
19, 1997, granting TVMAX Communications (Texas), Inc. a
temporary permit to operate a Telecommunications
Network.(1)
10.29 -- City of Houston, Texas, Ordinance No. 97-1088 dated
September 3, 1997, extending to TVMAX Communications
(Texas), Inc. a temporary permit to operate a
Telecommunications Network (originally granted pursuant
to the permit referenced in Exhibit 10.28 hereto).(2)
10.30 -- City of Houston, Texas, Ordinance No. 97-1567 dated
December 23, 1997, granting to TVMAX Communications
(Texas), Inc. a franchise to operate a Telecommunications
Network (superseding and replacing the temporary permits
referenced in Exhibits 10.28 and 10.29 hereto).(4)
10.31 -- Amendment Number 001 to the Videotron/Lucent Agreement,
dated August 28, 1997, among Videotron Telecom Ltee and
Lucent Technologies Canada Inc. and TVMAX and Lucent
Technologies Inc.(2)
10.32 -- Credit Agreement dated as of December 19, 1997, ("Credit
Agreement") among TVMAX, OpTel, Goldman Sachs Credit
Partners L.P., as arranger and syndication agent,
Canadian Imperial Bank of Commerce, individually and as
administrative agent, General Electric Capital
Corporation, individually and as documentation agent, and
the lenders party thereto from time to time
(collectively, the "Lenders").(4)
10.33 -- First Amendment to the Credit Agreement dated as of April
29, 1998.(4)
10.34 -- Interconnection Agreement under Sections 251 and 252 of
the Telecom Act by and between Southwestern Bell
Telephone Company and OpTel (Texas) Telecom, Inc.(2)
10.35 -- Residential Reseller Agreement dated as of May 29, 1998
by and between Teleport Communications Group Inc. and
TVMAX.(8)**
</TABLE>
66
<PAGE> 69
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
------- -----------
<C> <S>
10.36 -- Strategic Alliance Agreement dated as of March 10, 1998
between I(3)S, Inc. and TVMAX.(7)**
12.1 -- Statement Re: Deficiency of Earnings to Fixed Charges.
21.1 -- List of subsidiaries of OpTel.(7)
27.1 -- Financial Data Schedule
27.2 -- Restated Financial Data Schedule
</TABLE>
- ---------------
(1) Filed as an exhibit to OpTel's registration statement on Form S-4 filed with
the Commission on April 10, 1997 and incorporated herein by reference.
(2) Filed as an exhibit to the Company's 10-K filed with the Commission for
fiscal year ended August 31, 1997 and incorporated herein by reference.
(3) Filed as an exhibit to the Company's 10-K/A filed with the Commission for
fiscal year ended August 31, 1997 and incorporated herein by reference.
(4) Filed as an exhibit to OpTel's registration statement on Form S-1 filed with
the Commission on June 5, 1998 and incorporated herein by reference.
(5) Filed as an exhibit to Amendment No. 2 to OpTel's registration statement on
Form S-1 filed with the Commission on July 20, 1998 and incorporated herein
by reference.
(6) Filed as an exhibit to Amendment No. 3 to OpTel's registration statement on
Form S-1/ filed with the Commission on August 14, 1998 and incorporated
herein by reference.
(7) Filed as an exhibit to OpTel's registration statement on Form S-4 filed with
the Commission on September 4, 1998 and incorporated herein by reference.
(8) Filed as an exhibit to Amendment No. 1 to OpTel's registration statement on
Form S-4 filed with the Commission on October 9, 1998.
** The Commission granted the Company's request for confidential treatment of
portions of this document in an order dated October 9, 1998.
(b) Reports on Form 8-K
The Company filed a Current Report on Form 8-K, dated April 13, 1998,
reporting under Item 2 the completion of the initial closing of the acquisition
of the ICS Operations and filing under Item 7 the Statements of Assets and
Liabilities acquired as of December 31, 1997 and March 31, 1998 (unaudited) and
the Statement of Revenues and Direct Expenses for the year ended December 31,
1997 and the three months ended March 31, 1998 (unaudited).
The Company filed a Current Report on Form 8-K, dated June 8, 1998,
reporting under Item 5 the filing of a registration statement for a primary
offering of shares of its Class A Common Stock for gross proceeds of
approximately $100 million.
The Company filed a Current Report on Form 8-K, dated June 12, 1998,
reporting under Item 5 the Company's intent to issue $200 million gross proceeds
of Senior Notes due 2008 in a private placement.
SUPPLEMENTAL INFORMATION TO BE FURNISHED WITH REPORTS FILED PURSUANT TO
SECTION 15(d) OF THE SECURITIES EXCHANGE ACT BY REGISTRANTS WHICH HAVE NOT
REGISTERED SECURITIES PURSUANT TO SECTION 12 OF THE SECURITIES EXCHANGE ACT.
None.
67
<PAGE> 70
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Company has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized, in the City of Dallas, State of Texas,
on this 25th day of November, 1998.
OPTEL, INC.
By: /s/ LOUIS BRUNEL
----------------------------------
Louis Brunel
President and Chief Executive
Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons in the capacities and on
the dates indicated.
<TABLE>
<CAPTION>
SIGNATURE TITLE DATE
--------- ----- ----
<C> <S> <C>
Principal Executive Officer:
/s/ LOUIS BRUNEL President and Chief November 25, 1998
- ----------------------------------------------------- Executive Officer
Louis Brunel
Principal Financial and Accounting Officers:
/s/ BERTRAND BLANCHETTE Chief Financial Officer November 25, 1998
- -----------------------------------------------------
Bertrand Blanchette
/s/ CRAIG MILACEK Controller November 25, 1998
- -----------------------------------------------------
Craig Milacek
Directors:
/s/ ANDRE CHAGNON Chairman of the Board November 25, 1998
- -----------------------------------------------------
Andre Chagnon
/s/ ALAIN MICHEL Vice Chairman of the Board November 25, 1998
- -----------------------------------------------------
Alain Michel
/s/ LOUIS BRUNEL Director November 25, 1998
- -----------------------------------------------------
Louis Brunel
Director November 25, 1998
- -----------------------------------------------------
Frederick W. Benn
/s/ CHRISTIAN CHAGNON Director November 25, 1998
- -----------------------------------------------------
Christian Chagnon
/s/ WILLIAM O. HUNT Director November 25, 1998
- -----------------------------------------------------
William O. Hunt
Director November 25, 1998
- -----------------------------------------------------
R. Douglas Leonhard
/s/ LYNN MCDONALD Director November 25, 1998
- -----------------------------------------------------
Lynn McDonald
</TABLE>
68
<PAGE> 71
INDEPENDENT AUDITORS' REPORT
To the Board of Directors of
OpTel, Inc.:
We have audited the accompanying consolidated balance sheets of OpTel, Inc.
and subsidiaries (the "Company") as of August 31, 1997 and 1998, and the related
consolidated statements of operations, stockholders' equity and cash flows for
the years ended August 31, 1996, 1997 and 1998. 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 audits 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 OpTel, Inc. and subsidiaries as
of August 31, 1997 and 1998, and the results of their operations and their cash
flows for the years ended August 31, 1996, 1997 and 1998, in conformity with
generally accepted accounting principles.
/s/ DELOITTE & TOUCHE LLP
Dallas, Texas
October 6, 1998
<PAGE> 72
OPTEL, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS, EXCEPT PER-SHARE AMOUNTS)
ASSETS
<TABLE>
<CAPTION>
AUGUST 31
--------------------
1997 1998
-------- ---------
<S> <C> <C>
Cash and cash equivalents................................... $ 87,305 $ 123,774
Restricted investments (Notes 6 and 12)..................... 67,206 63,207
Accounts receivable (net of allowance for doubtful accounts
of $1,125 and $1,803, respectively)....................... 4,044 9,458
Prepaid expenses, deposits and other assets................. 1,836 2,317
Property and equipment, net (Note 4)........................ 160,442 268,044
Intangible assets, net (Note 5)............................. 82,583 160,370
-------- ---------
TOTAL............................................. $403,416 $ 627,170
======== =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Accounts payable, accrued expenses and other liabilities.... $ 21,896 $ 31,842
Deferred revenue and customer deposits...................... 2,978 5,274
Convertible notes payable to stockholder (Note 9)........... 129,604 --
Notes payable and long-term obligations (Note 6)............ 228,573 429,278
-------- ---------
Total liabilities................................. 383,051 466,394
Commitments and contingencies (Notes 3 and 7)
Stockholders' equity (Notes 9, 10 and 13):
Preferred stock, $.01 par value; 1,000,000 shares
authorized; none issued and outstanding................ -- --
Series A preferred stock, $.01 par value; 10,000 shares
authorized; none and 6,962 issued and outstanding...... -- 146,115
Series B preferred stock, $.01 par value; 2,000 shares
authorized; none and 991 issued and outstanding........ -- 61,343
Class A common stock, $.01 par value; 8,000,000 shares
authorized; none and 164,272 issued and outstanding.... -- 2
Class B common stock, $.01 par value; 6,000,000 shares
authorized; 2,353,498 issued and outstanding........... 24 24
Class C common stock, $.01 par value; 300,000 shares
authorized; 225,000 issued and outstanding............. 2 2
Additional paid-in capital.................................. 97,683 113,780
Accumulated deficit......................................... (77,344) (160,490)
-------- ---------
Total stockholders' equity........................ 20,365 160,776
-------- ---------
TOTAL............................................. $403,416 $ 627,170
======== =========
</TABLE>
See notes to consolidated financial statements.
F-2
<PAGE> 73
OPTEL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
(DOLLARS AND SHARES IN THOUSANDS, EXCEPT PER-SHARE AMOUNTS)
<TABLE>
<CAPTION>
1996 1997 1998
-------- -------- --------
<S> <C> <C> <C>
REVENUES:
Cable television.......................................... $ 25,893 $ 36,915 $ 61,081
Telecommunications........................................ 1,711 2,922 3,882
-------- -------- --------
Total revenues.................................... 27,604 39,837 64,963
OPERATING EXPENSES:
Programming, access fees and revenue sharing.............. 11,868 19,202 28,825
Customer support, general and administrative.............. 19,636 28,926 35,847
Depreciation and amortization............................. 8,676 14,505 28,481
-------- -------- --------
Total operating expenses.......................... 40,180 62,633 93,153
-------- -------- --------
LOSS FROM OPERATIONS........................................ (12,576) (22,796) (28,190)
OTHER INCOME (EXPENSE):
Interest expense on convertible notes payable to
stockholder (Notes 4 and 9)............................ (5,342) (15,204) (9,640)
Other interest expense.................................... (657) (16,210) (38,837)
Interest and other income................................. 145 5,675 8,913
-------- -------- --------
LOSS BEFORE INCOME TAXES AND EXTRAORDINARY ITEM............. (18,430) (48,535) (67,754)
INCOME TAXES (Note 8)....................................... -- -- --
-------- -------- --------
LOSS BEFORE EXTRAORDINARY ITEM.............................. (18,430) (48,535) (67,754)
EXTRAORDINARY LOSS ON DEBT EXTINGUISHMENT (Note 6).......... -- -- (6,644)
-------- -------- --------
NET LOSS.................................................... (18,430) (48,535) (74,398)
EARNINGS ATTRIBUTABLE TO PREFERRED STOCK.................... -- -- (8,748)
-------- -------- --------
NET LOSS ATTRIBUTABLE TO COMMON EQUITY...................... $(18,430) $(48,535) $(83,146)
======== ======== ========
BASIC AND DILUTED LOSS BEFORE EXTRAORDINARY ITEM PER SHARE
OF COMMON EQUITY.......................................... $ (8.30) $ (19.98) $ (28.94)
BASIC AND DILUTED EXTRAORDINARY LOSS PER SHARE OF COMMON
EQUITY.................................................... -- -- (2.51)
-------- -------- --------
BASIC AND DILUTED LOSS PER SHARE OF COMMON EQUITY (Notes 2
and 10)................................................... $ (8.30) $ (19.98) $ (31.45)
======== ======== ========
WEIGHTED AVERAGE NUMBER OF SHARES OF COMMON EQUITY
OUTSTANDING (Notes 2 and 10).............................. 2,220 2,430 2,644
======== ======== ========
</TABLE>
See notes to consolidated financial statements.
F-3
<PAGE> 74
OPTEL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
(DOLLARS AND SHARES IN THOUSANDS)
<TABLE>
<CAPTION>
SERIES A SERIES B CLASS A CLASS B
PREFERRED STOCK PREFERRED STOCK COMMON STOCK COMMON STOCK
------------------------- ------------------------- ------------------- -------------------
SHARES LIQUIDATION SHARES LIQUIDATION SHARES PAR SHARES PAR
OUTSTANDING VALUE OUTSTANDING VALUE OUTSTANDING VALUE OUTSTANDING VALUE
----------- ----------- ----------- ----------- ----------- ----- ----------- -----
<S> <C> <C> <C> <C> <C> <C> <C> <C>
BALANCE, SEPTEMBER 1, 1995... -- $ -- -- $ -- -- $-- 2,150 $21
Issuance of stock upon debt
conversion................ -- -- -- -- -- -- 171 2
Contribution and
cancellation of shares.... -- -- -- -- -- -- (16) --
Net loss.................... -- -- -- -- -- -- -- --
-- -------- -- ------- --- --- ----- ---
BALANCE, AUGUST 31, 1996..... -- -- -- -- -- -- 2,305 23
Issuance of stock with
senior notes offering..... -- -- -- -- -- -- -- --
Stock options exercised..... -- -- -- -- -- -- 48 1
Net loss.................... -- -- -- -- -- -- -- --
-- -------- -- ------- --- --- ----- ---
BALANCE, AUGUST 31, 1997..... -- -- -- -- -- -- 2,353 24
Earnings attributable to
preferred stock........... -- 6,871 -- 1,877 -- -- -- --
Issuance of stock upon debt
conversion................ 7 139,244 -- -- -- -- -- --
Issuance of stock to acquire
the ICS operations........ -- -- 1 59,466 164 2 -- --
Net loss.................... -- -- -- -- -- -- -- --
-- -------- -- ------- --- --- ----- ---
BALANCE, AUGUST 31, 1998..... 7 $146,115 1 $61,343 164 $ 2 2,353 $24
== ======== == ======= === === ===== ===
<CAPTION>
CLASS C
COMMON STOCK
------------------- ADDITIONAL
SHARES PAR PAID-IN ACCUMULATED
OUTSTANDING VALUE CAPITAL DEFICIT TOTAL
----------- ----- ---------- ----------- --------
<S> <C> <C> <C> <C> <C>
BALANCE, SEPTEMBER 1, 1995... -- $-- $ 78,902 $ (10,379) $ 68,544
Issuance of stock upon debt
conversion................ -- -- 9,163 -- 9,165
Contribution and
cancellation of shares.... -- -- -- -- --
Net loss.................... -- -- -- (18,430) (18,430)
--- --- -------- --------- --------
BALANCE, AUGUST 31, 1996..... -- -- 88,065 (28,809) 59,279
Issuance of stock with
senior notes offering..... 225 2 6,998 -- 7,000
Stock options exercised..... -- -- 2,620 -- 2,621
Net loss.................... -- -- -- (48,535) (48,535)
--- --- -------- --------- --------
BALANCE, AUGUST 31, 1997..... 225 2 97,683 (77,344) 20,365
Earnings attributable to
preferred stock........... -- -- -- (8,748) --
Issuance of stock upon debt
conversion................ -- -- -- -- 139,244
Issuance of stock to acquire
the ICS operations........ -- -- 16,097 -- 75,565
Net loss.................... -- -- -- (74,398) (74,398)
--- --- -------- --------- --------
BALANCE, AUGUST 31, 1998..... 225 $ 2 $113,780 $(160,490) $160,776
=== === ======== ========= ========
</TABLE>
See notes to consolidated financial statements.
F-4
<PAGE> 75
OPTEL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
1996 1997 1998
-------- --------- ---------
<S> <C> <C> <C>
OPERATING ACTIVITIES:
Net loss................................................. $(18,430) $ (48,535) $ (74,398)
Adjustments to reconcile net loss to net cash flow used
in operating activities:
Depreciation and amortization......................... 8,676 14,505 28,481
Noncash portion of extraordinary loss on debt
extinguishment...................................... -- -- 5,349
Noncash interest expense.............................. 5,661 15,107 10,950
Noncash interest earned on restricted investments..... -- (2,303) (3,466)
Increase (decrease) in cash from changes in operating
assets and liabilities, net of effect of business
combinations:
Accounts receivable................................. (1,370) (754) (4,003)
Prepaid expenses, deposits and other assets......... (126) (785) (68)
Deferred revenue and customer deposits.............. 906 640 1,081
Accounts payable, accrued expenses and other
liabilities...................................... 4,230 6,190 9,806
-------- --------- ---------
Net cash flows used in operating activities...... (453) (15,935) (26,268)
-------- --------- ---------
INVESTING ACTIVITIES:
Purchases of businesses.................................. (9,916) (6,717) (43,354)
Acquisition of intangible assets......................... (7,904) (10,112) (7,172)
Purchases and construction of property and equipment..... (54,217) (61,393) (78,471)
Purchases of restricted investments...................... -- (79,609) (21,785)
Proceeds from maturity of restricted investments......... -- 14,706 29,250
-------- --------- ---------
Net cash flows used in investing activities...... (72,037) (143,125) (121,532)
-------- --------- ---------
FINANCING ACTIVITIES:
Proceeds from convertible notes payable.................. 73,438 33,700 --
Repayments on convertible notes payable.................. -- (10,000) --
Proceeds from senior notes payable....................... -- 218,000 200,000
Financing costs of senior notes payable.................. -- (5,738) (6,480)
Proceeds from bank financing, net of transaction costs... -- -- 119,329
Repayment on bank financing.............................. -- -- (125,000)
Proceeds from issuance of common stock................... -- 9,620 --
Payment on notes payable and long-term obligations....... (1,307) (894) (3,580)
-------- --------- ---------
Net cash flows provided by financing
activities..................................... 72,131 244,688 184,269
-------- --------- ---------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS....... (359) 85,628 36,469
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR............. 2,036 1,677 87,305
-------- --------- ---------
CASH AND CASH EQUIVALENTS AT END OF YEAR................... $ 1,677 $ 87,305 $ 123,774
======== ========= =========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION (Notes 3
and 9):
Cash paid during the period for interest................. $ 290 $ 15,059 $ 36,831
======== ========= =========
Increase in capital lease obligations.................... $ 879 $ 1,630 $ 2,742
======== ========= =========
Convertible debt issued for accrued interest............. $ 6,436 $ 16,490 $ 9,640
======== ========= =========
Common stock issued for convertible debt................. $ 9,166 $ -- $ --
======== ========= =========
Preferred stock issued for convertible debt.............. $ -- $ -- $ 139,244
======== ========= =========
Preferred stock issued for purchase of business.......... $ -- $ -- $ 59,466
======== ========= =========
Common stock issued for purchase of business............. $ -- $ -- $ 16,099
======== ========= =========
Earnings attributable to preferred stock................. $ -- $ -- $ 8,748
======== ========= =========
</TABLE>
See notes to consolidated financial statements.
F-5
<PAGE> 76
OPTEL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED AUGUST 31, 1996, 1997 AND 1998
(DOLLARS IN THOUSANDS, EXCEPT PER-SHARE AMOUNTS)
1. DESCRIPTION OF BUSINESS
OpTel, Inc., a Delaware corporation, and subsidiaries (the "Company" or
"OpTel") is the successor of the cable television and telecommunications
operations of Vanguard Communications, L.P. ("Vanguard"). Vanguard commenced
operations in April 1993. On December 20, 1994, Vanguard contributed its cable
television and telecommunications operations to its wholly owned subsidiary,
OpTel. The contribution to OpTel was recorded at Vanguard's historical cost.
OpTel is a developer, operator and owner of private cable television and
telecommunications systems that utilize advanced technologies to deliver cable
television and telecommunications services to customers in multiple dwelling
units ("MDUs"). The Company negotiates long-term, generally exclusive cable
television service agreements and nonexclusive telecommunications service
agreements with owners and managers of MDUs, generally for terms of up to 15
years. The Company's primary markets are major metropolitan areas in Arizona,
California, Colorado, Florida, Georgia, Illinois, Indiana, Texas and Washington,
D.C.
During the period from April 20, 1993 (date of inception) to March 31,
1995, the Company was wholly owned by Vanguard. On March 31, 1995, VPC
Corporation ("VPC") (a wholly owned subsidiary of Le Groupe Videotron Ltee
("Videotron"), a Quebec corporation) acquired a 66.75% interest in the Company.
At August 31, 1998, VPC's interest in the Company was 70.13% (see Note 9).
2. SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation -- The consolidated financial statements
include the accounts of OpTel and its wholly owned and majority-owned
subsidiaries and limited partnerships. All significant intercompany accounts and
transactions have been eliminated. Amounts due to minority limited partners are
included in notes payable and long-term obligations.
Cash and Cash Equivalents -- Cash and cash equivalents of the Company are
composed of demand deposits with banks and highly liquid, short-term investments
with maturities of three months or less when purchased.
Restricted Investments -- Restricted investments of the Company are
composed of U.S. Treasury securities restricted for payment of interest on the
Company's Senior Notes. These investments are classified as held to maturity and
are carried at amortized cost.
Property and Equipment -- Property and equipment are stated at cost, which
includes amounts for construction materials, direct labor and overhead, and
capitalized interest. When assets are disposed of, the costs and related
accumulated depreciation are removed, and any resulting gain or loss is
reflected in income for the period. Cost of maintenance and repairs is charged
to operations as incurred; significant renewals and betterments are capitalized.
Depreciation is calculated using the straight-line method over the
estimated useful lives of the various classes of property and equipment as
follows:
<TABLE>
<S> <C>
Headends.................................................... 15 years
Telephone switches.......................................... 10 years
Distribution systems and enhancements....................... 15 years
Computer software and equipment............................. 2 to 4 years
Other....................................................... 5 to 10 years
</TABLE>
F-6
<PAGE> 77
OPTEL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Management routinely evaluates its recorded investments for impairment in
accordance with Statement of Financial Accounting Standards ("SFAS") No. 121,
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
be Disposed Of," based on projected undiscounted cash flows and other methods
when events or changes in circumstances indicate that the carrying amount of an
asset may not be recoverable. Management believes the investments to be
recoverable.
Intangible Assets -- Costs associated with licensing fees, commissions and
other direct costs incurred in connection with the execution of rights-of-entry
agreements to provide cable television and telecommunications service to MDUs,
the excess of purchase price over the fair value of tangible assets acquired
(goodwill) and other intangible assets are amortized using the straight-line
method over the following estimated useful lives:
<TABLE>
<S> <C>
Goodwill.............................................. 20 years
Licensing fees and rights-of entry costs.............. Initial term of contract
Deferred financing costs.............................. Terms of indebtedness
Other................................................. 1 to 5 years
</TABLE>
Management routinely evaluates its recorded investments in intangible
assets for impairment in accordance with SFAS No. 121 based on projected
undiscounted cash flows and other methods when events or changes in
circumstances indicate that the carrying amount of an asset may not be
recoverable and believes the investments to be recoverable. Amounts recorded as
goodwill have been acquired in the business combinations discussed in Note 3.
Such amounts are generally attributable to market entry or expansion.
Federal and State Income Taxes -- Prior to August 2, 1996, the Company and
its corporate subsidiaries filed a consolidated federal income tax return.
Beginning August 2, 1996, in connection with VPC's acquiring additional stock
from Vanguard, the Company was included in VPC's consolidated federal income tax
return. Effective February 14, 1997, as the result of issuing Class C Common
(see Notes 6 and 9), the Company was deconsolidated from VPC for tax purposes.
Beginning March 1, 1998, as the result of VPC's converting its convertible notes
payable to Series A Preferred, the Company will be included in VPC's
consolidated federal income tax return. Effective April 13, 1998, as the result
of issuing Class A Common and Series B Preferred, the Company will again be
required to file a separate consolidated federal income tax return. During the
period in which the Company was consolidated with VPC, for purposes of financial
reporting, the Company recorded federal and state income tax as if it were
filing a separate return. Deferred tax assets and liabilities are recorded based
on the difference between the tax basis of the assets and liabilities and their
carrying amounts for financial reporting purposes, referred to as "temporary
differences." Provision is made or benefit recognized for deferred taxes
relating to temporary differences in the recognition of expense and income for
financial reporting purposes. To the extent a deferred tax asset does not meet
the criterion of "more likely than not" for realization, a valuation allowance
is recorded.
Revenue Recognition and Deferred Revenue -- The Company recognizes revenue
as cable television programming and telecommunications services are provided to
subscribers. OpTel typically bills customers in advance for monthly cable
television services, which results in the deferral of revenue until those
services are provided. Installation revenue is recognized in the period
installation services are provided to the extent of direct selling costs. For
all periods presented, installation revenues have not exceeded direct selling
costs. The Company expenses all initial subscriber costs as incurred due to the
short-term subscriber lives associated with MDU service and because such costs
do not constitute additions to property and equipment.
Net Loss per Common Share -- The computation of basic and diluted loss per
common share is based on the weighted average number of common shares
outstanding during the period (see Note 10). Common stock equivalents are
included in the computation if they are dilutive. For the year ended August 31,
1996, the convertible notes payable to stockholder are excluded from the diluted
earnings per share calculation because
F-7
<PAGE> 78
OPTEL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
of their antidilutive effect. For the years ended August 31, 1997 and 1998, the
convertible notes payable to stockholder; the Series A and the Series B
preferred stock; and 90,037 and 123,685 stock options and warrants,
respectively, are excluded from the diluted earnings per share calculation
because of their antidilutive effect. As a result, diluted loss per common share
for the years ended August 31, 1996, 1997 and 1998, is considered to be the same
as basic.
Derivative Financial Instruments -- Derivative financial instruments are
utilized by the Company to reduce interest rate risk and include interest rate
swaps. The Company does not hold or issue derivative financial instruments for
speculative or trading purposes. Gains and losses resulting from the termination
of derivative financial instruments are recognized over the shorter of the
remaining original contract lives of the derivative financial instruments or the
lives of the related hedged positions or, if the hedged positions are sold or
extinguished, are recognized in the current period as gain or loss.
Acquisitions -- The Company's acquisitions are accounted for using the
purchase method of accounting and include results of operations of the acquired
businesses in the accompanying consolidated financial statements from the dates
of acquisition. Identifiable tangible and intangible assets acquired and
liabilities assumed are recorded at their estimated fair value at the date of
acquisition. The excess of the purchase price over the net assets acquired is
recorded as goodwill.
Use of Estimates -- The preparation of financial statements in conformity
with generally accepted accounting principles requires management to make
estimates and assumptions that affect reporting amounts of certain assets,
liabilities, revenues and expenses. Actual results may differ from such
estimates. The Company is in the initial stages of entering new markets and
acquiring or constructing the infrastructure necessary to deliver cable
television and telecommunication services. The Company's network upgrades and
investment in central office switched telecommunications require significant
investment, a portion of which will not be recovered unless the Company's
customer base increases from current levels, as to which there can be no
assurance due to possible adverse effects of competition, regulatory changes,
technology changes, the ability to finance future expenditures or other
unforeseen factors. The carrying value of property, equipment and intangible
assets will be subject to ongoing assessment.
New Accounting Pronouncements -- In February 1997, the Financial Accounting
Standards Board ("FASB") issued SFAS No. 128, "Earnings per Share," which
established new standards for computing and presenting earnings per share and
was effective for financial statements issued for periods ending after December
15, 1997, including interim periods. Prior periods presented have been restated
to reflect the adoption of SFAS No. 128, which did not have a significant impact
upon the Company's reported earnings per share.
Also in February 1997, the FASB issued SFAS No. 129, "Disclosure of
Information about Capital Structure," which establishes standards for disclosing
information about an entity's capital structure and is effective for financial
statements for periods ending after December 15, 1997.
In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive
Income," which establishes standards for reporting and display of comprehensive
income and its components in the financial statements. SFAS No. 130 is effective
for fiscal years beginning after December 15, 1997.
Also in June 1997, the FASB issued SFAS No. 131, "Disclosures about
Segments of an Enterprise and Related Information," which establishes standards
for the way public companies disclose information about operating segments,
products and services, geographic areas and major customers. SFAS No. 131 is
effective for financial statements for fiscal years beginning after December 15,
1997.
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities," which establishes standards for accounting
and reporting for derivative instruments. SFAS No. 133 is effective for fiscal
years beginning after June 15, 1999; however, earlier application is permitted.
F-8
<PAGE> 79
OPTEL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Management is currently not planning on early adoption of this statement and has
not completed an evaluation of the impact of the provisions of this statement on
the Company's consolidated financial statements.
Reclassifications -- Certain reclassifications of prior-year amounts have
been made to conform to the current-year presentation.
3. ACQUISITIONS
On December 28, 1994, the Company acquired the stock of the operating
subsidiaries of International Richey Pacific Cablevision, Ltd. ("IRPC"). The
Company, as a result of the acquisition from IRPC, is a general partner in
limited partnership investments (the "Partnerships"). The operations of these
Partnerships have been consolidated with those of the Company. The Company had
the option to purchase the interest of each limited partner at defined amounts
ranging from 110% to 140% of each limited partner's initial capital contribution
for the first four years of the partnership agreements and was required to
purchase the interests at the end of the fifth year at 150% of the initial
capital contribution. During the periods ended August 31, 1996, 1997 and 1998,
OpTel paid $392, $0 and $753, respectively, to repurchase all of the partnership
obligations, including the appreciation described above (see Note 6). The
operations of the acquired subsidiaries and the partnerships are located in the
San Diego, California, and Phoenix, Arizona, areas.
On January 11, 1995, the Company purchased the assets of EagleVision for
$15,200 in cash, the assumption of approximately $110 of liabilities and a
deferred payment due to the seller of not less than $6,000 and not more than
$10,000 based on the profitability of OpTel's assets in the Houston, Texas,
market with certain adjustments. This deferred payment is payable at the
seller's option, either (a) following the sale of all or substantially all of
the EagleVision assets or the sale of a majority of the outstanding voting
capital of the OpTel subsidiary that acquired EagleVision assets to a third
party that is not an affiliate or (b) at the conclusion of the fifth or sixth
year following the acquisition. This deferred payment is carried on the
accompanying consolidated balance sheets in notes payable and long-term
obligations at the net present value of the estimated final payment with an
accretion of interest recorded to operations. As of the date of acquisition and
as of August 31, 1998, the estimated payment due was $6,000 with a net present
value at August 31, 1997 and 1998, of $4,903 and $5,338, respectively.
EagleVision's operations are located in the Houston, Texas, area.
On June 30, 1995, the Company purchased the stock of Sunshine Television
Entertainment, Inc. ("Sunshine") for $5,500 in cash and the assumption of
approximately $350 of liabilities. Sunshine's operations are located in the
Miami, Florida, area.
On July 31, 1995, the Company purchased the assets of Interface
Communications Group, Inc. and certain related entities ("Interface") for $8,900
in cash and the assumption of approximately $30 of liabilities. The operations
of Interface are located in the Denver, Colorado, area.
On August 31, 1995, the Company purchased the general and limited
partnership interests of Triax Associates V, L.P. ("Triax"), for $15,200 in cash
and the assumption of approximately $100 of liabilities. The operations of Triax
are located in the Chicago, Illinois, area.
On January 30, 1996, the Company purchased the assets of Telecom Master
L.P. and Telecom Satellite Systems Corporation ("Telecom") for approximately
$5,700 in cash and the assumption of $100 of liabilities. The operations of
Telecom are located in the Dallas, Texas, area.
On August 2, 1996, the Company purchased certain assets of certain
subsidiaries of Wireless Holdings, Inc., and Videotron (Bay Area), Inc.,
companies that are 50% and 80% owned and controlled by Videotron, respectively,
for approximately $3,880. The amount paid represents the sellers' historical
cost, which also approximates the acquired assets' estimated fair market value.
The operations of the acquired assets are located in the San Francisco,
California, and Tampa, Florida, areas.
F-9
<PAGE> 80
OPTEL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
On November 12, 1996, the Company purchased the assets of Malvey Cable
Company ("Nor-Cal") for approximately $2,500 in cash. The operations of Nor-Cal
are located in the San Francisco, California, area.
On March 14, 1997, the Company purchased the stock of Tara Communication
Systems, Inc. ("Tara") for $2,450 in cash and the assumption of approximately
$65 of liabilities. The operations of Tara are located in the Chicago, Illinois,
area.
On August 1, 1997, the Company purchased certain assets of Northgate
Communications, Inc. ("Northgate") for approximately $1,700 in cash. The
operations of Northgate are located in the Los Angeles and San Diego,
California, areas.
On October 27, 1997, the Company purchased the residential cable television
and associated fiber optic network assets of Phonoscope Ltd. and the stock of
several affiliated entities (collectively "Phonoscope"). The operations of
Phonoscope are in Houston, Texas. The purchase price consisted of $38 million in
cash and the assumption of $0.2 million of liabilities. The purchase price was
allocated $15.5 million to property and equipment, $5.4 million to
rights-of-entry and $17.3 million to goodwill.
On March 3, 1998, the Company entered into a definitive purchase agreement
to acquire certain cable television and telephone assets of Interactive Cable
Systems, Inc. ("ICS"). The total purchase price is approximately $83.4 million
and consists of approximately $4.8 million of cash, Series B Preferred with a
liquidation preference of $59.5 million, and 164,272 shares of Class A Common
plus assumed liabilities of $1.6 million and including transaction costs of
approximately $1.4 million. The Series B Preferred earns dividends at an annual
rate of 8%, payable in additional shares of Series B, and is convertible into
Class A Common based upon the liquidation preference plus any cumulative unpaid
dividends at the time of the conversion divided by the share price upon
consummation of an initial public offering. As of August 31, 1998, the Company
had received consents and accepted the transfer of legal title to approximately
80% of the assets that are the subject of the aggregate acquisition. The Company
expects the transfer of legal title for the balance of the acquisition to be
completed during the first and second quarters of fiscal 1999 as ICS meets
certain conditions. Approximately 20% of the total purchase price has been
escrowed until ICS meets these conditions. The Company has included 100% of the
assets and operating results of the ICS operations in its consolidated financial
statements since April 13, 1998, because (i) although the transfer of legal
title to the remaining assets is subject to the receipt of certain third-party
consents, the Company may elect to waive the consent conditions, (ii) under the
terms of a management agreement, during the period that ICS has to secure the
necessary consents, the Company is managing these assets and receives all the
revenues associated with and incurs all the expenses associated with these units
and (iii) the entire purchase price was paid (although a portion of the purchase
price is being held in escrow for the protection of the Company, subject to the
receipt of the necessary consents). The assets being acquired are located in
Houston, Dallas/Fort Worth, San Diego, Phoenix, Chicago, Denver, San Francisco,
Los Angeles, Miami-Ft. Lauderdale, Tampa-Orlando, Atlanta, Indianapolis and
greater Washington, D.C. At August 31, 1998, the allocation of the purchase
price is recorded on a preliminary basis subject to final appraisals and
third-party consents, as follows and is subject to adjustment; however,
management does not expect the impact of any adjustments to be material:
<TABLE>
<S> <C>
Accounts receivable......................................... $ 1,333
Prepaid expenses, deposits and other assets................. 249
Property and equipment...................................... 30,000
Identifiable intangible assets (rights-of-entry)............ 9,325
Goodwill.................................................... 42,580
Deferred revenue and customer deposits...................... (842)
Capital lease obligations................................... (793)
-------
Total............................................. $81,852
=======
</TABLE>
F-10
<PAGE> 81
OPTEL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The pro forma results presented below have been prepared to illustrate the
effects of the ICS acquisition as if it had occurred on the first day of the
periods presented. The pro forma financial information is not necessarily
indicative of either future results of operations or the results that might have
been achieved if such transactions had been consummated on the indicated dates.
<TABLE>
<CAPTION>
YEARS ENDED AUGUST 31
---------------------
1997 1998
--------- ---------
<S> <C> <C>
Total revenues.......................................... $ 56,465 $ 75,665
Loss from operations.................................... (33,166) (33,620)
Net loss................................................ (59,047) (79,913)
Basic and diluted loss per common share of common
equity................................................ (24.60) (33.38)
</TABLE>
The pro forma effect of the acquisition of Phonoscope would have had an
insignificant impact on the consolidated results of operations of the Company
for the years ended 1997 and 1998.
4. PROPERTY AND EQUIPMENT
Property and equipment consisted of the following:
<TABLE>
<CAPTION>
AUGUST 31
-------------------
1997 1998
-------- --------
<S> <C> <C>
Headends.................................................... $ 53,088 $ 77,470
Telephone switches.......................................... 9,347 23,474
Distribution systems and enhancements....................... 68,538 113,775
Computer software and equipment............................. 9,512 16,753
Other....................................................... 8,762 12,813
Construction in progress.................................... 26,177 57,748
-------- --------
175,424 302,033
Less accumulated depreciation............................... (14,982) (33,989)
-------- --------
$160,442 $268,044
======== ========
</TABLE>
Included in property and equipment is $3,069 and $5,532 of equipment
acquired under capital leases at August 31, 1997 and 1998, respectively.
Interest expense of $2,256 and $2,753 was capitalized during 1997 and 1998,
respectively.
5. INTANGIBLE ASSETS
Intangible assets consisted of the following:
<TABLE>
<CAPTION>
AUGUST 31
-------------------
1997 1998
-------- --------
<S> <C> <C>
Goodwill.................................................... $ 53,081 $112,485
Licensing fees and rights-of-entry costs.................... 30,833 53,030
Deferred financing costs.................................... 5,784 12,264
Other....................................................... 3,243 1,926
-------- --------
92,941 179,705
Less accumulated amortization............................... (10,358) (19,335)
-------- --------
$ 82,583 $160,370
======== ========
</TABLE>
F-11
<PAGE> 82
OPTEL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The Company's right-of-entry agreements represent the Company's agreement
to provide cable television and telecommunications service to MDUs and typically
have initial terms of 10 to 15 years. The right-of-entry agreements generally
provide for MDU owners to receive an up-front cash payment and payment of a
portion of revenues over the terms of the agreements.
6. NOTES PAYABLE AND LONG-TERM OBLIGATIONS
Notes payable and long-term obligations consisted of the following:
<TABLE>
<CAPTION>
AUGUST 31
----------------------
1997 1998
-------- --------
<S> <C> <C>
13% Senior Notes Due 2005, Series B, net of unamortized
discount of $6,526 and $5,651............................. $218,474 $219,349
11.5% Senior Notes Due 2008................................. -- 200,000
Installment notes payable bearing interest at rates ranging
from 7.75% to 13% per annum, substantially all
collateralized by certain transportation equipment or
private cable television systems.......................... 280 167
Limited partner obligations................................. 714 --
Obligations under capital leases, net of amounts
representing interest of $581 and $941 for 1997 and
1998...................................................... 2,185 4,424
Deferred acquisition liabilities............................ 6,920 5,338
-------- --------
$228,573 $429,278
======== ========
</TABLE>
On February 14, 1997, the Company issued $225 million of 13% Senior Notes
Due 2005 ("2005 Notes"). The 2005 Notes require semiannual interest payments due
on August 15 and February 15 of each year until their maturity on February 15,
2005. The 2005 Notes are redeemable at the option of the Company generally at a
premium at any time after February 15, 2002, and can be redeemed, in part, also
at a premium, earlier upon the occurrence of certain defined events. In
addition, a transfer by VPC of its interest in OpTel, a transfer by Videotron of
its interest in VPC or an election by VPC to convert its Class B Common into
shares of Class A Common may result in a change of control under the indenture,
which could require the Company to purchase the 2005 Notes. The 2005 Notes are
unsecured.
In connection with the issuance of the 2005 Notes, the Company issued
225,000 shares of Class C Common. The portion of the net proceeds allocated to
the Class C Common is $7 million. Such amount has been recorded as stockholders'
equity and as a discount to the 2005 Notes.
Concurrent with the issuance of the 2005 Notes, the Company was required to
deposit in an escrow account $79.6 million in cash that, together with the
proceeds from such investment, will be sufficient to pay when due the first six
interest payments on the 2005 Notes. Such amount is reflected as restricted
investments on the accompanying consolidated balance sheets.
In December 1997, the Company, through subsidiaries, secured a $150 million
senior secured credit facility (the "Senior Facility") from a syndicate of
financial institutions. The Senior Facility consisted of a term loan in the
amount of $125 million (which was drawn on December 19, 1997, with an original
maturity of August 2004) bearing interest at LIBOR plus 3.5% and a $25 million
revolving credit commitment. The Senior Facility was secured by a first fixed
and floating lien on substantially all of the assets of the Company and its
subsidiaries. The Senior Facility contained financial maintenance requirements
and certain limitations on the Company's ability to incur indebtedness, incur
capital expenditures and pay dividends.
On July 7, 1998, the Company repaid and terminated the Senior Facility with
proceeds from a private placement of $200 million 11.5% Senior Notes Due 2008
(the "2008 Notes"). In connection with the
F-12
<PAGE> 83
OPTEL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
repayment of the Senior Facility, the Company was required to pay a prepayment
penalty of $1.3 million. Additionally, the Company wrote off debt issuance costs
of $5.4 million related to the Senior Facility. These amounts are included in
extraordinary loss on debt extinguishment in the accompanying statements of
operations. The 2008 Notes require semiannual interest payments on January 1 and
July 1 of each year until their maturity on July 1, 2008. The 2008 Notes are
redeemable at the option of the Company, generally at a premium, at any time
after July 1, 2003, and can be redeemed in part, also at a premium, earlier upon
the occurrence of certain defined events. Concurrent with the issuance of the
2008 Notes, the Company was required to deposit in an escrow account $21.8
million in cash that, together with the proceeds of the investment thereof, will
be sufficient to pay when due the first two interest payments on the 2008 Notes.
Subsequent to year-end, the Company has initiated an offer to exchange the 2008
Notes for registered securities with substantially identical terms, including
interest rate and maturity (the "Offer to Exchange").
To comply with certain covenants of the Senior Facility and to reduce the
impact of changes in interest rates on the Senior Facility, the Company entered
into interest rate swap agreements with total notional amounts of $75 million in
which the Company had agreed to receive a variable rate equal to LIBOR and pay
fixed rates ranging from 5.96% to 6.00%. The swap agreements were terminated on
July 17, 1998, in exchange for cash payments of $578,000, which was expensed.
Aggregate maturities of the Company's indebtedness are as follows as of
August 31, 1998:
<TABLE>
<S> <C>
Fiscal year ending:
1999...................................................... $ 1,579
2000...................................................... 6,621
2001...................................................... 760
2002...................................................... 228
2003...................................................... 49
Thereafter.................................................. 420,041
--------
Totals............................................ $429,278
========
</TABLE>
7. COMMITMENTS AND CONTINGENCIES
Legal -- The Company is a defendant in certain lawsuits incurred in the
ordinary course of business. It is the opinion of the Company's management that
the outcome of the suits now pending will not have a material, adverse effect on
the operations, cash flows or consolidated financial position of the Company.
On April 9, 1998, a purported class action complaint was filed in the
District Court of Harris County, Texas, on behalf of all cable subscribers in
the United States that have paid late fees to either Phonoscope or the Company.
The plaintiff, who formerly subscribed to cable television services provided by
Phonoscope, alleges that Phonoscope's charging preestablished late fees for
delinquent payments of cable subscription charges constitutes an illegal
collection of a penalty and that cable service providers should be entitled to
only their actual collection costs. The plaintiff seeks to enjoin Phonoscope and
the Company from collecting, or attempting to collect, such late fees. The case
is in its very early stages, and no assurance can be given as to its ultimate
outcome or that any such outcome will not materially adversely affect the
Company. OpTel believes that it will have meritorious factual and legal
defenses, and it intends to defend vigorously against these claims.
On April 27, 1998, a civil action was commenced against the Company in the
United States District Court for the Northern District of California by Octel
Communication Corp. ("Octel"), charging the Company with trademark infringement,
trade name infringement, trademark dilution and unfair competition based on its
use of the name "OpTel" (the "Civil Action") and seeking to enjoin the Company
from using the name "OpTel." The Civil Action follows a now-suspended
administrative proceeding in the Patent and
F-13
<PAGE> 84
OPTEL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Trademark Office ("PTO") relating to registration of the "OpTel" mark by the
Company. The PTO found the Company's application for registration to be
allowable; however, Octel commenced the PTO proceeding claiming that the
Company's mark is confusingly similar to the "Octel" mark used by that party in
a related field, and claiming that the Company's application had procedural
deficiencies. During the course of the PTO proceeding, the Company acquired
rights to the marks "Optel" and "Optel Communications" in the telecommunications
field, which are believed to predate the rights of Octel to its trademark, and
the Company commenced two further proceedings against Octel in the PTO seeking
cancellation of two of the trademark registrations owned by Octel. The various
proceedings in the PTO between the Company and Octel were consolidated and
thereafter suspended on May 15, 1998, in view of the commencement of the Civil
Action. The Company believes it has meritorious counterclaims in the Civil
Action and intends to vigorously defend against Octel's claims. Although the
Company does not believe that its use of the name "OpTel" infringes on the
trademark or trade name rights of Octel or any other person, there can be no
assurance as to the outcome of the Civil Action or the proceedings in the PTO
(if reinstated) or that any such outcome would not materially adversely affect
the Company.
Employment and Consulting Agreements -- Employment agreements with certain
executive employees provide for separation payments ranging from 3 to 24 months
of the employee's annual salary if employment is terminated due to change of
control or without cause. However, stipulations for termination payment and
payment terms vary. The Company paid or accrued approximately $297, $278 and $0
in severance during 1996, 1997 and 1998, respectively, related to such
employment agreements.
The Company leases office space and certain equipment under operating
leases. The leases generally have initial terms of 3 to 20 years. Minimum future
obligations on operating leases at August 31, 1998, consist of the following:
<TABLE>
<S> <C>
Fiscal year ending:
1999...................................................... $ 3,579
2000...................................................... 3,258
2001...................................................... 2,806
2002...................................................... 2,337
2003...................................................... 1,996
Thereafter.................................................. 3,768
-------
Total minimum lease payments...................... $17,744
=======
</TABLE>
Rental expense under operating leases for the years ending August 31, 1996,
1997 and 1998, was $2,158, $2,763 and $3,876, respectively. The Company's rental
expense under operating leases includes facility rentals as well as rental of
space for distribution purposes.
8. INCOME TAXES
Income tax expense (benefit) consists of the following for the years ended
August 31, 1996, 1997 and 1998:
<TABLE>
<CAPTION>
1996 1997 1998
------- -------- --------
<S> <C> <C> <C>
Current tax expense................................... $ -- $ -- $ --
Deferred tax expense (benefit)........................ (4,470) (13,213) (25,261)
Change in deferred tax valuation allowance............ 4,470 13,213 25,261
------- -------- --------
Total income tax expense (benefit).......... $ -- $ -- $ --
======= ======== ========
</TABLE>
F-14
<PAGE> 85
OPTEL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
A reconciliation of income taxes on reported pretax loss at statutory rates
to actual income tax expense (benefit) for the years ended August 31, 1996, 1997
and 1998, is as follows:
<TABLE>
<CAPTION>
1996 1997 1998
--------------- ---------------- ----------------
<S> <C> <C> <C> <C> <C> <C>
Income tax at statutory rates............ $(6,266) (34.0)% $(16,502) (34.0)% $(25,295) (34.0)%
State income taxes, net of federal tax
benefit................................ (1) -- 8 -- -- --
Valuation allowance...................... 4,470 24.0 13,213 27.0 25,261 34.0
Expenses (deductible) not deductible for
tax purposes........................... 1,797 10.0 (842) (2.0) 34 --
Utilization of net operating loss by
parent company in consolidated
return................................. -- -- 4,123 9.0 -- --
------- ----- -------- ----- -------- -----
Total income tax benefit....... $ -- --% $ -- --% $ -- --%
======= ===== ======== ===== ======== =====
</TABLE>
The net deferred tax assets consist of the tax effects of temporary
differences related to the following:
<TABLE>
<CAPTION>
AUGUST 31
-------------------
1997 1998
-------- --------
<S> <C> <C>
Allowance for uncollectible accounts receivable............. $ 381 $ 613
Equipment, furniture and fixtures........................... (10,694) (10,663)
Intangible assets........................................... 421 (246)
Accrued employee compensation............................... 214 505
Net operating loss carryforwards............................ 31,121 56,410
IRPC deferred tax liability................................. (480) (480)
Other....................................................... 59 144
-------- --------
Deferred tax asset before valuation allowance............... 21,022 46,283
Valuation allowance......................................... (21,022) (46,283)
-------- --------
Net deferred tax asset...................................... $ -- $ --
======== ========
</TABLE>
Realization of deferred tax assets is dependent on generating sufficient
taxable income prior to expiration of the loss carryforwards. The Company is
unable to determine whether these accumulated losses will be utilized;
accordingly, a valuation allowance has been provided.
The following are the expiration dates and the approximate net operating
loss carryforwards at August 31, 1998:
<TABLE>
<S> <C>
Expiration dates through:
2010...................................................... $ 1,346
2011...................................................... 11,521
2012...................................................... 26,161
2013...................................................... 47,921
2014...................................................... 78,965
</TABLE>
Certain of the Company's net operating losses were utilized by VPC while
the Company was included in VPC's consolidated tax return. Such losses will not
be available for future use by the Company, and accordingly, the deferred tax
benefit and valuation allowance were reduced. In connection with the revised
shareholder agreement (see Note 9), subsequent to August 31, 1997, the Company
will be reimbursed for any tax benefit generated by the Company and utilized by
VPC.
F-15
<PAGE> 86
OPTEL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
9. CONVERTIBLE NOTES PAYABLE TO STOCKHOLDER, STOCK ISSUANCE AND OTHER
TRANSACTIONS WITH STOCKHOLDERS AND RELATED PARTIES
Transactions With VPC -- From December 22, 1994 through March 31, 1995, the
Company borrowed $60,000 from VPC under a Senior Secured Convertible Note
Agreement. The note was converted to 1,120,985 shares of Class B Common of OpTel
on March 31, 1995. Concurrently, VPC purchased 105,667 shares of OpTel's Class B
Common from Vanguard.
On July 26, 1995, VPC invested $25,000 in the Company, of which $16,688
represented VPC's purchase of an additional 311,652 shares of OpTel's Class B
Common, and $8,312 represented a convertible note payable that bore interest at
15% and was convertible to 155,229 shares of Class B Common at the option of
VPC. On April 1, 1996, VPC converted the $8,312 note and accrued interest of
$854 into 155,229 shares of Class B Common.
From August 1995 through August 1997, the Company issued a total of
$131,400 in convertible notes ("Convertible Notes") to VPC, all of which bore
interest at 15%, generally with principal and interest due on demand. Under the
terms of the Convertible Notes, any accrued interest on which there was no
demand for payment as of each August 31 automatically converted to additional
principal payable. On March 1, 1998, VPC converted its Convertible Notes
payable, including accrued interest, of $139.2 million into a like amount of
Series A Preferred. Such stock earns dividends at the annual rate of 9.75%,
payable in additional shares of Series A Preferred, and is convertible under
certain circumstances and at certain prices at the option of the holder of the
shares into shares of Class B Common upon consummation of an initial public
offering, or during the 90-day period commencing April 30, 1999.
Transactions With CDPQ -- In August 1997, in connection with a revised
shareholder agreement, Capital Communication CDPQ, Inc. ("CDPQ"), a minority
stockholder of Videotron, acquired all of Vanguard's interest in OpTel.
Immediately prior to the sale to CDPQ, Vanguard exercised an option to purchase
48,937 shares of Class B Common at an exercise price of $53.55 per share,
subject to adjustment, that had been granted to Vanguard in August 1996. The
option exercise resulted in the Company's receiving $2,620 in cash.
In connection with the sale by Vanguard of its minority stock position in
the Company to CDPQ, the Company, VPC and CDPQ entered into the Stockholders'
Agreement, and the Company and CDPQ entered into a related Registration Rights
Agreement (the "Registration Rights Agreement"), under which CDPQ has certain
rights and obligations relating to the Company and VPC.
Under the Stockholders' Agreement, for as long as CDPQ holds at least 5% of
the Company's voting stock, CDPQ may designate a number of Directors of the
Company and each of its subsidiaries, and each committee of the Board and each
of its subsidiaries, which is proportionate (in relation to the total number of
Directors or committee members) to CDPQ's percentage ownership of the Company's
voting stock, but in no event less than one Director and one committee member.
Pursuant to the Stockholders' Agreement, VPC is obligated to cause the Company
to afford CDPQ rights equivalent to those afforded other purchasers of the
Company's capital stock to the extent they are more advantageous than the rights
held by CDPQ. Subject to certain exceptions (including a public offering of the
Company's equity securities) and waiver by CDPQ at VPC's request in connection
with certain events, the Company is obligated to afford CDPQ preemptive rights
to purchase equity securities that the Company proposes to sell in proportion to
CDPQ's ownership of the total outstanding equity securities of the Company prior
to the sale. In addition, pursuant to the Stockholders' Agreement, CDPQ has
certain tag-along rights in connection with sales by VPC of outstanding shares
of the Company's voting stock. Pursuant to the Registration Rights Agreement,
nine months after the consummation of the IPO and, subject to certain
conditions, CDPQ has the right, on two occasions, to require the Company to
register under the Securities Act shares of Class A Common issued to CDPQ upon
the conversion of the Multi-Vote Common. In addition, CDPQ has piggyback
registration rights, on three occasions, to include
F-16
<PAGE> 87
OPTEL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
such shares of Class A Common held by it in registration statements filed by the
Company for the sale of its equity securities, subject to certain conditions,
including customary allocation and holdback provisions.
Pursuant to the terms of the Stockholders' Agreement, VPC and certain of
its affiliates provide certain strategic planning and treasury support services
to the Company and perform internal audits of the Company's operations.
Additional services may be provided as and when requested by the Company. The
Company is charged for such services based on an estimate of the actual cost of
the personnel engaged and materials used to provide such services (without an
allowance for profit).
Transactions With THI -- The Company has assigned substantially all of its
frequency licenses to THI, an entity owned by an employee of the Company and two
individuals who provide legal counsel to the Company, in exchange for a $1
million secured promissory note with interest at 8% due on February 14, 2007
(the "License Note"). The License Note contains covenants that restrict THI
from, among other things, incurring indebtedness other than to the Company or in
the ordinary course of business and merging or consolidating with another
entity.
The terms of the Company's continued and unencumbered use of the frequency
licenses are subject to a license and services agreement (the "THI Agreement")
pursuant to which THI agreed to provide to the Company all the transmission
capacity it requires or may in the future require, and the Company granted THI a
nonexclusive license to use all of the Company's facilities and related
equipment, such as microwave transmitting and receiving equipment, required to
provide such transmission capacity.
The Company received an option from THI to purchase all or, in certain
circumstances, some of the assets of THI at a price equal to the principal
balance on the License Note plus accrued interest at 10% per annum and a
separate option from each stockholder of THI to purchase all of such person's
shares of capital stock of THI at the lesser of (x) the book value of the shares
being purchased and (y) the price paid for such shares plus a 10% premium
compounded annually. The THI option and the individual options are exercisable
at any time prior to February 14, 2007, subject to FCC approval.
THI is included in the consolidated financial statements of the Company
based upon the Company's ability to control THI as a result of a combination of
the covenants contained in the License Note and the Company's ability to
exercise its option to purchase the assets or stock of THI. The option agreement
and the License Note are eliminated upon consolidation.
Transactions With Other Related Parties -- Videotron is party to an
indenture that limits the aggregate amount of indebtedness that can be incurred
by Videotron and its subsidiaries, including the Company, taken as a whole
(based upon a ratio of total consolidated indebtedness to consolidated operating
cash flow).
In September 1996, the Company entered into a consulting agreement with a
former director of the Company who is a limited partner of Vanguard. In
connection therewith, the Company granted him a warrant to purchase up to 24,992
shares of Class A Common at an exercise price of $53.55 per share, subject to
adjustment, that is presently exercisable and expires on August 31, 1999.
VPC and an affiliate of Vanguard had each agreed to provide consultant,
advisory and management services for $350 per annum (plus travel expenses) per
party. This arrangement terminated in August 1997 with the sale of Vanguard's
interest in the Company.
The Company purchases certain insurance coverage through Videotron,
including directors' and officers' liability insurance. The Company paid an
aggregate of approximately $478,000, $434,000 and $456,000 to Videotron for this
insurance coverage in fiscal 1996, 1997 and 1998, respectively. OpTel provides
certain customer support and billing services to certain affiliates of Videotron
that operate wireless cable systems using MMDS technology. OpTel charges such
affiliates based on the actual cost of the personnel engaged and materials used
to provide such services.
F-17
<PAGE> 88
OPTEL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Upon consummation of an initial public offering, each Director who is
neither an employee of the Company nor a designee of the Company's significant
stockholders will receive options to purchase shares of Class A Common having an
aggregate value of $150 (or, if such Director is not serving in such capacity
upon consummation of an initial public offering, on the date of his or her
election to the Board) with an exercise price equal to the initial public
offering price (or the fair market value on the date of grant). The options will
become exercisable in equal installments on each of the second, third, fourth
and fifth anniversaries of the effective date of the grant. As of August 31,
1998, no options have been issued.
10. STOCKHOLDERS' EQUITY
The Class A Common, Class B Common and Class C Common of the Company are
identical in all respects and have equal powers, preferences, rights and
privileges except that each holder of Class A Common is entitled to one vote for
each share of Class A Common held, each holder of Class B Common is entitled to
ten votes for each share of Class B Common held, and each holder of Class C
Common does not possess any voting privileges. VPC and CDPQ are the only holders
of Class B Common, and upon any transfer other than to a permitted holder, the
Class B Common automatically converts to a like number of shares of Class A
Common.
On February 7, 1997, the Company approved a stock split effected in the
form of a stock dividend. Each share of outstanding Class B Common (the only
class of common stock then outstanding) received 17.3768 additional shares. The
number of authorized shares of Class A Common and Class B Common was increased
to 8,000,000 and 6,000,000, respectively. The financial statements have been
restated to reflect the stock split as if it had occurred on December 20, 1994,
the date the Company reorganized as a corporation. Additionally, the Company
authorized the issuance of 300,000 shares of Class C Common.
The Series A Preferred (see Note 9) is convertible under certain
circumstances and at certain prices at the option of the holder of the shares
into shares of Class B Common upon consummation of an initial public offering,
or during the 90-day period commencing April 30, 1999.
The Series B Preferred (see Note 3) is convertible into Class A Common
based upon the liquidation preference plus any cumulative unpaid dividends at
the time of the conversion divided by the share price upon consummation of an
initial public offering.
Following the consummation of an initial public offering, all of the
outstanding shares of the Company's Class C Common and Series B Preferred will
be converted to Class A Common.
On June 5, 1998, OpTel filed a registration statement on Form S-1 with the
Securities and Exchange Commission (the "SEC") with respect to a proposed
initial public offering (the "IPO") of $100 million of its Class A Common. No
assurance can be given that the IPO will be consummated or, if consummated, that
the proceeds received by the Company will be the amount currently contemplated.
11. EMPLOYEE BENEFIT PLAN
401(k) Plan -- The OpTel 401(k) Plan (the "401(k) Plan") conforms to the
provisions of the Employee Retirement Income Security Act of 1974. It is a
contributory tax deferred 401(k) Plan. All employees are required to have three
consecutive months of service to be eligible to participate in the 401(k) Plan.
Also, effective January 1, 1998, an employee must have one year of service with
the employer before being eligible to receive employer matching contributions.
The Company's matching contribution is a discretionary amount to be annually
determined by the Board of Directors of the Company. For the periods ended
August 31, 1996, 1997 and 1998, the Company's match of its employees' elective
contributions was $188, $289 and $349, respectively.
F-18
<PAGE> 89
OPTEL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
12. RESTRICTED INVESTMENTS
Concurrent with the issuance of the 2005 Notes, the Company was required to
deposit in an escrow account $79.6 million in cash that was subsequently
invested in U.S. Treasury securities. The securities are classified as
held-to-maturity and, at August 31, 1997 and 1998, have an amortized cost basis
of $67,206 and $41,422, respectively; an aggregate fair value of $67,233 and
$41,855, respectively; and gross unrealized holding gains of $27 and $432,
respectively. The contractual maturity of the securities correspond to the
semiannual interest payment dates required under the 2005 Notes through February
15, 2000.
Concurrent with the issuance of the 2008 Notes, the Company was required to
deposit in an escrow account $21.8 million in cash that was subsequently
invested in U.S. Treasury securities. The securities are classified as
held-to-maturity and, at August 31, 1998, have an amortized cost basis of
$21,785, an aggregate fair value of $22,002 and gross unrealized holding gains
of $217. The contractual maturity of the securities correspond to the semiannual
interest payment dates required under the 2008 Notes through July 1, 1999.
13. EMPLOYEE STOCK OPTIONS AND WARRANTS AND STOCK PURCHASE PLAN
During the year ended August 31, 1997, the Company adopted a stock option
and award plan (the "Incentive Stock Plan") for the benefit of officers and key
employees. The plan is administered by a committee of the Board of Directors.
The plan authorizes the Board to issue incentive stock options, as defined in
Section 422A(b) of the Internal Revenue Code of 1986, as amended (the "Code"),
and stock options that do not conform to the requirements of that Code section.
The Board has discretionary authority to determine the types of options to be
granted, the persons to whom options shall be granted, the number of shares to
be subject to each option granted and the terms of the stock option agreements.
In fiscal 1998, the Company adopted amendments to the Incentive Stock Plan,
certain of which will become effective, subject to stockholder approval, on the
date an initial public offering is consummated (as so amended, the "Plan"). Five
percent of the Class A Common Stock outstanding, on a fully diluted basis, on
the date an initial public offering is consummated, may be issued under the
terms of the Plan.
F-19
<PAGE> 90
OPTEL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Unless otherwise specifically provided in the option agreement, (i) the
exercise price of an option will not be less than the fair market value, as
determined by the Board, of the Class A Common on the date of grant and (ii) the
options vest in equal installments on each of the second, third, fourth and
fifth anniversaries of the date of grant. The options issued as of August 31,
1998, expire ten years from the date of grant. In the event of a "change in
control," all options shall vest and become immediately exercisable. The Board
has authorized 123,677 shares of Class A Common to be issued under the Plan.
Stock option activity under the Plan and warrants issued (see Note 9) for the
years ended August 31, 1997 and 1998, was as follows:
<TABLE>
<CAPTION>
NUMBER OF WEIGHTED AVERAGE
SHARES PRICE PER SHARE PRICE PER SHARE
--------- ---------------- ----------------
<S> <C> <C> <C>
Options and warrants outstanding at
September 1, 1996....................... -- -- $ --
Granted................................. 112,115 $53.55 to $85.75 $76.70
Exercised............................... -- -- --
Forfeited............................... (22,078) $53.55 to $85.75 $80.92
-------
Options and warrants outstanding at August
31, 1997................................ 90,037 $53.55 to $85.75 $75.66
Granted................................. 43,657 $74.42 to $85.75 $83.31
Exercised............................... -- -- --
Forfeited............................... (10,009) $85.75 $85.75
-------
Options and warrants outstanding at August
31, 1998 (including 35,127 warrants).... 123,685 $53.55 to $85.75 $77.54
=======
Options and warrants exercisable at August
31, 1998................................ 52,770 $53.55 to $85.75 $67.99
Options available for grant at August 31,
1998.................................... 35,119
</TABLE>
The weighted average remaining contractual life of the stock options and
warrants outstanding at August 31, 1998, is seven years.
At August 31, 1998, the Company has reserved a total of 88,558 and 35,127
shares of Class A Common for issuance upon the exercise of stock options and
stock warrants, respectively. The Company has also granted stock warrants in
connection with an agreement to provide consulting services (see Note 9).
The Company applies APB Opinion No. 25, "Accounting for Stock Issued to
Employees," in accounting for its stock option and award plan and the stock
warrants. During 1997 and 1998, the exercise price of each option granted was
greater than or equal to the estimated fair value of the Company's stock on the
date of grant. Accordingly, no compensation expense has been recognized under
this plan. For the years ended August 31, 1997 and 1998, the difference between
actual net loss and loss per share and net loss and loss per share on a pro
forma basis as if the Company had utilized the accounting methodology prescribed
by SFAS No. 123, "Accounting for Stock-Based Compensation," would have been $44
and $.02 per share and $547 and $.21 per share, respectively.
The estimated weighted average grant date fair value of options and
warrants granted during 1997 and 1998 was $1.10 per share and $31.76 per share,
respectively. For purposes of determining fair value of each option, the Company
used the minimum value method using the following assumptions:
<TABLE>
<CAPTION>
1997 1998
-------------- --------------
<S> <C> <C>
Risk-free interest rate.............................. 6.18% to 6.88% 5.47% to 6.92%
2.5 to 10
Expected life........................................ 3 to 10 years years
</TABLE>
F-20
<PAGE> 91
OPTEL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
In fiscal 1998, the Company adopted the 1998 Employee Stock Purchase Plan
(the "Stock Purchase Plan"), which is intended to qualify as an "employee stock
purchase plan" under Section 423 of the Code. The Stock Purchase Plan will
become effective, subject to stockholder approval, on the date an initial public
offering is consummated. One percent of the Class A Common outstanding, on a
fully diluted basis, on the date an initial public offering is consummated, will
be issuable under the terms of the Stock Purchase Plan. As of August 31, 1998,
no stock has been issued under the Stock Purchase Plan.
14. FINANCIAL INSTRUMENTS
The following disclosure of the estimated fair value of financial
instruments is made in accordance with the requirement of SFAS No. 107,
"Disclosure About Fair Value of Financial Instruments." The estimated fair value
amounts have been determined by the Company using available market information
and appropriate valuation methodologies. However, considerable judgment is
necessarily required to interpret market data to develop estimates of fair
value. Accordingly, the estimates presented herein are not necessarily
indicative of the amounts the Company could realize in a current market
exchange. The use of different market assumptions and/or estimation
methodologies may have a material effect on the estimated fair value amounts.
<TABLE>
<CAPTION>
AUGUST 31, 1997 AUGUST 31, 1998
--------------------- ---------------------
CARRYING ESTIMATED CARRYING ESTIMATED
AMOUNT FAIR VALUE AMOUNT FAIR VALUE
-------- ---------- -------- ----------
<S> <C> <C> <C> <C>
Assets:
Cash and cash equivalents........................ $ 87,305 $ 87,305 $123,774 $123,774
Restricted investments........................... 67,206 67,233 63,207 63,857
Accounts receivable.............................. 4,044 4,044 9,458 9,458
Liabilities:
Accounts payable, accrued expenses and other
liabilities................................... 21,896 21,896 31,842 31,842
Customer deposits and deferred revenue........... 2,978 2,978 5,274 5,274
Convertible notes payable to stockholder......... 129,604 129,605 -- --
Notes payable and long-term obligations.......... 228,573 235,570 429,278 440,367
</TABLE>
The carrying amount of cash and cash equivalents, accounts receivable,
accounts payable, and customer deposits and deferred revenue approximates fair
value. The fair values of convertible notes payable to stockholder, and certain
notes payable and long-term obligations are estimated based on present values
using applicable market discount rates or rates that approximate what the
Company could obtain from the open market. The fair value of restricted
investments and the 1997 and 1998 Notes are based on quoted market prices. The
fair value estimates presented herein are based on pertinent information
available to management as of August 31, 1997 and 1998. Although management is
not aware of any factors that would significantly affect the estimated fair
value amounts, such amounts have not been comprehensively revalued for purposes
of these financial statements since the date presented, and therefore, current
estimates of fair value may differ significantly from the amounts presented
herein.
F-21
<PAGE> 92
OPTEL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
15. QUARTERLY FINANCIAL DATA (UNAUDITED)
The following is a summary of the unaudited quarterly results of operations
for the years ended August 31, 1997 and 1998:
<TABLE>
<CAPTION>
YEAR ENDED AUGUST 31, 1997
-----------------------------------------
FIRST SECOND THIRD FOURTH
QUARTER QUARTER QUARTER QUARTER
-------- -------- -------- --------
<S> <C> <C> <C> <C>
Revenues........................................... $ 9,076 $ 9,546 $ 10,495 $ 10,720
Operating expenses................................. 12,693 14,096 17,003 18,841
Other expense...................................... 3,277 4,849 8,867 8,746
Loss before extraordinary item..................... (6,894) (9,399) (15,375) (16,867)
Extraordinary loss on debt extinguishment.......... -- -- -- --
Net loss........................................... (6,894) (9,399) (15,375) (16,867)
Dividends on preferred stock....................... -- -- -- --
Net loss attributable to common equity............. (6,894) (9,399) (15,375) (16,867)
Basic and diluted loss per common share............ (2.99) (4.01) (6.08) (6.65)
Weighted average number of shares outstanding...... 2,305 2,342 2,530 2,538
</TABLE>
<TABLE>
<CAPTION>
YEAR ENDED AUGUST 31, 1998
-----------------------------------------
FIRST SECOND THIRD FOURTH
QUARTER QUARTER QUARTER QUARTER
-------- -------- -------- --------
<S> <C> <C> <C> <C>
Revenues........................................... $ 12,252 $ 14,639 $ 18,025 $ 20,047
Operating expenses................................. 18,748 20,285 24,656 29,464
Other expense...................................... 9,774 12,112 7,574 10,104
Loss before extraordinary item..................... (16,270) (17,758) (14,205) (19,521)
Extraordinary loss on debt extinguishment.......... -- -- -- (6,644)
Net loss........................................... (16,270) (17,758) (14,205) (26,165)
Dividends on preferred stock....................... -- -- (4,068) (4,680)
Net loss attributable to common equity............. (16,270) (17,758) (18,273) (30,845)
Basic and diluted loss per common share............ (6.31) (6.89) (6.84) (11.24)
Weighted average number of shares outstanding...... 2,578 2,578 2,673 2,743
</TABLE>
F-22
<PAGE> 93
INDEPENDENT AUDITORS' REPORT
To the Board of Directors of
OpTel, Inc.:
We have audited the financial statements of OpTel, Inc. and subsidiaries (the
"Company") as of August 31, 1997 and 1998, and for each of the three years in
the period ended August 31, 1998 and have issued our report dated October 6,
1998; such financial statements and report are included herein. Our audits also
included the financial statement schedule of OpTel, Inc., listed in Item 14.
This financial statement schedule is the responsibility of the Company's
management. Our responsibility is to express an opinion based on our audits. In
our opinion, such financial statement schedule, when considered in relation to
the basic financial statements taken as a whole, presents fairly in all material
respects the information set forth therein.
/s/ DELOITTE & TOUCHE LLP
Dallas, Texas
October 6, 1998
S-1
<PAGE> 94
SCHEDULE II
VALUATION AND QUALIFYING ACCOUNTS
($ IN THOUSANDS)
<TABLE>
<CAPTION>
DEDUCTIONS,
BALANCE AT CHARGED TO WRITE-OFFS BALANCE AT
BEGINNING OF COSTS AND AND END OF
PERIOD EXPENSES RECOVERIES PERIOD
------------ ---------- ----------- ----------
<S> <C> <C> <C> <C>
ALLOWANCE FOR DOUBTFUL ACCOUNTS
Year ended August 31, 1996.................. $ 473 $1,376 $(1,307) $ 542
Year ended August 31, 1997.................. 542 1,788 (1,205) 1,125
Year ended August 31, 1998.................. 1,125 2,707 (2,029) 1,803
</TABLE>
S-2
<PAGE> 95
INDEX TO EXHIBITS
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
------- -----------
<C> <S>
12.1 -- Statement Re: Deficiency of Earnings to Fixed Charges.
27.1 -- Financial Data Schedule
27.2 -- Restated Financial Data Schedule
</TABLE>
<PAGE> 1
EXHIBIT 12.1
OPTEL, INC.
DEFICIENCY OF EARNINGS TO FIXED CHARGES
<TABLE>
<CAPTION>
Period from
April 20, 1993
(Date of Eight Month
Inception) to Year Ended Period Ended Year Ended Year Ended
December 31, December 31, August 31, August 31, August 31,
------------------------------------------------------------------------
1993 1994 1995 1996 1997
---- ---- ---- ---- ----
<S> <C> <C> <C> <C> <C>
Loss before income taxes $ (307) $ (7,944) $ (10,630) $ (18,430) $ (48,535)
Plus: fixed charges before capitalized interest 3 114 1,473 6,402 32,335
------------------------------------------------------------------------
Total loss $ (304) $ (7,830) $ (9,157) $ (12,028) $ (16,200)
========================================================================
Fixed charges
Financial expenses (per financial statements) $ 3 $ 76 $ 1,268 $ 5,999 $ 31,414
Interest factor of rental expense of operating leases - 38 205 403 921
------------------------------------------------------------------------
Total fixed charges before capitalized interest 3 114 1,473 6,402 32,335
Capitalized interest - - - 1,850 2,256
------------------------------------------------------------------------
Total fixed charges $ 3 $ 114 $ 1,473 $ 8,252 $ 34,591
========================================================================
Deficiency of earnings to fixed charges $ 307 $ 7,944 $ 10,630 $ 20,280 $ 50,791
========================================================================
Operating lease expense per financial statements $ - $ 113 $ 616 $ 1,208 $ 2,763
========================================================================
<CAPTION>
Year Ended
August 31,
------------
1998
----
<S> <C>
Loss before income taxes $ (74,398)
Plus: fixed charges before capitalized interest 49,769
------------
Total loss $ (24,629)
============
Fixed charges
Financial expenses (per financial statements) $ 48,477
Interest factor of rental expense of operating leases 1,292
------------
Total fixed charges before capitalized interest 49,769
Capitalized interest 2,753
------------
Total fixed charges $ 52,522
============
$ 77,151
Deficiency of earnings to fixed charges ============
Operating lease expense per financial statements $ 3,876
============
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE OPTEL,
INC YEAR ENDED AUGUST 31, 1998 FINANCIAL STATEMENTS AND IS QUALIFIED IN ITS
ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> AUG-31-1998
<PERIOD-END> AUG-31-1998
<CASH> 123,774
<SECURITIES> 0
<RECEIVABLES> 11,261
<ALLOWANCES> (1,803)
<INVENTORY> 0
<CURRENT-ASSETS> 0
<PP&E> 302,033
<DEPRECIATION> (33,989)
<TOTAL-ASSETS> 627,170
<CURRENT-LIABILITIES> 0
<BONDS> 429,278
0
207,458
<COMMON> 28
<OTHER-SE> (46,710)
<TOTAL-LIABILITY-AND-EQUITY> 627,170
<SALES> 0
<TOTAL-REVENUES> 64,963
<CGS> 0
<TOTAL-COSTS> 28,825
<OTHER-EXPENSES> 35,847
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 48,477
<INCOME-PRETAX> (67,754)
<INCOME-TAX> 0
<INCOME-CONTINUING> (67,754)
<DISCONTINUED> 0
<EXTRAORDINARY> (6,644)
<CHANGES> 0
<NET-INCOME> (74,398)
<EPS-PRIMARY> (31.45)
<EPS-DILUTED> (31.45)
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE OPTEL,
INC YEAR ENDED AUGUST 31, 1998 FINANCIAL STATEMENTS AND IS QUALIFIED IN ITS
ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<RESTATED>
<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> AUG-31-1997
<PERIOD-END> AUG-31-1997
<CASH> 87,305
<SECURITIES> 0
<RECEIVABLES> 5,169
<ALLOWANCES> (1,125)
<INVENTORY> 0
<CURRENT-ASSETS> 0
<PP&E> 175,424
<DEPRECIATION> (14,982)
<TOTAL-ASSETS> 403,416
<CURRENT-LIABILITIES> 0
<BONDS> 358,177
0
0
<COMMON> 26
<OTHER-SE> 20,339
<TOTAL-LIABILITY-AND-EQUITY> 403,416
<SALES> 0
<TOTAL-REVENUES> 39,837
<CGS> 0
<TOTAL-COSTS> 19,202
<OTHER-EXPENSES> 28,926
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 31,414
<INCOME-PRETAX> (48,535)
<INCOME-TAX> 0
<INCOME-CONTINUING> (48,535)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (48,535)
<EPS-PRIMARY> (19.98)
<EPS-DILUTED> (19.98)
</TABLE>
