<PAGE>
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
________________
FORM 10-Q
________________
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 1998
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
COMMISSION FILE NUMBER 000-22609
________________
QWEST COMMUNICATIONS INTERNATIONAL INC.
(EXACT NAME OF REGISTRANT SPECIFIED IN ITS CHARTER)
_______________
DELAWARE 84-1339282
-------- ----------
(STATE OR OTHER JURISDICTION OF (I. R. S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
1000 QWEST TOWER
555 SEVENTEENTH STREET
DENVER, COLORADO 80202
----------------------
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
(303) 992-1400
--------------
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
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 [_]
The number of shares of Common Stock, $.01 par value, outstanding (the only
class of common stock of the Company outstanding) was 335.6 million, as of
October 31, 1998.
1
<PAGE>
QWEST COMMUNICATIONS INTERNATIONAL INC.
QUARTER ENDED SEPTEMBER 30, 1998
TABLE OF CONTENTS
<TABLE>
<CAPTION>
Part I. FINANCIAL INFORMATION PAGE
---------
<S> <C> <C> <C>
Item 1. Financial Statements (Unaudited)
Condensed Consolidated Statements of Operations for the Three and
Nine Months Ended September 30, 1998 and 1997 3
Condensed Consolidated Balance Sheets as of September 30, 1998 and
December 31, 1997 4
Condensed Consolidated Statements of Cash Flows for the Nine Months
Ended September 30, 1998 and 1997 5
Notes to Condensed Consolidated Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations for the Three and Nine Months Ended September
30, 1998 and 1997 14
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 26
Item 2. Changes in Securities and Use of Proceeds 27
Item 6. Exhibits and Reports on Form 8-K 27
Signature Page 28
</TABLE>
2
<PAGE>
Part I. Financial Information
Item 1. Condensed Financial Statements
QWEST COMMUNICATIONS INTERNATIONAL INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
For the Three and Nine Months Ended September 30, 1998 and 1997
(In Millions, Except Per Share Information)
(Unaudited)
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
----------------------------- ---------------------------
1998 1997 1998 1997
----------------------------- ---------------------------
<S> <C> <C> <C> <C>
Revenue:
Communications services $ 601.8 $ 32.5 $ 884.2 $ 77.1
Construction services 205.0 156.5 493.4 413.2
-------------- ------------ ------------ ------------
Total revenue 806.8 189.0 1,377.6 490.3
-------------- ------------ ------------ ------------
Operating expenses:
Access and network operations 371.6 25.0 556.1 61.8
Construction services 128.2 107.5 333.8 292.0
Selling, general and administrative 189.4 31.4 341.5 123.2
Depreciation and amortization 76.6 5.1 115.6 13.1
Merger costs - - 62.5 -
Provision for in-process research and development - - 818.0 -
-------------- ------------ ------------ ------------
Total operating expenses 765.8 169.0 2,227.5 490.1
-------------- ------------ ------------ ------------
Earnings (loss) from operations 41.0 20.0 (849.9) 0.2
Other (income) expense:
Interest expense, net 29.0 4.2 62.3 8.9
Other (income) expense, net 2.9 (4.0) (11.6) (13.2)
-------------- ------------ ------------ ------------
Earnings (loss) before income taxes 9.1 19.8 (900.6) 4.5
Income tax expense (benefit) 14.1 7.0 (12.5) 2.2
-------------- ------------ ------------ ------------
Net earnings (loss) $ (5.0) $ 12.8 $(888.1) $ 2.3
============== ============ ============ ============
Net earnings (loss) per share - basic $ (0.02) $ 0.06 $ (3.42) $ 0.01
============== ============ ============ ============
Net earnings (loss) per share - diluted $ (0.02) $ 0.06 $ (3.42) $ 0.01
============== ============ ============ ============
Weighted average shares outstanding - basic 330.7 206.6 259.9 185.1
============== ============ ============ ============
Weighted average shares outstanding - diluted 330.7 211.6 259.9 189.0
============== ============ ============ ============
</TABLE>
See accompanying notes to condensed consolidated financial statements.
3
<PAGE>
QWEST COMMUNICATIONS INTERNATIONAL INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
As of September 30, 1998 and December 31, 1997
(In Millions, Except Share Information)
(Unaudited)
<TABLE>
<CAPTION>
1998 1997
---------------- -----------------
<S> <C> <C>
ASSETS
Current assets:
Cash $ 225.4 $ 379.8
Trade accounts receivable, net 293.9 58.3
Deferred income tax asset 295.3 -
Prepaid expenses and other 313.8 285.9
---------------- -----------------
Total current assets 1,128.4 724.0
Property and equipment, net 2,043.9 614.6
Excess of cost over net assets acquired 3,215.4 21.2
Other, net 327.6 38.3
---------------- -----------------
TOTAL ASSETS $ 6,715.3 $ 1,398.1
================ =================
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 160.4 $ 55.9
Facility costs accrued and payable 276.4 8.3
Accrued expenses and other 743.0 251.1
---------------- -----------------
Total current liabilities 1,179.8 315.3
Long-term debt and capital lease obligations 1,387.1 630.5
Other long-term liabilities 461.9 70.5
Commitments and contingencies
Stockholders' equity:
Preferred stock - $.01 par value; authorized 25.0 million
shares; no shares issued and outstanding - -
Common stock - $.01 par value; authorized 600.0 million
shares; 332.7 million shares and 206.6 million shares
issued and outstanding at September 30, 1998 and
December 31, 1997, respectively. 3.3 2.1
Paid-in capital 4,603.2 411.6
Accumulated deficit (920.0) (31.9)
---------------- -----------------
Total stockholders' equity 3,686.5 381.8
---------------- -----------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 6,715.3 $ 1,398.1
================ =================
</TABLE>
See accompanying notes to condensed consolidated financial statements.
4
<PAGE>
QWEST COMMUNICATIONS INTERNATIONAL INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
For the Nine Months Ended September 30, 1998 and 1997
(In Millions)
(Unaudited)
<TABLE>
<CAPTION>
1998 1997
-------------- --------------
<S> <C> <C>
Net cash provided by (used in) operating activities $ 106.3 $ (60.0)
-------------- --------------
Cash flows from investing activities:
Acquisitions and other (27.4) 9.0
Expenditures for property and equipment (751.0) (205.3)
-------------- --------------
Net cash used in investing activities (778.4) (196.3)
-------------- --------------
Cash flows from financing activities:
Proceeds from long-term debt 300.0 328.0
Repayments of long-term debt (25.8) (186.0)
Net short-term debt borrowings 151.9 -
Proceeds from issuance of common stock, net - 319.5
Proceeds from employee stock transactions and issuance of stock warrants 96.4 2.3
Other (4.8) (27.7)
-------------- --------------
Net cash provided by financing activities 517.7 436.1
-------------- --------------
Net (decrease) increase in cash and cash equivalents (154.4) 179.8
Cash and cash equivalents, beginning of period 379.8 6.9
-------------- --------------
Cash and cash equivalents, end of period $ 225.4 $ 186.7
============== ==============
Supplemental disclosure of cash flow information:
Cash paid for interest, net $ 21.8 $ 4.5
============== ==============
Cash paid for taxes $ 7.9 $ 0.2
============== ==============
</TABLE>
See accompanying notes to condensed consolidated financial statements.
5
<PAGE>
QWEST COMMUNICATIONS INTERNATIONAL INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(1) ORGANIZATION AND BACKGROUND
Qwest Communications International Inc. and subsidiaries (the "Company" or
"Qwest") was wholly-owned by Anschutz Company (the "Majority Shareholder") until
June 27, 1997, when the Company issued common stock in an initial public
offering (the "IPO"). As of September 30, 1998, the Majority Shareholder owned
approximately 52.0% of the outstanding common stock of the Company.
The Company is a facilities-based provider of a full range of multimedia
communications services to businesses, consumers and other communications
entities ("Communications Services"). In addition, the Company is constructing
and installing fiber optic systems for interexchange carriers and other
communications entities, as well as for its own use ("Construction Services").
(2) BASIS OF PRESENTATION
The accompanying unaudited interim condensed consolidated financial statements
as of September 30, 1998 and for the three and nine months ended September 30,
1998 and 1997 include the accounts of the Company and all majority-owned
subsidiaries. All material intercompany balances and transactions have been
eliminated. The unaudited interim condensed consolidated financial statements
reflect all adjustments, consisting of normal recurring items, which are, in the
opinion of management, necessary to fairly present the results of the interim
periods. The results of operations for any interim period are not necessarily
indicative of results for the full year. Such financial statements should be
read in conjunction with the audited financial statements included in the
Company's Annual Report on Form 10-K for the year ended December 31, 1997.
Certain prior year balances have been reclassified to conform with 1998
presentation.
The Company has no elements of comprehensive income other than net income.
(3) ACQUISITIONS
(a) Icon Acquisition
On September 13, 1998, the Company signed a definitive merger agreement with
Icon CMT Corp. ("Icon"), a provider of integrated Internet solutions associated
with web hosting and Internet protocol integration. The terms of the merger
agreement call for the acquisition of all of Icon's outstanding common shares
and the assumption of all of Icon's stock options by the Company. The purchase
price of the all-stock transaction is anticipated to be approximately $207.0
million, not including approximately $3.5 million of direct acquisition costs.
The merger is intended to qualify as a tax-free reorganization and will be
accounted for as a purchase. The merger is expected to close by December 31,
1998.
The Company has also agreed to advance up to $15.0 million to Icon, with an
initial availability date of January 31, 1999, to fund working capital
requirements and for other corporate purposes. In consideration for this
commitment, Icon issued to the Company a warrant to purchase up to 750,000
shares of Icon stock at $12 per share.
Approval of the merger is subject to the affirmative vote of a majority of
the outstanding shares of Icon common stock. Icon's three founders also entered
into agreements with the Company to vote to approve the merger and to grant the
Company purchase options on their shares. The warrant and purchase options give
the Company beneficial ownership of approximately 44% of Icon's common stock.
6
<PAGE>
(b) LCI Acquisition
On June 5, 1998, the Company acquired LCI International, Inc. and
subsidiaries ("LCI"), a communications services provider for approximately $3.9
billion in Company common stock. At the close of the acquisition (the "LCI
Merger"), the Company issued approximately 129.9 million shares of the Company's
common stock (including outstanding LCI stock options assumed by the Company),
and incurred approximately $13.5 million in direct acquisition costs. The LCI
Merger was accounted for as a purchase.
In connection with the acquisition of LCI, the Company allocated $750.0
million of the purchase price to in-process research and development ("R&D")
projects, $250.0 million to developed technology and $3,037.8 million to
goodwill. This allocation to the in-process R&D represents the estimated fair
value based on risk-adjusted cash flows related to the incomplete projects. The
developed technology and goodwill are being amortized on a straight-line basis
from 10 to 40 years.
The acquired R&D represents engineering and test activities associated with
the introduction of new services and information systems. Specifically, LCI had
been working on a variety of projects that are essential to delivering data
services, which are a significant departure in terms of technological complexity
from the Company's traditional voice products. These efforts are related to
redesigning and scaling the network infrastructure as well as developing the
requisite network management systems. These projects are time-consuming and
difficult to complete. If the R&D projects are not completed as planned, they
will neither satisfy the technical requirements of a changing market nor be cost
effective. Since these projects had not yet reached technological feasibility
and have no alternative future uses, there can be no guarantee as to the
achievability of the projects or the ascribed values. Accordingly, these costs
were expensed as of the acquisition date.
The Securities and Exchange Commission staff is in the process of performing
a limited review of the Company's Form S-3 (File No. 333-58617) filed July 7,
1998, as amended on September 30, 1998. The limited review includes, among
other items, questions regarding the in-process R&D writeoff discussed above.
The outcome of the limited review could result in changes to the three- and
nine-month periods ended September 30, 1998 financial results and disclosures
(including adjustment to the in-process R&D writeoff). The Company is unable to
predict the outcome of the limited review.
7
<PAGE>
The aggregate purchase price was allocated as follows (in millions):
Working capital, excluding deferred taxes $ (352.1)
Deferred tax asset, net 197.6
Property and equipment 716.6
Goodwill 3,037.8
R&D 750.0
Developed technology 250.0
Long-term debt, excluding current portion (462.4)
Other liabilities and assets, net (207.0)
--------------
$3,930.5
--------------
LCI's results of operations have been included in the accompanying
condensed consolidated statements of operations of the Company from the date of
acquisition. The Company will complete final allocation of purchase price within
one year from the acquisition date. The items awaiting final allocation include
non-current asset valuation and final determination of the costs to sell or exit
certain activities of LCI. It is anticipated that final allocation of purchase
price will not differ materially from the preliminary allocation.
(c) EUnet Acquisition
On April 14, 1998, the Company acquired EUnet International Limited
("EUnet"), a European Internet service provider with subsidiaries in 14
countries, for approximately $158.2 million. Certain EUnet stockholders and
option holders received approximately 3.6 million shares of Company common
stock, having a value of approximately $135.3 million, and $4.2 million in cash.
Direct costs of the acquisition were approximately $3.5 million. Approximately
0.6 million shares were placed in escrow for two years and may be recovered by
the Company to satisfy any indemnification claims. At the expiration of the
escrow period, these shares revert to the EUnet stockholders. In addition, the
Company committed to purchase certain preference shares for $15.2 million. The
Company will issue additional shares of Company common stock or cash to fulfill
this purchase commitment. The EUnet acquisition was accounted for as a purchase.
The Company allocated $68.0 million of the purchase price to incomplete R&D
projects. These projects include the design and development of several new
value-added internet services as well as the development of the necessary
customer care and network management systems. Remaining development efforts for
these projects include various phases of design, development and testing efforts
that are expected to be completed in stages over the next 21 months. Since
these projects had not yet reached technological feasibility and have no
alternative future uses, there can be no guarantee as to the achievability of
the projects or the ascribed values. Accordingly, these costs were expensed as
of the acquisition date. The remaining intangibles from the purchase relate to
developed technology and goodwill and are being amortized on a straight-line
basis over five years and ten years, respectively.
The aggregate purchase price was allocated as follows (in millions):
Working capital $ (5.1)
Property and equipment 10.7
Deferred tax liability (50.3)
R&D 68.0
Developed technology 7.0
Goodwill 127.6
Other 0.3
--------------
$158.2
--------------
The results of operations of EUnet have been included in the accompanying
condensed consolidated statements of operations of the Company from the date of
acquisition. The accompanying condensed consolidated financial statements
reflect the preliminary allocation of purchase price which is subject to
adjustment.
8
<PAGE>
(d) Phoenix Transaction
On March 30, 1998, the Company acquired Phoenix Network, Inc. ("Phoenix"),
a non-facilities-based reseller of long distance services. Approximately 0.8
million shares of the Company common stock having a value of approximately $27.2
million were exchanged for the outstanding shares of Phoenix. The results of
operations of Phoenix have been included in the accompanying condensed
consolidated statements of operations of the Company from the date of
acquisition. The Phoenix acquisition was accounted for as a purchase.
The aggregate purchase price was allocated as follows (in millions):
Working capital $(16.5)
Property and equipment 2.9
Goodwill 53.8
Other liabilities (13.0)
--------------
$ 27.2
--------------
(e) Pro Forma Results
The following pro forma operating results of the Company, LCI, Phoenix and
EUnet for the nine months ended September 30, 1998 and 1997 have been prepared
assuming these acquisitions occurred on January 1, 1998 and 1997, respectively.
On a pro forma basis for the nine months ended September 30, 1998 and 1997,
revenue was $2,158.8 million and $1,790.8 million, respectively, and net loss
was $886.6 million, or ($2.71) per basic and diluted share, and $869.0 million,
or ($2.68) per basic and diluted share, respectively. The pro forma results do
not purport to represent what the Company's results of operations would have
actually been had the above transactions occurred on the dates indicated and are
not indicative of future results.
(4) ACCOUNTS RECEIVABLE SECURITIZATION
As of September 30, 1998, the Company, through its wholly-owned subsidiary,
LCI, maintained an agreement to sell a percentage ownership interest in a
defined pool of trade accounts receivable (the "Securitization Program"). Under
the Securization Program, LCI SPC I, Inc. ("SPC"), a single purpose subsidiary
of the Company, sells accounts receivable. Receivables sold are not included in
the accompanying condensed consolidated balance sheet as of September 30, 1998.
SPC had approximately $150.0 million of accounts receivable available for sale
and had sold a total of approximately $125.0 million as of September 30, 1998.
The Company retains substantially the same risk of credit loss as if the
receivables had not been sold, and has established reserves for such estimated
credit losses.
In October 1998, the Company funded the reacquisition of the ownership
interest in the $125.0 million pool of trade accounts receivable that were sold
under the Securitization Program through short-term debt borrowings and
available cash balances.
(5) CONSTRUCTION SERVICES
Costs and billings on uncompleted contracts included in the accompanying
condensed consolidated financial statements were as follows (in millions):
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
1998 1997
---------------- ---------------
<S> <C> <C>
Costs incurred on uncompleted contracts $ 791.9 $473.8
Estimated earnings 411.4 238.2
---------------- ---------------
1,203.3 712.0
Less: billings to date 941.2 476.8
---------------- ---------------
Costs and estimated earnings in excess of billings, net $ 262.1 $235.2
================ ===============
Revenue the Company expects to realize for work to be
performed on the above uncompleted contracts $ 268.9 $506.8
================ ===============
</TABLE>
9
<PAGE>
The Company has entered into various agreements to provide indefeasible
rights of use of multiple fibers along the Qwest Network, an approximately
18,450 route-mile, coast-to-coast, technologically advanced fiber optic
communications network. Such agreements include contracts with three major
customers for an aggregate purchase price of approximately $1.0 billion.
Construction Services revenue relating to the contracts with these major
customers was approximately $75.1 million and $136.2 million for the three
months ended September 30, 1998 and 1997, respectively, and $286.8 million and
$374.0 million for the nine months ended September 30, 1998 and 1997,
respectively. Progress billings are made upon customers' acceptance of
performance milestones.
Although these construction agreements provide for certain penalties if the
Company does not complete construction within the time frames specified within
the agreements, management does not anticipate that the Company will incur any
substantial penalties under these provisions.
(6) LONG-TERM DEBT
Long-term debt consisted of the following (in millions):
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
1998 1997
------------ --------------
<S> <C> <C>
8.29% Notes $ 316.9 $ --
9.47% Notes 382.6 356.9
10 7/8% Notes 250.0 250.0
7.25% Notes 351.7 --
Credit facility and lines of credit 232.5 --
Equipment credit facility 57.3 22.6
Capital lease and other obligations 32.0 13.0
------------ --------------
Total debt 1,623.0 642.5
Less current portion (235.9) (12.0)
------------ --------------
Long-term debt $1,387.1 $630.5
============ ==============
</TABLE>
Current portion of long-term debt is included in accrued expenses and other
in the accompanying condensed consolidated balance sheets.
In January 1998, the Company issued $450.5 million in principal amount at
maturity of 8.29% Senior Discount Notes, due 2008 (the "8.29% Notes"),
generating net proceeds of approximately $299.2 million, after deducting
offering costs. Interest on the 8.29% Notes is compounded semiannually. The
principal amount of the 8.29% Notes is due and payable in full on February 1,
2008. The 8.29% Notes are redeemable at the Company's option, in whole or in
part, at any time on or after February 1, 2003 at specified redemption prices.
In addition, prior to February 1, 2001, the Company may use the net cash
proceeds from certain equity transactions to redeem up to 35% of the 8.29% Notes
at specified redemption prices. Cash interest on the 8.29% Notes will not accrue
until February 1, 2003, and thereafter will accrue at a rate of 8.29% per annum,
and will be payable semiannually in arrears commencing on August 1, 2003, and
thereafter on February 1 and August 1 of each year. The Company has the option
of commencing cash interest on an interest payment date on or after February 1,
2001, in which case the outstanding principal amount at maturity of the 8.29%
Notes will, on such interest payment date, be reduced to the then accreted
value, and cash interest will be payable on each interest payment date
thereafter.
In July 1998, the Company completed an exchange of the 8.29% Series B Senior
Discount Notes (the "8.29% Exchange Notes"), registered under the Securities Act
of 1933, as amended ("the Act"), for all of the $450.5 million in principal
amount at maturity of the 8.29% Notes. The 8.29% Exchange Notes are identical
in all material respects to the originally issued 8.29% Notes.
In connection with the LCI Merger, the Company assumed LCI's existing debt
instruments, including $350.0 million of 7.25% Senior Notes, due 2007 (the
"7.25% Notes"); a $250.0 million revolving credit facility ("Credit Facility")
from a syndicate of banks; and three separate discretionary line of credit
agreements (the "Lines of Credit") with commercial banks for up to a total of
$75.0 million.
10
<PAGE>
The Credit Facility bears interest at a rate consisting of two components:
the base rate component is dependent upon a market indicator; the second
component varies from 0.30% to 0.75%, based on the more favorable of the
relationship of borrowing levels to operating cash flow (the "leverage ratio")
or the senior unsecured debt rating. As of September 30, 1998, the Company had
$215.0 million outstanding under the Credit Facility at an annual interest rate
of 6.0%. The Credit Facility contains various financial covenants, the most
restrictive being the leverage ratio requirement and the restriction on the
ability of the Company and its subsidiaries to pay dividends. As of September
30, 1998, the Company was in compliance with all Credit Facility covenants. The
Credit Facility expires December 31, 1998 and is therefore included in current
liabilities in the accompanying condensed consolidated balance sheet as of
September 30, 1998. In November 1998, the outstanding balance under the Credit
Facility was repaid.
As of September 30, 1998, $17.5 million was outstanding on the Lines of
Credit at an interest rate of 6.3%. The Lines of Credit are short-term in nature
and are therefore included in current liabilities in the accompanying condensed
consolidated balance sheet as of September 30, 1998. In November 1998, the
outstanding balance under the Lines of Credit was repaid.
In October 1998, the Company entered into a $67.0 million short-term demand
note with a bank to partially fund the reacquisition of the ownership interest
in the $125.0 million pool of trade accounts receivable that were sold under the
Securitization Program (see Note 4). The annual interest rate of the demand
note was 6.1% as of October 31, 1998. In November 1998, the outstanding balance
under the demand note was repaid.
In November 1998, the Company issued and sold $750.0 million in principal
amount of 7.50 % Senior Notes, due 2008 (the "7.50% Notes"), generating net
proceeds of approximately $741.0 million, after deducting offering costs.
Interest on the 7.50% Notes is payable semiannually in arrears on May 1 and
November 1 of each year, commencing May 1, 1999. The 7.50% Notes are subject to
redemption at the option of the Company, in whole or in part, at any time at
specified redemption prices.
In connection with the sale of the 7.50% Notes, the Company agreed to make
an offer to exchange new notes, registered under the Securities Act of 1933, as
amended (the "Securities Act"), and with terms identical in all material
respects to the 7.50% Notes, for the 7.50% Notes or, alternatively, to file a
shelf registration statement under the Securities Act with respect to the 7.50%
Notes. If the registration statement for the exchange offer or the shelf
registration statement, as applicable, is not declared effective within
specified time periods or, after being declared effective, ceases to be
effective or usable for resale of the 7.50% Notes during specified time periods
(each a "Registration Default"), additional cash interest will accrue at a rate
per annum equal to 0.50% of the principal amount of the 7.50% Notes during the
90-day period immediately following the occurrence of a Registration Default and
increasing in increments of 0.25% per annum of the principal amount of the 7.50%
Notes up to a maximum of 2.0% per annum, at the end of each subsequent 90-day
period until the Registration Default is cured.
On November 5, 1998, the Company executed a commitment letter with its
three lead banks to syndicate an unsecured, $500.0 million to $750.0 million
credit facility. Each of the lead banks has agreed to commit up to $100.0
million, with a minimum aggregate commitment of $250.0 million. The new credit
facility would be structured to include a $250.0 million 364-day revolving
credit facility, with the balance as a five-year revolving credit facility. The
364-day facility would be extendable for an additional 364 days on the lenders'
approval or convertible at the Company's option to a term loan terminating at
the same time as the five-year facility. Borrowings under the new credit
facility would bear interest at a variable rate based on LIBOR plus an
applicable margin. Consummation of the new credit facility is conditioned, among
other things, on the execution of a mutually satisfactory credit agreement. The
Company and the three lead banks are working toward a December 1998 closing, but
there can be no assurance that the new credit facility will be in place before
the Credit Facility expires.
(7) INCOME TAXES
Effective with the LCI Merger, Qwest is no longer included in the
consolidated federal income tax return of its Majority Shareholder. As a
result, the tax sharing agreement with the Majority Shareholder is no longer
effective for activity after June 5, 1998. The Company is still subject to the
provisions of the tax sharing agreement for activity through June 5, 1998.
11
<PAGE>
The Company's effective tax rate for the three and nine months ended
September 30, 1998 and 1997, differed from the statutory income tax rate as
follows:
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
-------------------------------- ----------------------------------
1998 1997 1998 1997
------------- ------------- -------------- -------------
<S> <C> <C> <C> <C>
Federal tax at statutory rate 35.0% 35.0% (35.0)% 35.0%
State taxes (net of federal effect) 5.0% -- (5.0)% 2.4%
In-process R&D -- -- 36.3% --
Goodwill and other non-deductible expenses 114.3% -- 1.8% 1.0%
Growth share plan -- -- -- 8.7%
Other, net -- 0.6% 0.5% 1.8%
------------- ------------- -------------- -------------
Effective tax rate 154.3% 35.6% (1.4%) 48.9%
============= ============= ============== =============
</TABLE>
(8) COMMITMENTS AND CONTINGENCIES
(a) Network Construction Project and Capital Requirements
In 1996, the Company commenced construction of the Qwest Network. The
Company estimates the total cost to construct and activate the Qwest Network
(which now includes the LCI network) and complete construction of the dark fiber
sold to customers will be approximately $2.3 billion. The Company projects its
total remaining cost as of September 30, 1998 for completing the construction of
the Qwest Network will be approximately $800.0 million.
(b) Network and Telecommunications Capacity Exchanges
From time to time, the Company enters into agreements to acquire long-term
telecommunications capacity rights from unrelated third parties in exchange for
long-term telecommunications capacity rights along segments of the Qwest Network
under construction. In general, the exchange agreements provide for the payment
of cash by either of the parties for any period during the contract term in
which a party provides less than the contracted telecommunications capacity. The
exchange agreements provide for liquidated damages to be levied against the
Company in the event the Company fails to deliver the telecommunications
capacity, in accordance with the agreed-upon timetables.
(c) Long-term Capacity Agreements
From time to time, the Company enteres into long-term agreements to sell
capacity on the Qwest Network to third parties. These agreements generally call
for the Company to provide the third party the use of a circuit on the Qwest
Network at varying capacity levels for a period of time ranging up to 25 years.
The agreements may or may not include maintenance fees paid to the Company.
(d) Vendor Agreements
The Company has agreements with certain telecommunications interexchange
carriers and third party vendors that require the Company to maintain minimum
monthly and/or annual billings based on usage. The Company has historically met
all minimum billing requirements and believes the minimum usage commitments will
continue to be met.
(e) Legal Matters
The Company has been named as a defendant in various litigation matters.
Management intends to vigorously defend these outstanding claims. The Company
believes it has adequate accrued loss contingencies and, that although the
ultimate outcome of these claims cannot be ascertained at this time, current
pending or threatened litigation matters are not expected to have a material
adverse impact on the Company's results of operations or financial position.
12
<PAGE>
(9) NET EARNINGS (LOSS) PER SHARE
The following are computations of the basic and diluted earnings per share
(in millions, except per share information):
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
----------------------------------- ----------------------------------
1998 1997 1998 1997
-------------- --------------- -------------- --------------
<S> <C> <C> <C> <C>
Net earnings (loss) $ (5.0) $ 12.8 $ (888.1) $ 2.3
============== =============== ============== ==============
Shares:
Weighted average number of shares outstanding during the
period for computing basic earnings per share 330.7 206.6 259.9 185.1
-------------- --------------- -------------- --------------
Incremental common shares attributable to dilutive
securities:
Common shares issuable for warrants - 2.0 - 0.7
Common shares issuable under stock option plan - 2.4 - 0.8
Common shares issuable for outstanding growth shares - 0.6 - 2.4
-------------- --------------- -------------- --------------
Number of shares as adjusted for purposes of computing
diluted earnings per share 330.7 211.6 259.9 189.0
============== =============== ============== ==============
Net earnings (loss) per share-basic $ (0.02) $ 0.06 $ (3.42) $ 0.01
============== =============== ============== ==============
Net earnings (loss) per share-diluted $ (0.02) $ 0.06 $ (3.42) $ 0.01
============== =============== ============== ==============
</TABLE>
13
<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
INFORMATION REGARDING FORWARD-LOOKING STATEMENTS
This Quarterly Report on Form 10-Q contains or refers to forward-looking
statements within the meaning of Section 27A of the Securities Act of 1933, as
amended (the "Securities Act"), and Section 21E of the Securities Exchange Act
of 1934, as amended, that include, among others, (1) statements by Qwest
concerning the benefits expected to result from certain business activities and
transactions, including, without limitation, synergies in the form of increased
revenues, decreased expenses and avoided expenses and expenditures that are
expected to be realized by the Company after the closing of such transactions,
(2) the Company's plans to complete the Qwest Network, an approximately 18,450
route-mile, coast-to-coast, technologically advanced fiber optic communications
network, and (3) other statements by the Company of expectations, beliefs,
future plans and strategies, anticipated developments and other matters that are
not historical facts. The Company cautions the reader that these forward-looking
statements are subject to risks and uncertainties, including financial,
regulatory environment, and trend projections, that could cause actual events or
results to differ materially from those expressed or implied by the statements.
Such risks and uncertainties include those risks, uncertainties and risk factors
identified, among other places, in documents filed with the Securities and
Exchange Commission (the "Commission"). The most important factors that could
prevent the Company from achieving its stated goals include, but are not limited
to: (a) failure by the Company to construct the Qwest Network on schedule and on
budget, (b) operating and financial risks related to managing rapid growth,
integrating acquired businesses and maintaining sufficient cash flow to meet its
debt service requirements, make capital expenditures and fund operations, (c)
intense competition in the Company's Communcations Services market, (d) the
Company's ability to achieve year 2000 compliance, (e) rapid and significant
changes in technology and markets, and (f) adverse changes in the regulatory or
legislative environment affecting the Company. These cautionary statements
should be considered in connection with any subsequent written or oral forward-
looking statements that may be issued by the Company or persons acting on its
behalf. The Company undertakes no obligation to review or confirm analysts'
expectations or estimates or to release publicly any revisions to any forward-
looking statements to reflect events or circumstances after the date hereof or
to reflect the occurrence of unanticipated events.
Overview
The Company is a facilities-based provider of a full range of multimedia
communications services to businesses, consumers and other communications
entities ("Communications Services"). In addition, the Company is constructing
and installing fiber optic systems for interexchange carriers and other
communications entities, as well as for its own use ("Construction Services").
The Company expects to complete its domestic voice and data network in 1999.
In April 1998, the Company activated the entire transcontinental portion of the
Qwest Network from Los Angeles to San Francisco to New York, thus becoming the
first network service provider to complete a transcontinental native Internet
Protocol ("IP") fiber network. The Company is also expanding its network to
carry international data and voice traffic to Mexico and Europe. Completion of
the Mexico network is scheduled for early 1999. The network expansion into
Europe includes capacity on three undersea submarine systems. The transatlantic
capacity includes eight STM-1s (the European equivalent to SONET OC-3) from New
York City to London and other European destinations.
In August 1998, the Company announced its participation in a consortium of
communications companies that is building a submarine cable system connecting
the United States to Japan. Scheduled for completion by the second quarter of
2000, the 13,125-mile four-fiber pair cable will ultimately possess the
capability to transmit information at the rate of 640 gigabits per second.
In September 1998, the Company announced that in November 1998 it planned to
make available for use the nation's first OC-48 native IP network along the
Qwest Network. Along this OC-48 network, the Company will offer high-speed
dedicated Internet access, web hosting, IP-based virtual private network
services and expanded availability of voice over IP long distance services.
Additionally, the Company's European subsidiary, EUnet International Limited
("EUnet), will provide the first pan-European Internet broadcasting network. The
new services will allow customers in Europe to broadcast video, data and voice
globally.
14
<PAGE>
Communications Services. Communications Services consists of retail and
wholesale services. The Company's retail services include voice, data and video
services to business and residential customers. The Company builds direct, end-
user relationships by developing strong distribution channels, providing
competitive pricing and superior network quality and offering enhanced, market-
driven services. The Company's wholesale services provides high-volume and
conventional private line services over the Company's owned capacity and
switched services over owned and leased capacity to other communications
providers. In addition to traditional communications carriers, the Company is
marketing to Internet service providers, electric utility companies and other
data service companies.
Construction Services. Construction Services constructs and installs fiber
optic systems for other communications providers, as well as for the Company's
own use. The Company began operations in 1988 constructing fiber optic conduit
systems primarily for major long distance carriers in exchange for cash and
capacity rights. The Company has entered into major construction contracts for
the sale of dark fiber to Frontier, MCI WorldCom and GTE whereby the Company has
agreed to install and provide dark fiber to each along portions of the Qwest
Network. In addition to these contracts, the Company has signed agreements with
other communications providers for the sale of dark fiber along the Qwest
Network. Revenue from Construction Services generally is recognized under the
percentage of completion method as performance milestones relating to the
contract are satisfactorily completed. After completion of the Qwest Network in
1999, the Company expects that revenue from Construction Services will be less
significant to the Company's operations.
Icon Acquisition. On September 13, 1998, the Company signed a definitive
merger agreement with Icon CMT Corp. ("Icon"), a provider of integrated Internet
solutions associated with web hosting and IP integration. The terms of the
merger agreement call for the acquisition of all of Icon's outstanding common
shares and the assumption of all of Icon's stock options by the Company. The
purchase price of the all-stock transaction is anticipated to be approximately
$207.0 million, not including approximately $3.5 million of direct acquisition
costs. The merger is intended to qualify as a tax-free reorganization and will
be accounted for as a purchase. The merger is expected to close by December 31,
1998.
The Company has also agreed to advance up to $15.0 million to Icon, with an
initial availability date of January 31, 1999, to fund working capital
requirements and for other corporate purposes. In consideration for this
commitment, Icon issued to the Company a warrant to purchase up to 750,000
shares of Icon stock at $12 per share.
Approval of the merger is subject to the affirmative vote of a majority of
the outstanding shares of Icon common stock. Icon's three founders also entered
into agreements with the Company to vote to approve the merger and to grant the
Company purchase options on their shares. The warrant and purchase options give
the Company beneficial ownership of approximately 44% of Icon's common stock.
LCI Acquisition. On June 5, 1998, the Company acquired LCI International,
Inc. and subsidiaries ("LCI"), a communications services provider, for
approximately $3.9 billion in Company common stock. At the close of the
acquisition (the "LCI Merger"), the Company issued approximately 129.9 million
shares of the Company's common stock (including outstanding LCI stock options
assumed by the Company), and incurred approximately $13.5 million in direct
acquisition costs. The LCI Merger was accounted for as a purchase.
In connection with the acquisition of LCI, the Company allocated $750.0
million of the purchase price to in-process research and development ("R&D")
projects, $250.0 million to developed technology and $3,037.8 million to
goodwill. This allocation to the in-process R&D represents the estimated fair
value based on risk-adjusted cash flows related to the incomplete projects. The
developed technology and goodwill are being amortized on a straight-line basis
from 10 to 40 years (See further discussion of the LCI Merger in RESULTS OF
OPERATIONS).
LCI's results of operations have been included in the accompanying condensed
consolidated statements of operations of the Company from the date of
acquisition. The Company will complete final allocation of purchase price
within one year from the acquisition date. The items awaiting final allocation
include non-current asset valuation and final determination of the costs to sell
or exit certain activities of LCI. It is anticipated that final allocation of
purchase price will not differ materially from the preliminary allocation.
EUnet Acquisition. On April 14, 1998, the Company acquired EUnet, a European
internet service provider with subsidiaries in 14 countries, for approximately
$158.2 million. Certain EUnet stockholders and option holders received
15
<PAGE>
approximately 3.6 million shares of Company common stock, having a value of
approximately $135.3 million, and $4.2 million in cash. Direct costs of
acquisition were approximately $3.5 million. Approximately 0.6 million shares
were placed in escrow for two years and may be recovered by the Company to
satisfy any indemnification claims. At the expiration of the escrow period,
these shares revert to the EUnet stockholders. In addition, the Company
committed to purchase certain preference shares for $15.2 million. The Company
will issue additional shares of Company common stock or cash to fulfill this
purchase commitment. The EUnet acquisition was accounted for as a purchase.
The Company allocated $68.0 million of the purchase price to incomplete R&D
projects. These projects include the design and development of several new
value-added internet services as well as the development of the necessary
customer care and network management systems. Remaining development efforts for
these projects include various phases of design, development and testing efforts
that are expected to be completed in stages over the next 21 months. Since
these projects had not yet reached technological feasibility and have no
alternative future uses, there can be no guarantee as to the achievability of
the projects or the ascribed values. Accordingly, these costs were expensed as
of the acquisition date. The remaining intangibles from the purchase relate to
developed technology and goodwill and are being amortized on a straight-line
basis over five years and ten years, respectively.
The results of operations of EUnet have been included in the accompanying
condensed consolidated statements of operations of the Company from the date of
acquisition. The accompanying condensed consolidated financial statements
reflect the preliminary allocation of purchase price which is subject to
adjustment.
Phoenix Transaction. On March 30, 1998, the Company acquired Phoenix
Network, Inc. ("Phoenix"), a non-facilities-based reseller of long distance
services. Approximately 0.8 million shares of the Company common stock having a
value of approximately $27.2 million were exchanged for the outstanding shares
of Phoenix. The results of operations of Phoenix have been included in the
accompanying condensed consolidated statements of operations of the Company from
the date of acquisition. The Phoenix acquisition was accounted for as a
purchase.
RESULTS OF OPERATIONS
THREE AND NINE MONTHS ENDED SEPTEMBER 30, 1998 COMPARED TO THREE AND NINE MONTHS
ENDED SEPTEMBER 30, 1997
The Company reported a net loss of $5.0 million for the three months ended
September 30, 1998, compared to net earnings of $12.8 million for the same
period of the prior year. For the nine months ended September 30, 1998, the
Company reported a net loss of $888.1 million compared to net earnings of $2.3
million for the nine months ended September 30, 1997. The increase in the net
loss for the three- and nine-month periods as compared to the same periods in
the prior year was primarily due to the factors discussed below. For the
comparative periods presented, the Company's results of operations include the
acquisitions of: SuperNet, Inc. from October 1997; Phoenix from March 1998;
EUnet from April 1998; and LCI from June 1998. Excluding the effect of the
merger related costs and the write-off of in-process R&D costs related to the
LCI and EUnet acquisitions, the Company's reported net loss would have been
$28.2 million for the nine months ended September 30, 1998 compared to net
earnings of $2.3 million for the same period of the prior year.
The following pro forma operating results of the Company, LCI, Phoenix and
EUnet for the nine months ended September 30, 1998 and 1997 have been prepared
assuming these acquisitions occurred on January 1, 1998 and 1997, respectively.
On a pro forma basis for the nine months ended September 30, 1998 and 1997,
revenue was $2,158.8 million and $1,790.8 million, respectively, and net loss
was $886.6 million, or ($2.71) per basic and diluted share, and $869.0 million,
or ($2.68) per basic and diluted share, respectively.
16
<PAGE>
Revenue. Selected components of revenue for the three and nine months ended
September 30, 1998 and 1997, were as follows (in millions):
Three Months Nine Months
1998 1997 Increase 1998 1997 Increase
------ ------ -------- -------- ------ --------
Communications services $601.8 $ 32.5 $ 569.3 $ 884.2 $ 77.1 $ 807.1
Construction services 205.0 156.5 48.5 493.4 413.2 80.2
------ ------ -------- -------- ------ --------
Total revenue $806.8 $189.0 $ 617.8 $1,377.6 $490.3 $ 887.3
====== ====== ======== ======== ====== ========
During the three and nine months ended September 30, 1998, as compared to the
same periods in the prior year, Communications Services revenue increased due to
the addition of revenue from the acquisitions discussed above. If the
anticipated acquisition of Icon is consummated, the Company expects
Communications Services revenue to grow. Additionally, excluding acquisitions,
revenue increased due to growth in retail and data services.
During the three and nine months ended September 30, 1998, as compared to the
same periods in the prior year, Construction Services revenue increased
primarily due to additional dark fiber sales to other carriers.
Operating Expenses. Selected components of operating expenses for the three
and nine months ended September 30, 1998 and 1997, were as follows (in
millions):
Three Months Nine Months
1998 1997 Increase 1998 1997 Increase
------ ------ -------- -------- ------ --------
Access and network
operations $371.6 $ 25.0 $ 346.6 $ 556.1 $ 61.8 $ 494.3
Construction services 128.2 107.5 20.7 333.8 292.0 41.8
Selling, general and
administrative 189.4 31.4 158.0 341.5 123.2 218.3
Depreciation and
amortization 76.6 5.1 71.5 115.6 13.1 102.5
Merger related costs - - - 880.5 - 880.5
------ ------ -------- -------- ------ --------
Total operating
expenses $765.8 $169.0 $ 596.8 $2,227.5 $490.1 $1,737.4
====== ====== ======== ======== ====== ========
Expenses for access and network operations primarily consist of the cost of
operation of the Qwest Network, Local Exchange Carrier ("LEC") access charges
and the cost of leased capacity. The increase in access and network operations
for both the three and nine months ended September 30, 1998 was primarily
attributable to growth in revenue from acquisitions, as well as internally
generated growth in Communications Services revenue. As the Qwest Network is
completed and activated, the Company is able to serve more customer needs over
its own network.
Expenses for construction services consist primarily of costs to construct the
Qwest Network, including conduit, fiber, cable, construction crews and rights of
way. Costs attributable to the construction of the Qwest Network for the
Company's own use are capitalized. Expenses for construction services increased
for the three and nine months ended September 30, 1998 as compared to the same
periods in the prior year due to additional contracts that were signed during
1998.
Selling, general and administrative ("SG&A") expense includes the cost of
salaries, benefits, occupancy costs, commissions, sales and marketing expenses
and administrative expenses. The increase in SG&A for the three and nine months
ended September 30, 1998 was primarily due to the addition of SG&A expenses
related to acquired entities, increased sales and marketing efforts, new service
offerings, administrative and information services supporting the Company's
growth, increased payroll from the recruiting and hiring of additional
personnel, increased commissions expense related to the growth in Communications
Services revenue, and increased property taxes and maintenance costs related to
the increase of fixed assets along the Qwest Network. During the three and nine
months ended September 30, 1998, as compared to the same periods in the prior
year, the Company experienced increases in the number of employees from
acquisitions and the expansion of the sales and customer support infrastructure
from approximately
17
<PAGE>
1,290 employees at September 30, 1997 to approximately 6,900 employees at
September 30, 1998. The increases in SG&A were partially offset by a decrease in
Growth Share Plan expense. The Company has a Growth Share Plan for certain of
its employees and directors, which was the Company's management incentive plan
prior to the initial public offering. Growth Share Plan expense for the three
and nine months ended September 30, 1998 was $2.3 million and $7.1 million,
respectively, compared to $4.1 million and $69.3 million for the three and nine
months ended September 30, 1997, respectively. Growth Share Plan expense is not
expected to be material to the operations of the Company in the future. SG&A is
expected to increase in the short term as the Company continues to grow, as
segments of the Qwest Network become operational and as the Company continues
the expansion of its Communications Services business.
The Company's depreciation and amortization expense increased primarily due to
activating segments of the Qwest Network during the three and nine months ended
September 30, 1998, purchases of fixed assets to accommodate the Company's
growth and depreciation and amortization of fixed assets and goodwill related to
the Company's acquisitions. The Company expects that depreciation and
amortization expense will continue to increase in subsequent periods as the
Company continues to activate additional segments of the Qwest Network.
During the nine months ended September 30, 1998, the Company recorded $62.5
million in merger-related costs due to the merger with LCI, including $31.0
million of duplicate facilities, $25.0 million of channel consolidation and
duplicate commitments and $6.5 million of other miscellaneous merger costs.
In connection with the acquisition of LCI, the Company allocated $750.0
million of the purchase price to in-process R&D projects, $250.0 million to
developed technology and $3,037.8 million to goodwill. The developed technology
and goodwill are being amortized on a straight-line basis from 10 to 40 years.
This allocation to the in-process R&D represents the estimated fair value based
on risk-adjusted cash flows related to the incomplete projects. At the date of
the merger, the development of these projects had not yet reached technological
feasibility and the R&D in progress had no alternative future uses. Accordingly,
these costs were expensed as of the merger date.
Through the use of third party appraisal consultants, the Company assessed
and allocated values to the in-process research and development. The values
assigned to these assets were determined by identifying significant research
projects for which technological feasibility had not been established. These
assets consisted of a significant number of R&D projects grouped into three
categories: (1) next-generation network systems automation tools; (2) advanced
data services, including frame relay and Internet Protocol technologies; and (3)
new operational systems and tools. Taken together, these projects, if
successful, will enable the Company to provide advanced voice and data services
as well as sophisticated network management and administration functions. A
brief description of the three categories of in-process projects is presented
below:
. R&D Related to Network Systems Automation. These R&D projects are
intended to create a new method of automating LCI's service provisioning
and network management systems. These proprietary projects include the
development of data warehousing and new interface technologies to enable
the interchange of data across disparate networks. As of the transaction
date, the Company believes that the overall project was 60% complete.
Development efforts through September 30, 1998 have proceeded according
to expectations. While material progress has been made with these
projects, significant risk still is associated with their completion. If
these projects are unsuccessful, their expected contribution to revenues
and profits will not materialize.
. R&D Related to Frame Relay and IP Services. These projects involve R&D
related to the deployment of frame relay and IP technologies within the
LCI network. With the completion of this next-generation network, LCI
will be able to address emerging new demand trends for data services.
Management considers this a complex project due to the customized work
required. As of the transaction date, the Company believes the overall
project was approximately 60% to 70% complete as of the LCI transaction
date. Development efforts through September 30, 1998 have proceeded
according to expectations. While material progress has been made with
these projects, significant risk still is associated with their
completion. If these projects are unsuccessful, their expected
contribution to revenues and profits will not materialize.
. R&D Related to Operational Systems and Tools. These projects involve R&D
related to the development of new service and network management tools
and engineering functions. These proprietary projects are closely
associated with LCI's deployment of advanced data services. Applications
enabled by these new technologies include the ability to offer new
products and service packages. As of the transaction date, the Company
believes the projects were 60% to 70% complete. Development efforts
through September 30, 1998 have proceeded according to expectations.
While material progress has been made with the R&D projects, these are
unique technologies and significant risk is associated with their
completion. If these projects are unsuccessful, their expected
contribution to revenues and profits will not materialize.
Remaining R&D efforts for these projects include various phases of technology
design, development and testing. Anticipated completion dates for the projects
in progress will occur in phases over the next two years, at which point the
Company expects to begin generating the economic benefits from the technologies.
At the time of valuation, the costs incurred and the expected costs to complete
all such projects were approximately $50 million and $60 million, respectively.
The value assigned to purchased in-process technology was determined by
estimating the contribution of the purchased in-process technology to developing
commercially viable products, estimating the resulting net cash flows from the
expected product sales of such products, and discounting the net cash flows from
the expected product sales of such products, to their present value using a
risk-adjusted discount rate.
The Company estimates total revenues from the specific acquired in-process
technology peak in 2003 and steadily decline from 2004 through 2009 as other new
product and service technologies are expected to be introduced by the company.
These projections are based on management's estimates of market size and growth,
expected trends in technology, and the expected timing of new product
introductions.
Discounting the net cash flows back to their present values is based on the
weighted average cost of capital ("WACC"). The business enterprise is comprised
of various types of assets, each possessing different degrees of investment risk
contributing to the LCI's overall weighted average cost of capital. Intangible
assets are assessed higher risk factors due to their lack of liquidity and poor
versatility for redeployment elsewhere in the business. Reasonable returns on
monetary and fixed assets were estimated based on prevailing interest rates. The
process for quantifying intangible asset investment risk involved consideration
of the uncertainty associated with realizing discernible cash flows over the
life of the asset. A discount rate of 19% was used for valuing the in-process
research and development. This discount rate is higher than the implied WACC due
to the inherent uncertainties surrounding the successful development of the
purchased in-process technology, the useful life of such technology, the
profitability levels of such technology, and the uncertainty of technological
advances that are unknown at this time. As is standard in the appraisal of high
growth markets, projected revenues, expenses and discount rates reflect the
probability of technical and marketing successes.
The value of the in-process projects was adjusted to reflect value and
contribution of the acquired research and development. In doing so,
consideration was given to the R&D's stage of completion, the complexity of the
work completed to date, the difficulty of completing the remaining development,
costs already incurred, and the projected cost to complete projects.
The Company believes that the foregoing assumptions used in the forecasts
were reasonable at the time of the merger. The Company cannot assure, however,
that the underlying assumptions used to estimate expected project sales,
development costs or profitability, or the events associated with such projects,
will transpire as estimated. For these reasons, actual results may vary from the
projected results.
The Company expects to continue their support of these efforts and believes
the Company has a reasonable chance of successfully completing the R&D programs.
However, risk is associated with the completion of the projects and the Company
cannot assure that the projects will meet with either technological or
commercial success.
If none of these projects is successfully developed, the sales and
profitability of the Company may be adversely affected in future periods. The
failure of any particular individual project in-process would not materially
impact the Company's financial condition, results of operations or the
attractiveness of the overall LCI investment. Operating results are subject to
uncertain market events and risks, which are beyond the Company's control, such
as trends in technology, government regulations, market size and growth, and
product introduction or other actions by competitors.
The Commission staff is in the process of performing a limited review of the
Company's Form S-3 (File No. 333-58617) filed July 7, 1998, as amended on
September 30, 1998. The limited review includes, among other items, questions
regarding the in-process R&D writeoff discussed above. The outcome of the
limited review could result in changes to the three- and nine-month periods
ended September 30, 1998 financial results and disclosures (including adjustment
to the in-process R&D writeoff). The Company is unable to predict the outcome
of the limited review.
18
<PAGE>
Other (Income) Expense. Selected components of other (income) expense for
the three and nine months ended September 30, 1998 and 1997, were as follows
(in millions):
Three Months Nine Months
1998 1997 Increase 1998 1997 Increase
------ ------ -------- ------ ------ --------
Interest expense, net $ 29.0 $ 4.2 $ 24.8 $ 62.3 $ 8.9 $ 53.4
Other (income) expense,
net 2.9 (4.0) 6.9 (11.6) (13.2) 1.6
------ ------ -------- ------ ------ --------
Total other (income)
expense $ 31.9 $ 0.2 $ 31.7 $ 50.7 $ (4.3) $ 55.0
====== ====== ======== ====== ====== ========
The increase in interest expense, net during the three and nine months ended
September 30, 1998, as compared to the same period in the prior year, resulted
from an increase in long-term indebtedness, (see "Liquidity and Capital
Resources" below), partially offset by an increase in capitalized interest
resulting from construction of the Qwest Network. As the Qwest Network is
completed, interest expense will increase as the amount of capitalized interest
decreases. Other (income) expense, net, increased due primarily to decreases in
interest income due to lower average cash balances and a loss recorded for the
write-off of certain assets during the three and nine months ended September 30,
1998. Additionally, in the first half of 1997, the Company recorded a $9.3
million gain on sale of contract rights.
Income Taxes. Effective with the LCI Merger, Qwest is no longer included in
the consolidated federal income tax return of its Majority Shareholder. As a
result, the tax sharing agreement with the Majority Shareholder is no longer
effective for activity after June 5, 1998. The Company is still subject to the
provisions of the tax sharing agreement for activity through June 5, 1998.
The Company's effective tax rate for the three and nine months ended
September 30, 1998, differed from the statutory income tax rate primarily as a
result of the nondeductibility of R&D write-offs and acquisition-related
goodwill. The effective tax rate for the nine months ended September 30, 1997,
differred from the statutory rate primarily as a result of the nondeductibility
of a portion of growth share expense.
LIQUIDITY AND CAPITAL RESOURCES
Cash provided by operations was $106.3 million during the nine months ended
September 30, 1998. Cash used in investing activities was $778.4 million during
the nine months ended September 30, 1998, including $751.0 million to fund
capital expenditures. Cash provided by financing activities was $517.7 million
during the nine months ended September 30, 1998, including total debt borrowings
of $451.9 million.
The Company estimates the total cost to construct and activate the Qwest
Network and complete construction of dark fiber sold to third parties will be
approximately $2.3 billion. Of this amount, the Company had already expended
approximately $1.5 billion as of September 30, 1998.
The Company has obtained the following sources of funds which are available to
complete the build-out: (i) approximately $1.4 billion under the Frontier,
WorldCom and GTE contracts and additional smaller construction contracts for
sales of dark fiber, of which approximately $900.0 million had already been
received and $500.0 million remained to be received at September 30, 1998; (ii)
$90.0 million of vendor financing, with approximately $57.3 million outstanding
as of September 30, 1998; and (iii) approximately $1.1 billion from various debt
and equity financings, with approximately $949.5 million of such debt
outstanding as of September 30, 1998. The Company believes that its available
cash and cash equivalent balances at September 30, 1998, cash flow from
operations, proceeds from the November 1998, 7.50% senior notes offering
(described below) and its proposed bank financings (described below) will
satisfy its currently anticipated cash requirements at least for the next 12
months.
In connection with the LCI Merger, the Company assumed LCI's existing debt
instruments, including $350.0 million of 7.25% Senior Notes, due 2007 (the
"7.25% Notes"); a $250.0 million revolving credit facility ("Credit
19
<PAGE>
Facility") from a syndicate of banks; and three separate discretionary line of
credit agreements (the "Lines of Credit") with commercial banks for up to a
total of $75.0 million.
The Credit Facility bears interest at a rate consisting of two components:
the base rate component is dependent upon a market indicator; the second
component varies from 0.30% to 0.75%, based on the more favorable of the
relationship of borrowings levels to operating cash flow (the "leverage ratio")
or senior unsecured debt rating. As of September 30, 1998, the Company had
$215.0 million outstanding under the Credit Facility. The Credit Facility
contains various financial covenants, the most restrictive being the leverage
ratio requirement and the restriction on the ability of the Company and its
subsidiaries to pay dividends. As of September 30, 1998, the Company was in
compliance with all Credit Facility covenants. The Credit Facility expires
December 31, 1998 and is therefore included in current liabilities in the
accompanying condensed consolidated balance sheet as of September 30, 1998. In
November 1998, the outstanding balance under the Credit Facility was repaid.
As of September 30, 1998, $17.5 million was outstanding on the Lines of
Credit. The Lines of Credit are short-term in nature and are therefore included
in current liabilities in the accompanying condensed consolidated balance sheet
as of September 30, 1998. In November 1998, the outstanding balance under the
Lines of Credit was repaid.
As of September 30, 1998, the Company, through its wholly-owned subsidiary,
LCI, maintained an agreement to sell a percentage ownership interest in a
defined pool of trade accounts receivable (the "Securitization Program"). The
Company can transfer an undivided interest in the trade accounts receivable on
an ongoing basis to maintain the participation interest up to $150.0 million. As
of September 30, 1998, the Company had approximately $150.0 million of accounts
receivable available for sale and had sold a total of approximately $125.0
million. The Company retains substantially the same risk of credit loss as if
the receivables had not been sold, and has established reserves for such
estimated credit losses.
In October 1998, the Company funded the reacquisition of the ownership
interest in the $125.0 million pool of trade accounts receivable that were sold
under the Securitization Program through short-term debt borrowings and
available cash balances.
In November 1998, the Company issued and sold $750.0 million in principal
amount of 7.50 % Senior Notes, due 2008 (the "7.50% Notes"), generating net
proceeds of approximately $741.0 million, after deducting offering costs.
Interest on the 7.50% Notes is payable semiannually in arrears on May 1 and
November 1 of each year, commencing May 1, 1999. The 7.50% Notes are subject to
redemption at the option of the Company, in whole or in part, at any time at
specified redemption prices.
In connection with the sale of the 7.50% Notes, the Company agreed to make an
offer to exchange new notes, registered under the Securities Act and with terms
identical in all material respects to the 7.50% Notes, for the 7.50% Notes or,
alternatively, to file a shelf registration statement under the Securities Act
with respect to the 7.50% Notes. If the registration statement for the exchange
offer or the shelf registration statement, as applicable, is not declared
effective within specified time periods or, after being declared effective,
ceases to be effective or usable for resale of the 7.50% Notes during specified
time periods (each a "Registration Default"), additional cash interest will
accrue at a rate per annum equal to 0.50% of the principal amount of the 7.50%
Notes during the 90-day period immediately following the occurrence of a
Registration Default and increasing in increments of 0.25% per annum of the
principal amount of the 7.50% Notes up to a maximum of 2.0% per annum, at the
end of each subsequent 90-day period until the Registration Default is cured.
On November 5, 1998, the Company executed a commitment letter with its three
lead banks to syndicate an unsecured, $500.0 million to $750.0 million credit
facility. Each of the lead banks has agreed to commit up to $100.0 million,
with a minimum aggregate commitment of $250.0 million. The new credit facility
would be structured to include a $250.0 million 364-day revolving credit
facility, with the balance as a five-year revolving credit facility. The 364-
day facility would be extendable for an additional 364 days on the lenders'
approval or convertible at the Company's option to a term loan terminating at
the same time as the five-year facility. Borrowings under the new credit
facility would bear interest at a variable rate based on LIBOR plus an
applicable margin. Consummation of the new credit facility is conditioned,
among other things, on the execution of a mutually satisfactory credit
agreement. The Company and the three lead banks are working toward a December
1998 closing, but there can be no assurance that the new credit facility will be
in place before the Credit Facility expires.
20
<PAGE>
YEAR 2000
Many existing computer systems, including hardware and software, use only the
last two digits to identify a year. Consequently, as the year 2000 approaches,
such systems will not recognize the difference in a year that begins with "20"
rather than "19". As a result of the date change in the year 2000, if any of
the Company's computer systems use only two digits to define the year, these
defective systems may cause disruptions in its network operations through which
the Company provides communications services to its customers and in its
internal operations. Additionally, the Company is dependent upon outside
sources to provide communications services to its customers and to bill its
customers for such services. The greatest risk to the Company's ability to
provide communications services is the failure of third-party service providers
to be year 2000 compliant, especially those third-party service providers that
provide local access and certain of the billing systems upon which the provision
of long distance telecommunications service relies.
The Company has established a year 2000 compliance group. The objective of
the year 2000 compliance group is to eliminate disruptions as a result of the
date change in the year 2000. The compliance group has developed a five-step
plan to identify and repair year 2000 affected systems: (i) identify potentially
date-sensitive systems, including third-party products; (ii) assess such systems
for year 2000 compliance; (iii) modify, upgrade or replace non-compliant
systems; (iv) test the corrected systems; and (v) deploy the corrected systems.
The year 2000 compliance group has focused mainly on the Company's domestic
operations and, to a lesser extent, on its international operations.
In addition to reviewing its own systems, the year 2000 compliance group is
submitting requests to third-party service providers to obtain information as to
their compliance efforts.
The Company currently anticipates that remediation of the systems supporting
the domestic operations will be completed by December 31, 1998. Testing and
deployment of corrected systems is scheduled for completion by June 30, 1999.
The Company's ability to meet these target dates depends on third parties for
operational testing, as well as the Company's overall efforts to integrate the
operations of recently acquired businesses, including LCI. Thus, various
factors, including the compliance efforts of third parties, over which the
Company has no control, may affect these target dates.
The Company is developing contingency plans in the event that the Company or
any of its third-party service providers fail to be year 2000 compliant. The
contingency plans are expected to be completed by June 1999.
The Company estimates the SG&A expenses of implementing its year 2000 plan
will be approximately $5.0 million to $7.0 million for the year ending December
31, 1998. During the nine months ended September 30, 1998, the Company incurred
approximately $3.0 million for the year 2000 compliance costs, included in SG&A
expense. The Company expects to incur an additional approximately $10.0 million
to 15.0 million in SG&A expense during the remainder of 1998 and in 1999 to
implement its year 2000 plan.
INDUSTRY ENVIRONMENT
Historically, the Company has operated in the $80 billion long-distance
telecommunications industry. Recent legislative and regulatory activity is
designed to create one telecommunications industry to encompass both long-
distance and local telecommunications services. The Company intends to compete
in what is estimated to be a $150 billion combined market.
The current industry environment subjects the Company to varying degrees of
regulatory oversight on both the national and state levels. There are numerous
judicial and regulatory actions that are ongoing which can impact the nature and
degree of competition in the telecommunications industry. The Company is unable
to predict the timing for resolution of these actions, or the ultimate impact of
these matters on the industry and competition. The regulatory and legislative
actions discussed below could impact the Company's pricing and cost structure by
changing access or by generally increasing competition. The Company is unable to
predict what impact these changes will have on its pricing, revenue growth or
operating margin.
21
<PAGE>
LEGISLATIVE MATTERS
- -------------------
Telecommunications Act of 1996. In February 1996, the Telecommunications Act
of 1996 ("the Telecommunications Act") was enacted to increase competition in
the long-distance and local telecommunications industries. The legislation is
intended to open competition in the local services market and, at the same time,
contains provisions intended to protect consumers and businesses from unfair
competition by incumbent LECs, including the Regional Bell Operating Companies
("RBOCs"). The Telecommunications Act allows RBOCs to provide long-distance
service between LATAs to consumers inside their local service territories only
after meeting certain criteria, including a list of 14 specific "competitive
checklist" requirements for opening the local market to competition. The
Telecommunications Act also provides a framework for the Company and other
long-distance carriers to compete with LECs by reselling local telephone
service, leasing unbundled elements of the incumbent LEC networks or building
new local service facilities. The Company has signed local service resale
agreements with Ameritech Corporation, BellSouth Corporation and Bell Atlantic
Corporation ("Bell Atlantic"). The Company has also signed an interconnection
agreement with Ameritech Corporation.
In July 1997, SBC Communications Inc. ("SBC"), followed by U S West and Bell
Atlantic, filed a lawsuit in the United States District Court for the Northern
District of Texas ("the District Court") challenging, on constitutional grounds,
the restrictions contained in the Telecommunications Act applicable only to
RBOCs. In December 1997, the District Court ruled that the RBOC-specific
provisions of the Telecommunications Act were an unconstitutional bill of
attainder. The FCC, AT&T, MCI WorldCom and Sprint appealed this ruling to the
United States Court of Appeals for the Fifth Circuit (the "Fifth Circuit"),
which stayed the ruling pending appeal. In September 1998, the Fifth Circuit
overturned the District Court ruling and upheld the Telecommunications Act's
provisions. On October 20, 1998, SBC and U.S. West petitioned the United States
Supreme Court for review. If the District Court ruling is ultimately upheld, the
RBOCs may be able to provide long-distance services within their local service
territories much sooner than expected and without the detailed review and
approval process by state regulators and the FCC that is currently required
under the Telecommunications Act. If this decision were upheld, the Company
expects an increase in competition for long-distance services which could result
in the loss of market share and/or a decrease in operating margins. However, the
Company believes that the RBOCs' and other companies' participation in the
market will provide opportunities for the Company to sell fiber or lease long
distance high volume capacity. The Company is unable to predict the outcome of
the pending petition for review.
22
<PAGE>
REGULATORY MATTERS
In order to implement the Telecommunications Act, the FCC is required to
undertake a variety of regulatory actions that impact competition in the
telecommunications industry. Many of the actions taken by the FCC to implement
the Telecommunications Act, in addition to the Telecommunications Act itself,
face court challenges. Certain of these regulatory actions are described below.
Access Charge Reform. In May 1997, the FCC issued an order designed to reform
the system of interstate access charge expenses levied by LECs on long-distance
service carriers. In that order, the FCC used rate reductions and presumably
increased competition in interstate access in an attempt to bring interstate
access charges closer to actual economic cost. Various parties filed petitions
for reconsideration of the order with the FCC. Some parties, including the
Company, appealed the order to the Eighth Circuit, which, in August 1998, upheld
the FCC's determinations. The FCC has stated that it will issue a further order
designed to permit incumbent LECs to lower interstate access charges in response
to competition, and has recently announced it will delay certain adjustments
until July 1, 1999. The manners in which the FCC implements its approach to
lowering access charge levels will have a material effect on the prices the
Company and its long-distance competitors pay for originating and terminating
interstate traffic. Although the ultimate outcome of the FCC actions is
uncertain, the Company did expect lower access charges in 1998. This decrease,
however, has been offset by increases in customer line charges and charges for
the universal service fund.
Under traditional federal regulatory policy, providers of long distance
services over the Internet and companies that use IP technology to provide long
distance services have been exempt from access charges. Two RBOCs recently
informed carriers that provide long distance voice services over the Internet or
use IP technology that they also must pay access charges on IP telephony
services. This is the first effort by incumbent local exchange carriers to levy
access charges on IP telephony services. Furthermore, there has been no
definitive FCC determination as to treating IP telephony as a service subject to
access charges. If local exchange carriers are allowed to levy access charges on
IP telephony long distance service offerings, this development would increase
the Company's costs to provide such services and might cause the Company to
reevaluate the pricing of such services.
Universal Service. The FCC released a companion order on universal service
reform in May 1997. In accordance with the Telecommunications Act, the FCC
adopted plans to implement the recommendations of a Federal-State Joint Board to
preserve universal service, including a definition of services to be supported,
and defining carriers eligible for contributing to and receiving from universal
service subsidies. The FCC ruled, among other things, that: contributions to
universal service funding would be based on all interexchange carriers' gross
retail revenues from both interstate and international telecommunications
services; only common carriers providing a full complement of defined local
services were eligible for support; and up to $2.25 billion in new annual
subsidies for discounted telecommunications services used by schools, libraries,
and rural health care providers would be funded by an assessment on total
interstate and intrastate revenues of all interexchange carriers. The FCC stated
that it intends to study the mechanism for continued support of universal
service in high cost areas in a subsequent proceeding. Several parties have
filed petitions for reconsideration or judicial appeals or both of this order,
many of which are still pending. Further to its study of the mechanism for
support of universal service, on April 10, 1998, the FCC released a report to
Congress suggesting that the FCC might, in a later proceeding, classify some
kinds of "phone-to-phone" voice services using the Internet protocol as
telecommunications services. Such an outcome would extend new regulatory
obligations and associated costs, including the obligation to support universal
service, to providers of those services. The Company is unable to predict the
outcome of the further FCC proceedings or the pending judicial appeals or
petitions for FCC reconsideration on its operations. The Company is required to
contribute in 1998 a percentage of its gross retail revenue to the universal
services fund and includes charges for these contributions in its 1998 billings.
23
<PAGE>
Deployment of Advanced Telecommunications Services. Recently, the FCC
initiated two proceedings on the deployment of advanced telecommunications
services (e.g., high-speed Internet access, video telephony) and the petitions
filed by several entities pursuant to the Telecommunications Act of 1996. A
Notice of Inquiry examines if advanced telecommunications services are being
made available to consumers on a reasonable and timely basis. A Notice of
Proposed Rulemaking proposes to offer incumbent local telephone companies the
option to provide advanced telecommunications services through a separate
affiliate on a largely deregulated basis. The Company has filed comments in
both proceedings, but is unable to predict what impact these proceedings will
have on the nature of competition or how advanced telecommunications services
offered by LECs will be regulated.
State Regulation. The Company's intrastate long distance telecommunications
operations are subject to various state laws and regulations including, in many
jurisdictions, certification and tariff filing requirements.
Generally, the Company must obtain and maintain certificates of authority
from regulatory bodies in most states in which it offers intrastate services.
In most of these jurisdictions the Company must also file and obtain prior
regulatory approval of tariffs for its intrastate services. Certificates of
authority can generally be conditioned, modified, canceled, terminated, or
revoked by state regulatory authorities for failure to comply with state law
and/or the rules, regulations, and policies of the state regulatory authorities.
Fines and other penalties also may be imposed for such violations. The Company
is currently authorized to provide intrastate services throughout the United
States. The Company intends to have authority in all states where competition
is allowed.
Those states that permit the offering of intrastate/intraLATA service by
interexchange carriers generally require that end users desiring to use such
services dial special access codes. Historically, this has put the Company at a
24
<PAGE>
competitive disadvantage compared with LECs whose customers can make
intrastate/intraLATA calls simply by dialing 1 plus the desired number. If a
long distance carrier's customer attempts to make an intraLATA call by simply
dialing 1 plus the desired number, the call will be routed to and completed by
the LEC. Regulatory agencies in a number of states have issued decisions that
would permit the Company and other interexchange carriers to provide intraLATA
calling on a 1 + basis. Further, the Telecommunications Act requires in most
cases that the RBOCs provide such dialing parity coincident to their providing
in-region interLATA services. The Company expects to benefit from the ability to
offer 1 + intraLATA services in states that allow this type of dialing parity.
Local Regulation. The Company is occasionally required to obtain street use
and construction permits and licenses and/or franchises to install and expand
its fiber optic network using municipal rights-of-way. Termination of the
existing franchise or license agreements prior to their expiration dates or a
failure to renew the franchise or license agreements and a requirement that the
Company remove its facilities or abandon its network in place could have a
material adverse effect on the Company. In some municipalities where the
Company has installed or anticipates constructing networks, it will be required
to pay license or franchise fees based on a percentage of gross revenue or on a
per linear foot basis. There can be no assurance that, following the expiration
of existing franchises, fees will remain at their current levels. In addition,
the Company could be at a competitive disadvantage if its competitors do not pay
the same level of fees as the Company. However, the Telecommunications Act
requires municipalities to manage public rights-of-way in a competitively
neutral and non-discriminatory manner.
Other. The Company monitors compliance with federal, state and local
regulations governing the discharge and disposal of hazardous and
environmentally sensitive materials, including the emission of electromagnetic
radiation. The Company believes that it is in compliance with such regulations,
although there can be no assurance that any such discharge, disposal or emission
might not expose the Company to claims or actions that could have a material
adverse effect on the Company.
INDUSTRY STRUCTURE
The long-distance telecommunications market is highly competitive. The
principal competitive factors affecting the Company's market share are pricing,
regulatory and judicial developments (as described above), customer service and
diversity of services and features. The Telecommunications Act is expected to
change the nature of the industry by allowing carriers other than incumbent LECs
to provide local service, while permitting RBOCs to provide interLATA long-
distance services. As RBOCs are allowed into the long-distance market, the
Company expects competition within the industry to increase in both the long-
distance and local markets.
Several of the Company's competitors are larger and have greater financial,
technical and marketing resources. In addition to the largest telecommunications
companies, AT&T, MCI WorldCom and Sprint, the Company also competes with
hundreds of other long-distance carriers, as well as LECs, in various types of
telecommunications services. The Company's principal pricing strategy is to
offer a simple, flat-rate pricing structure with rates competitive with those of
AT&T, MCI WorldCom and Sprint. Although the Company is prepared to respond to
competitive offerings from other carriers, the Company continues to believe that
its marketing and service pricing approach is competitive in retaining existing
customers, as well as in obtaining new customers. The Company believes that the
nature of competition will continue to change with consolidation in the
industry. The telecommunications industry has experienced significant merger
activity in the last year. Of the many mergers that have occurred or have been
announced in the last year, the most significant include: SBC/Pacific Telesis
Group, MCI/WorldCom, Inc., SBC/Southern New England Telephone Company,
AT&T/Teleport Communications Group, SBC/Ameritech, AT&T/TCI and GTE/Bell
Atlantic. At this time the Company is unable to predict the impact of these
mergers, if any, on the Company or competition within the industry as a whole.
The Company's ability to compete effectively will depend on maintaining
exceptional customer service and high quality, market-responsive services at
prices generally equal to or below those charged by its major competitors.
25
<PAGE>
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
In March, 1998 four putative class action complaints ("Complaints") against
LCI, its directors and in two of these cases, Qwest, were filed in the Court of
Chancery of the State of Delaware in and for New Castle County (the "Court").
The Complaints each made substantially the same allegations. The plaintiffs
alleged that the consummation of the LCI Merger subjected LCI stockholders to
the control of the Majority Shareholder. The plaintiffs further alleged that
the LCI Merger constitutes a change in control of LCI and imposes heightened
fiduciary duties on the members of the LCI Board to maximize stockholder value.
The plaintiffs also alleged that the members of the LCI Board violated their
fiduciary duties by failing to auction LCI or to undertake an active "market
check" for other potential bidders. The plaintiffs had sought, among other
things, to have the Court declare the suit a proper class action, enjoin the LCI
Merger and require the members of' the LCI Board to auction LCI and/or conduct a
"market check," and award monetary damages, together with costs and
disbursements.
On May 5, 1998, Qwest and LCI entered into a proposed settlement with the
plaintiffs in the Complaints. Pursuant to the Memorandum of Understanding
entered into by counsel for Qwest, LCI and the plaintiffs, Qwest and LCI agreed,
among other things, to (i) include in the Joint Proxy Statement/Prospectus for
the LCI Merger financial information with respect to the quarter ended March 31,
1998, (ii) request Lehman Brothers to issue an updated opinion with respect to
the fairness of the LCI Merger; (iii) include in the Joint Proxy
Statement/Prospectus additional disclosure regarding actions by LCI and its
representatives regarding alternative business combination transactions and (iv)
not oppose an application for legal fees and expenses by the plaintiffs'
attorneys in the amount of not more than $410,000. Pursuant to the proposed
settlement, the actions will be dismissed with prejudice and the defendants will
be released from claims that were or could have been asserted in the actions.
Because the Complaints are putative class actions, the proposed settlement is
subject to reasonable confirmatory discovery, certification of the plaintiff
class of LCI Stockholders as of March 9, 1998 through the consummation of the
LCI Merger, notice to the class and Court approval. The proposed settlement
does not affect the Phillips action discussed below. On June 3, 1998, the four
putative class action lawsuits were consolidated by an Order of the Court and
the complaint in Miri Shapiro v. William F. McConnell [sic], Julius W. Erving,
Douglas M. Karp, George M. Perrin, H. Brian Thompson, John L. Vogelstein, Thomas
J. Wayne [sic], LCI International, Inc. and Qwest Communications International
Inc., was designated as the operative complaint in the consolidated action.
Confirmatory discovery was completed in June 1998. The parties have prepared
for execution a Stipulation and Agreement of Compromise, Settlement and Release.
The parties also have prepared for submission to the Court a scheduling order
for approval of the settlement. On November 2, 1998, the Court approved the
settlement.
On April 3, 1998, in an action captioned Lionel Phillips v. LCI International
Inc. and H. Brian Thompson, the plaintiff filed a putative class action
complaint in the United States District Court for the Eastern District of
Virginia against LCI and H. Brian Thompson, the Chairman and Chief Executive
Officer of LCI. The plaintiff brought the action purportedly on behalf of
stockholders of LCI who sold LCI Common Stock between February 17, 1998 and
March 9, 1998. The plaintiff alleged, among other things, that the defendants
violated Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder
by making materially false and misleading statements that LCI was not for sale
at a time when negotiations between Qwest and LCI regarding a potential merger
were allegedly ongoing. The plaintiff sought, among other things, to have the
Court declare the suit a proper class action and award damages, together with
costs and disbursements. On June 25, 1998, defendants moved to dismiss the
complaint on the grounds that it failed to state a claim against defendants. By
Order dated July 20, 1998, the Court granted defendants' motion to dismiss the
complaint but granted the plaintiff leave to amend the complaint within fifteen
days. On August 4, 1998, the plaintiff filed an amended complaint and the
Company again moved to dismiss the lawsuit. On September 30, 1998, the Court
granted the defendant's motion to dismiss the complaint. On October 20, 1998,
the plaintiff filed notice to appeal the Court's decision.
The Company also has been named as a defendant in various other litigation
matters. Management intends to vigorously defend these outstanding claims. The
Company believes it has adequate accrued loss contingencies and, that although
the ultimate outcome of these claims cannot be ascertained at this time, current
pending or threatened litigation matters are not expected to have a material
adverse impact on the Company's results of operations or financial position.
26
<PAGE>
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
(d) Use of Proceeds
The Company has used approximately $187.1 million of the $319.5 million
net proceeds from its initial public offering for construction of its
fiber optic communications network with the remaining net proceeds
temporarily invested in certain short-term investment grade securities.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
Exhibit No. Description
-----------------------------------------------------------------------
2.1 Agreement and Plan of Merger dated as of September 13, 1998
among Qwest Communications International Inc., and Icon CMT
Corp. (incorporated by reference to Annex A of the Joint
Proxy Statement/Prospectus included as part of the
Registration Statement on Form S-4 filed by Qwest on
September 30, 1998 (File No. 333-65095).
27 Financial Data Schedule filed herewith
(b) Reports on Form 8-K:
During the quarter ended September 30, 1998, the Company filed the
following Current Reports on Form 8-K:
(i) On July 8, 1998, the Company filed a Current Report on Form 8-K
announcing that it would host a major investment community
meeting to discuss strategic direction, operational plans and
status of integration activities related to the merger of LCI
International, Inc. and the Company.
(ii) On July 10, 1998, the Company filed a Current Report on Form 8-
K/A to amend a portion of Exhibit 99.1 to Form 8-K filed on
July 8, 1998.
(iii) On September 16, 1998, the Company filed a Current Report on
Form 8-K announcing the signing of a definitive merger
agreement with Icon CMT Corp.
27
<PAGE>
SIGNATURE
PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THE
REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE
UNDERSIGNED THEREUNTO DULY AUTHORIZED.
Qwest Communications International Inc.,
a Delaware corporation
By: /s/ Robert S. Woodruff
--------------------------------------
ROBERT S. WOODRUFF
Executive Vice President--Finance and
Chief Financial Officer and Treasurer
(Principal Financial and Accounting
Officer)
November 13, 1998
28
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FINANCIAL STATEMENTS.
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