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FORM 10-K/A
AMENDMENT NO. 2
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
(X) ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934 (FEE REQUIRED)
For the fiscal year ended December 31, 1997
( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 (NO FEE REQUIRED)
Commission File No. 0-22825
RCN CORPORATION
(Exact name of registrant as specified in its charter)
Delaware 22-3498533
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
105 Carnegie Center, Princeton, New Jersey 08540
(Address of principal executive offices) (Zip Code)
Registrant's telephone number including area code: 609-734-3700
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, par value $1.00 per share
(Title of Class)
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.
X Yes No
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. (X)
Number of shares of the Registrant's Stock ($1.00 par value) outstanding at
February 28, 1998
28,889,584 Common Stock
Aggregate market value of Registrant's voting stock held by non-affiliates at
February 28, 1998 computed by reference to closing price as reported by NASDAQ
for Common Stock ($58.75 per share)
$ 914,684,566 Common Stock
Documents Incorporated by Reference
1. Proxy Statement for 1998 Annual Meeting of Shareholders is incorporated by
reference into Part I and Part III of this Form 10-K or any amendment to this
Form 10-K.
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PART I
ITEM 1. BUSINESS
THE COMPANY
Prior to September 30, 1997, the Company was operated as part of C-TEC
Corporation ("C-TEC"). On September 30, 1997, C-TEC distributed 100 percent of
the outstanding shares of common stock of its wholly owned subsidiaries, RCN
Corporation ("RCN" or the "Company") and Cable Michigan, Inc. ("Cable Michigan")
to holders of record of C-TEC's Common Stock and C-TEC's Class B Common Stock as
of the close of business on September 19, 1997 (the "Distribution") in
accordance with the terms of a Distribution Agreement dated September 5, 1997
among C-TEC, RCN and Cable Michigan (the "Distribution Agreement"). See
"Relationship Among RCN, CTE and Cable Michigan." RCN consists primarily of C-
TEC's high growth, bundled residential voice, video and Internet access
operations in the Boston to Washington, D.C. corridor, its existing New York,
New Jersey and Pennsylvania cable television operations, a portion of its long
distance operations and its international investment in Megacable, S.A. de C.V.
("Megacable"). Cable Michigan, Inc. consists of C-TEC's Michigan cable
television operations, including its 62% ownership in Mercom, Inc. As part of
C-TEC's restructuring, C-TEC changed its name to Commonwealth Telephone
Enterprises, Inc. ("CTE").
RCN is developing advanced fiber optic networks to provide a wide range of
telecommunications services including local and long distance telephone, video
programming and data services (including high speed Internet access), primarily
to residential customers in selected markets in the Boston to Washington, D.C.
corridor. The region, one of the most densely populated in the United States,
represents approximately 4% of the geography of the U.S., but accounts for over
26% of the telecommunications market based upon the number of telephone access
lines. The Company believes that of the estimated 22 million homes in the Boston
to Washington, D.C. corridor, approximately 9 million homes are located in high-
density urban and suburban residential areas that will support development of an
advanced fiber optic network on an attractive economic basis. RCN believes that
its capability to deliver multiple services (telephone, video programming and
Internet access) to any given customer on its networks will provide it with
competitive advantages over other competitors. RCN's strategy is to become the
leading single-source provider of voice, video and data services to residential
customers in each of its markets by offering individual or bundled service
options, superior customer service and competitive prices.
RCN's initial advanced fiber optic networks have been established in New York
City and, through a joint venture with Boston Edison Company ("BECO"), in Boston
and surrounding communities. RCN has also entered into a joint venture named
Starpower Communications, L.L.C. ("Starpower") with Pepco Communications, L.L.C.
("Pepco Communications"), an indirect wholly owned subsidiary of Potomac
Electric Power Company ("PEPCO"), to develop an advanced fiber network in the
Washington, D.C. area. In February 1998, RCN acquired Boston and Washington,
D.C.'s largest internet service providers ("ISPs"), Ultranet Communications,
Inc. ("Ultranet"), and Erols Internet, Inc. ("Erols"), respectively. RCN also
benefits from a strategic relationship with MFS Communications Company, Inc.
(now a subsidiary of WorldCom, Inc.) ("MFS/WorldCom") in New York City and
Boston and from its interconnection and resale agreements with incumbent
telephone service providers including Bell Atlantic. RCN believes that these
joint ventures and relationships provide it with a number of important
advantages including access to rights of way and use of existing fiber optic
facilities, the ability to enter its target markets quickly and efficiently and
a reduction in the up-front capital investment required to develop its networks.
In addition, the Company's joint venture partners provide access to additional
assets, equity capital and established customer bases. The Company also benefits
from its relationship with its largest shareholder, Peter Kiewit Sons', Inc.
("PKS"), the founder of MFS Communications Company, Inc. (now a subsidiary of
WorldCom, Inc., "MFS/WorldCom"), and from the experience gained by certain of
the Company's key employees who participated in the development of MFS
Communications Company, Inc.
As of December 31, 1997, the Company had approximately 267,600 connections
which were delivered through a variety of owned and leased facilities including
hybrid fiber/coaxial cable systems, a wireless video
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system and advanced fiber optic networks. In addition, the Company gained
approximately 325,000 Internet service customers as a result of the acquisitions
of Ultranet and Erols. The Company is deploying advanced fiber optic networks
specifically designed to provide high speed, high capacity telecommunications
services for all new network facilities. RCN also intends to upgrade certain of
its hybrid fiber/coaxial cable systems to enable them to provide the same range
of voice, video and data services, including bundled service options. Since it
formally commenced operation of its advanced fiber optic networks in New York
City and Boston in September 1996, RCN has built or acquired, through its joint
venture with BECO and long term lease arrangements, approximately 400 route
miles of fiber optic cable and added approximately 15,100 customer connections
to its advanced fiber optic networks. In addition, during the same period the
Company added approximately 29,700 wireless video, resold telephone and other
connections, the majority of which represent customers that RCN expects to
migrate to its advanced fiber optic networks. At December 31, 1997, RCN had
approximately 82,700 total connections attributable to customers in the New York
City and Boston markets (of which approximately 42,600 were wireless video
service and other connections and approximately 24,900 were resold telephone
connections) and had approximately 184,900 connections attributable to its
hybrid fiber/coaxial cable systems in the states of New York (outside New York
City), New Jersey and Pennsylvania, all within 75 miles of New York City.
Because it delivers multiple services, RCN reports the total number of its
various service connections (for local telephone, video programming and Internet
access) rather than the number of customers.
RCN's extensive operating experience in both the telephone and video
industries and in the design and development of telecommunications facilities
provides it with expertise in systems operation and development, an established
infrastructure for customer service and billing for both voice and video
services and established relationships with providers of equipment and video
programming. In addition, the Company's management team and board of directors
benefit from experience gained in connection with the management of C-TEC, which
prior to September 30, 1997 owned and operated RCN. C-TEC has 100 years of
experience in the telephone business and nearly 25 years of experience in the
cable television business. Both C-TEC and certain members of management also
have extensive experience in the design and development of advanced
telecommunications facilities.
RCN seeks to exploit competitive opportunities which have resulted from
widespread changes in the U.S. telecommunications industry. RCN believes that
density is a critical factor in the effective economic deployment of its
networks, and that the Boston to Washington, D.C. corridor is a particularly
attractive market for developing advanced fiber optic facilities due to
population density, favorable demographics and the aging infrastructure of the
incumbent service providers' network facilities in this region. The Company
applies a subscriber-driven investment strategy focusing on subscriber density,
proximity to the Company's advanced fiber optic networks and network development
costs, in order to determine if the number of potential connections in a target
area will permit network development on an attractive economic basis.
BUSINESS STRATEGY
The Company believes that the opportunity to effectively deploy advanced fiber
optic networks and to compete with incumbent telephone and cable television
service providers results from several key factors, including the broad
deregulation of the telecommunications industry pursuant to the
Telecommunications Act of 1996 (the "1996 Act"), the need for more advanced,
higher capacity networks to meet growing consumer demands for new communications
products and services and the superior technology of the Company's networks. In
order to achieve its goal of becoming the leading provider of
telecommunications, video and data services to residential customers in its
target markets, RCN is pursuing the following key strategies:
Developing Advanced Fiber Optic Networks. RCN's advanced fiber optic
networks are specifically designed to provide a single source for high speed,
high capacity voice, video programming and data services. RCN expects that the
substantial growth of the Internet and demand for high speed data service will
play an important role in the demand for its fiber optic networks. RCN believes
that its high capacity advanced fiber optic networks provide RCN with certain
competitive advantages such as increased capacity (including the ability to
offer bundled voice, video and data services) and generally superior signal
quality and network reliability relative to the typical networks of the
incumbent service providers. By using advanced fiber optic networks capable of
delivering multiple services, RCN is able to address a larger number of
potential subscriber connections in its target markets than incumbent service
providers which typically provide only single or limited services. The migration
of customers to the advanced fiber network will allow RCN to gain additional
revenue and higher margins by facilitating the delivery of multiple services to
customers over RCN's own switches, thereby allowing RCN to gain additional
revenue (and larger margins) from originating and terminating access fees.
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Focusing on Residential Customers in High-Density Markets. RCN seeks to be
the first operator of an advanced fiber optic network providing voice, video and
data services to residential customers in each of its target markets. RCN
believes that it is unique in its markets in offering a wide range of bundled
voice, video and data services to customers in residential areas and in striving
to connect residential customers directly to its advanced fiber optic networks.
RCN also believes that residential customers will be attracted to lower prices,
broader service offerings, enhanced levels of customer care and consumer choice.
Although the Company's primary focus is on residential customers, RCN also
serves certain commercial accounts which are located on or in close proximity to
its networks.
Implementing Subscriber-Driven Investment Strategy. RCN attempts to
efficiently deploy its capital by tying facility development to the procurement
of customer connections. In order to promote its presence in its markets and to
develop a subscriber base for its advanced fiber optic networks, the Company may
provide telephone services to customers located near its advanced fiber networks
by first reselling services, and then by establishing leased facilities (such as
unbundled local loops), in advance of constructing or extending its networks.
RCN also provides wireless video services to approximately 38,000 customers in
New York City with a view to extending the advanced fiber optic network to
service many of these existing customers. In addition, RCN intends to extend its
network to cover the primary areas currently served by Erols and Ultranet.
Utilizing Strategic Alliances and Existing Facilities to Speed and Reduce Cost
of Entry. By utilizing strategic alliances, RCN is able to enter the market
quickly and efficiently and to reduce the up-front capital investment required
to develop its networks. Through alliances with companies such as BECO, Pepco
Communications and MFS/WorldCom, which provide or are expected to provide RCN
with extensive fiber optic networks or other assets, by utilizing certain
components of its own existing cable television infrastructure, and through the
strategic acquisitions of Ultranet and Erols, RCN has been able to expedite and
reduce the cost of market entry and business development and has created the
opportunity to leverage existing customer relationships.
Offering Bundled Voice, Video and Data Services. RCN believes that, as a
full service voice, video and data programming provider, it will be able to
offer a single-source package of voice, video and data services, individually or
on a bundled basis, which is not yet generally available from any incumbent
telephone, cable or other service provider. In addition, services provided over
RCN's advanced fiber optic networks are generally priced at competitive rates as
compared to the incumbent service providers.
Providing Superior Customer Service. RCN seeks to provide superior customer
service as compared to incumbent service providers, with service features such
as a 24-hour-a-day call center and quality control system, on-time service
guarantees and bundled service offerings, providing the consumer with added
choice-and convenience.
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RCN SERVICES
RCN provides a wide range of local and long distance telephone, video
programming and data services, both individually and in bundled service options.
RCN provides these services through a range of facilities including its
advanced fiber optic networks in New York City and Boston, a wireless video
system in New York City, its hybrid fiber/coaxial cable systems in the states of
New York (outside New York City), New Jersey and Pennsylvania, and resale local
and long distance telephony services.
Connections. The following table summarizes the development of RCN's
subscriber base:
<TABLE>
<CAPTION>
As of
12/31/96 3/31/97 6/30/97 9/30/97 12/31/97
<S> <C> <C> <C> <C> <C>
Connections(1)
Advanced Fiber Optic Networks
Voice -- -- 370 1,909 3,214
Video -- -- 1,060 4,870 11,784
Internet -- -- 81 326 150
-------- ------- ------- ------- --------
Subtotal -- -- 1,511 7,105 15,148
Resold Voice 1,875 2,315 4,672 10,953 24,900
Wireless Video & Other(2) 40,162 43,616 46,668 46,053 42,681
-------- ------- ------- ------- --------
Total RCN Telecom 42,037 45,931 52,851 64,111 82,729
-------- ------- ------- ------- --------
Hybrid Fiber/Coaxial Cable
Operations(3) 179,932 180,169 181,790 183,145 184,938
-------- ------- ------- ------- --------
Total connections 221,969 226,100 234,641 247,256 267,667
======== ======= ======= ======= ========
</TABLE>
(1) Because RCN delivers multiple services, the Company accounts for its
customer activity by the number of individual local telephone, video
programming or Internet access services, or "connections", purchased.
Consequently, a single customer purchasing local telephone, video
programming and Internet access constitutes three connections.
(2) Includes approximately 38,000 wireless connections. RCN classifies
connections provided over advanced fiber optic networks within the "Other"
category until the relevant network is capable of providing voice, video and
data services, including local telephone service through an RCN switch.
"Other" also includes, among other things, wireline video connections
serving the University of Delaware (4,474 connections at December 31, 1997).
(3) In August 1997, RCN commenced offering resold local phone service, long
distance and Internet access to customers in the area served by its Hybrid
Fiber/Coaxial Cable Systems in the Lehigh Valley area.
Set forth below is a brief description of RCN's services:
Voice. RCN offers full-featured local exchange telephone service, including
standard dial tone access, enhanced 911 access, operator services and directory
assistance in competition with the incumbent local exchange providers and CLECs.
In addition, RCN offers a wide range of value-added services, including call
forwarding, call waiting, conference calling, speed dial, calling card, 800-
numbers and voice mail. RCN also provides Centrex service and associated
features. RCN's local telephone rates are generally competitive with the rates
charged by the incumbent providers. At December 31, 1997 RCN had approximately
3,200 telephone service connections on its advanced fiber optic networks and
approximately 24,900 customers for resold telephone service.
RCN Long Distance provides long distance telephone services, including
outbound, inbound, calling card, and operator services. These services are
offered to residential and business customers. As of December 31, 1997 RCN
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Long Distance had approximately 13,595 customers. In the future RCN intends to
offer long distance telephone service predominantly to customers whom it expects
will eventually be connected to its own facilities.
Video Services. RCN offers a diverse line-up of high quality basic, premium
and pay-per-view video programming. Depending on the system, RCN offers from 61
to 110 channels. RCN's basic video programming package provides extensive
channel selection featuring all major cable and broadcast networks. RCN's
premium services include HBO, Cinemax, Showtime and The Movie Channel, as well
as supplementary channels such as HBO 2, HBO 3 and Cinemax 2. RCN's StarCinema,
available on the Company's advanced fiber optic networks, utilizes the latest
"impulse" technology allowing convenient impulse pay-per-view ordering of the
latest hit movies and special events instantly from the customer's remote. RCN's
"Music Choice" offers 30 different commercial-free music channels delivered to
the customer's stereo in digital CD quality sound.
As of December 31, 1997, RCN had approximately 11,800 subscribers for its
video programming services provided over advanced fiber optic networks in New
York City and Boston. As of such date, RCN also had approximately 38,000
connections attributable to the wireless video system and approximately 184,900
connections attributable to the hybrid fiber/coaxial cable systems.
RCN also acts as a provider of DirecTV direct broadcast satellite service to
multiple dwelling units ("MDUs") in New York City. DirecTV allows RCN to deliver
an additional 175 channels of programming including exclusive sports
programming.
Internet Access and Data Transmission. RCN's StarPass Internet service
provides access for personal computers to RCN's advanced fiber optic network for
a reliable high speed connection to provide access to electronic mail, World
Wide Web, Internet chat lines and newsgroups and remote access and file transfer
services. RCN provides data transmission services over its advanced fiber optic
network either via two-way dial-up modem over traditional telephone lines or via
cable modem utilizing RCN's high capacity network. RCN also offers private line
point-to-point data transmission services such as DS-1 and DS-3 with the
capability to provide higher speed connections as well. Following the recent
Erols and Ultranet acquisitions, RCN believes it is the largest regional
provider of Internet services in the Northeast.
Migration of Customers to Advanced Fiber Networks
RCN provides wireless video services to customers located near its advanced
fiber optic network in New York City and provides Internet services and resale
telephone service with a view to extending the advanced fiber optic network and
fully activating RCN's own telephone switches to service many of those
customers. As RCN's advanced fiber optic network is extended into these areas or
buildings, customers receiving wireless video service in New York City will be
switched to the advanced fiber optic network from the wireless video network,
and the wireless video equipment will be used to provide service to other
customers in off-network premises. Similarly, as the advanced fiber optic
network is developed and switches are deployed, voice customers will be switched
to the advanced fiber optic network from resale accounts, thereby allowing RCN
to gain additional revenue (and larger margins) from originating and terminating
access fees and to control the related services and service quality.
STRATEGIC RELATIONSHIPS
RCN has developed a number of strategic alliances and relationships in order
to provide it with early entry and to reduce the cost of entry into the market
for telecommunications services. RCN expects to continue to pursue opportunities
that may be afforded by entering into strategic alliances to facilitate network
expansion and entry into new markets.
Fiber Agreements. RCN, through its affiliates, has entered into Fiber
Agreements (the "Fiber Agreements"), each dated May 8, 1997, with MFS/WorldCom,
which owns or has the right to use certain fiber optic network facilities (the
"Fiber Optic Facilities") in the Boston, Massachusetts and Borough of Manhattan,
New York, New York markets (the "Service Areas"). Pursuant to the Fiber
Agreements, MFS/WorldCom (i) will construct and provide extensions connecting
the Fiber Optic Facilities to buildings designated by RCN (the "Extensions") and
(ii) has granted to RCN the right to use certain dedicated fibers in the Fiber
Optic Facilities and the Extensions, except
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that RCN may not use such facilities to deliver telephone services to commercial
customers in the Service Areas. In return, RCN has reimbursed MFS/WorldCom for
the costs MFS/WorldCom incurred to install, construct and acquire the Fiber
Optic Facilities constructed prior to March 31, 1997. RCN has further agreed to
pay all of the costs MFS/WorldCom incurs to (i) install, construct and acquire
the Fiber Optic Facilities constructed between March 31, 1997 and May 8, 1998
and the Extensions, and (ii) maintain, and support RCN's use of, the Fiber Optic
Facilities and the Extensions. Unless earlier terminated upon the occurrence of
certain events set forth therein, including a change of control of RCN, the
Fiber Agreements terminate by their terms on January 1, 2007, provided that (i)
at such time the parties may agree to extend the Fiber Agreements for up to 10
years or enter into other alternative arrangements, and (ii) under certain
circumstances, MFS/WorldCom is required to transfer the Extensions to RCN.
BECO Joint Venture
In September 1996, RCN and BECO, through wholly owned subsidiaries, entered
into a letter of intent to form a joint venture to utilize 126 fiber miles of
BECO's fiber optic network to deliver RCN's comprehensive communications package
in Greater Boston. The venture, in the form of an unregulated entity with a term
expiring in the year 2060, was formed pursuant to a joint venture agreement
dated December 23, 1996 (the "Boston Joint Venture Agreement") providing for the
organization and operation of RCN-BECOCOM, LLC ("RCN-BECOCOM"). RCN-BECOCOM is a
Massachusetts limited liability company organized to own and operate an advanced
fiber optic telecommunications network (the "Network") and to provide, in the
market in and around Boston, Massachusetts (the "Boston Market"), voice, video
and data services, as well as the communications support component of energy
related customer services offered by BECO (collectively, the "Boston Services").
RCN, through RCN Massachusetts, owns 51% of the equity interest in RCN-BECOCOM
and BECO, through a subsidiary, owns the remaining 49% interest. This joint
venture with BECO is reflected on RCN's financial statements on a consolidated
basis.
The closing of the transactions contemplated by the Boston Joint Venture
Agreement occurred on June 17, 1997. At the closing, (i) RCN transferred to RCN-
BECOCOM its business of providing Boston Services; (ii) BECO transferred to RCN-
BECOCOM access to and use of certain existing BECO facilities; (iii) RCN and
BECO made initial cash capital contributions to RCN-BECOCOM; and (iv) the
parties and/or their affiliates executed and delivered (a) the Amended and
Restated Operating Agreement of RCN-BECOCOM dated as of June 17, 1997 (the
"Operating Agreement"); (b) the Construction and Indefeasible Right of Use
Agreement dated as of June 17, 1997 between BECOCOM, LLC and RCN-BECOCOM (the
"IRU Agreement"); (c) the Management Agreement (the "Management Agreement")
dated as of June 17, 1997 among RCN Operating Services, Inc. and BECOCOM, Inc.;
(d) the Exchange Agreement dated as of June 17, 1997 (the "Exchange Agreement");
and (e) the Joint Investment and Noncompetition Agreement dated as of June 17,
1997 among RCN Massachusetts, BECOCOM, Inc. and RCN-BECOCOM (the "Joint
Investment Agreement").
Pursuant to the Operating Agreement, RCN and BECO are required to make any
additional capital contributions required by RCN-BECOCOM's annual budget on a
51%/49% basis. The annual budget will be prepared by RCN and is subject to
review by each member of RCN-BECOCOM. RCN will manage the business of RCN-
BECOCOM; however, certain extraordinary actions require the consent of both
parties. In addition, the Operating Agreement provides that if a deadlock arises
relating to a merger, reorganization, issuances of equity, liquidation or
bankruptcy, amendments to the organizational documents or an expansion of
operations of RCN-BECOCOM beyond those contemplated by the Operating Agreement,
the disputing party will either sell its interest or purchase the other party's
interest in the joint venture. Neither RCN nor BECO may
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transfer its interest in RCN-BECOCOM until June 17, 2000 without the other's
written consent. After such date, each party has the right to purchase the
interest proposed to be sold by the other party. If a party proposes to sell
more than 33% of its interest, the other party has "tag-along" rights to sell a
proportionate share of its interest. In the event a member's interest becomes
less than 25%, the other members have the option to purchase such interest at
fair market value. Upon a change in control of either RCN Massachusetts or
BECOCOM, the other party has the right to purchase all of the equity interest in
RCN-BECOCOM for fair market value, as determined by an appraisal proceeding.
RCN will manage the business of RCN-BECOCOM pursuant to the terms of the
Management Agreement and, in consideration therefor, will receive reimbursement
for its reasonable costs, and a performance-based fee (based on factors
including the number of subscribers and operating cash flow) to be determined by
agreement of RCN and RCN-BECOCOM. The initial term of the agreement expires on
December 31, 2001. The agreement provides for automatic successive three-year
renewal periods, unless notice is given ninety days before the end of the
period.
Pursuant to the IRU Agreement, BECO will, for certain agreed upon fees, (i)
provide construction services to build out the Network, (ii) make available to
RCN-BECOCOM (a) all of the available capacity of BECO's existing fiber backbone,
and (b) the ability to use BECO's real estate, poles, easements and other
interests for the construction and operation of the Network and (iii) maintain
the Network. BECO's construction obligations expire on June 17, 2007 and the
term of the IRU Agreement generally expires on December 31, 2060. One year
before each respective expiration date, BECO agrees to commence good-faith
negotiations to extend construction obligations beyond June 17, 2007 and to
allow continued use of BECO's facilities beyond December 31, 2060.
Under the Joint Investment Agreement, BECO will have the right to acquire up
to a 20% equity interest in any joint venture between RCN and an electric
utility company formed to provide any services similar to the Boston Services in
New England outside the Boston Market. BECO's joint investment right shall
terminate (i) upon BECO's stake in RCN-BECOCOM dropping below a 1/3 interest and
(ii) on the later to occur of (a) June 17, 2002 or (b) two years after RCN's
stake in RCN-BECOCOM falls below a 1/3 interest. The agreement also provides
that neither RCN, BECO nor their affiliates will be permitted to be involved in
any other enterprise providing services similar to the Boston Services in the
Boston Market. This covenant not to compete will survive for a period of two
years after either party is no longer a member of RCN-BECOCOM.
Pursuant to the Exchange Agreement, BECO had the right at the time of the
Distribution, and has the right every two years thereafter, to convert its
ownership interest in RCN-BECOCOM into the Common Stock of RCN pursuant to
specific terms and conditions, including exercise periods, appraisal procedures
and restrictions specifically set forth in the Exchange Agreement. Although
BECO exercised its conversion rights, BECO will remain obligated to make 49% of
all cash contributions by the parties and any cash contributions made after
conversion will result in it owning a portion of RCN-BECOCOM based on the value
of RCN-BECOCOM at the time of the contribution. BECO may exercise its conversion
rights in whole or in part from time to time. BECO has notified RCN that it has
elected to exercise its option to the full extent permitted by the Exchange
Agreement with respect to 1997. RCN and BECO are presently in discussions with
respect to the calculation of the agreed upon value for the exercise of such
option. BECO's right to convert its joint venture interest into Company Common
Stock is subject to certain limitations designed to ensure that the conversion
does not jeopardize the tax free nature of the Distribution. In the event BECO
is unable to convert any portion of its interest as a result of such
limitations, BECO has the right to require RCN to purchase such portion. Subject
to certain restrictions set forth in the Exchange Agreement, BECO will also be
entitled, upon exchanging its investment interest in RCN-BECOCOM for Company
Common Stock, to customary registration rights with respect to such shares.
<PAGE>
RCN expects to benefit from the ability to utilize BECO's large fiber optic
network, its focus on innovative technology, its sales and marketing expertise
and its reach into the market. In the future, the venture may expand into energy
management and property monitoring services. Starting in Boston, the joint
venture partners will consider further expansion into surrounding markets. RCN
anticipates that as a result of its access to the extensive BECO network, RCN's
reliance on and utilization of MFS/WorldCom facilities in Boston will be reduced
significantly.
Starpower Joint Venture
On August 1, 1997, RCN Telecom Services, Inc., a subsidiary of RCN, and
Potomac Capital Investment Corporation ("PCI"), a wholly owned subsidiary of
PEPCO, entered into a letter of intent (the "Letter of Intent") to form a joint
venture to own and operate a communications network to provide voice, video,
data and other communications services to residential and commercial customers
in the greater Washington, D.C., Virginia and Maryland area (the "Washington,
D.C. Market"). Starpower, an unregulated limited liability company with a
perpetual term, was formed on October 28, 1997 by RCN Telecom Services of
Washington, D.C., Inc. ("RCN Washington") and Pepco Communications. Starpower
was formed to construct, own, lease, operate and market a network for the
selling of voice, video, data and other telecommunications services (the
"Relevant Business") to all potential commercial and residential customers in
the Washington, D.C. Market. RCN, through RCN Washington, owns 50% of the equity
interest in Starpower and PCI, through Pepco Communications, owns the remaining
50% interest. Starpower is accounted for by RCN under the equity method of
accounting.
The closing (the "Starpower Closing") of the Starpower joint venture occurred
on December 19, 1997. At the closing, RCN Washington transferred to Starpower
all its right, title and interest in and to (i) all customer accounts of RCN
Long Distance in the Washington, D.C. Market, (ii) its business plan in the
Washington, D.C. Market and experience with respect to the Relevant Business,
(iii) all building access agreements covering any property located in the
Washington, D.C. Market, (iv) the Support Services Agreement (as described
below) and (v) the benefit of certain agreements pursuant to the Assignment of
Benefits Agreement (as described below). The documents signed at the Starpower
Closing were the Amended and Restated Operating Agreement of Starpower dated as
of December 18, 1997 by and between Pepco Communications and RCN Washington
("Amended and Restated Operating Agreement"), Fiber Use Agreement dated as of
December 18, 1997 between PEPCO and Starpower ("Fiber Use Agreement"), Agency
Agreement dated as of December 18, 1997 by and between RCN Washington, RCN
Telecom Services of Maryland, Inc., RCN Telecom Services of Virginia, Inc. and
Starpower ("Agency Agreement"), Non-competition Agreement dated as of December
18, 1997 by and among RCN Telecom Services, Inc., PCI and Starpower ("Non-
competition Agreement"), Assignment of Benefits Agreement dated as of December
18, 1997 by and between RCN Washington and Starpower ("Assignment of Benefits
Agreement"), Support Services Agreement dated as of December 18, 1997 by and
between RCN Operating Services, Inc. and Starpower ("Support Services
Agreement"), Guarantee dated as of December 18, 1997 by PCI on behalf of Pepco
Communications in favor of Starpower, Guarantee dated as of December 18, 1997
by RCN on behalf of RCN Washington and other RCN obligors in favor of Starpower
and Contribution Agreement dated as of December 18, 1997 by and between RCN
Washington and Starpower ("Contribution Agreement"). RCN Washington and Pepco
Communications also each paid $12.5 million in cash in January 1998 as their
initial capital contributions.
Pursuant to the Amended and Restated Operating Agreement, RCN Washington and
Pepco Communications are each required to make additional capital contributions
in accordance with a schedule set forth in such agreement on a 50%/50% basis.
Failure of either RCN Washington or Pepco Communications to make a scheduled
capital contribution or to vote in favor of certain additional capital
contributions may result in the recalculation of equity interests. The business
and affairs of Starpower is to be managed by RCN Washington and Pepco
Communications. So long as RCN Washington and Pepco Communications maintain a
50%/50% equity interest in the joint venture, each of RCN Washington and Pepco
Communications will appoint three members to the operating committee, the
approval of which is required for any business action. Certain fundamental
business actions, such as mergers, acquisitions, sales of substantially all of
the assets, liquidation and amendments to the certificate of organization or any
agreement signed at the Starpower Closing, require the unanimous approval of the
operating committee regardless of whether the parties continue to maintain a
50%/50% ownership interest. Failure to reach agreement may trigger a deadlock
event. In the event a deadlock arises within the first three years of the joint
venture, the proposed action shall be deemed rejected. If the deadlock arises
thereafter, the disputing party may give a notice to
<PAGE>
the other party offering to sell its membership or to purchase all membership
interests from the other party; the offeree has the obligation to elect to buy
or sell its interest. Subject to certain exceptions, neither RCN Washington nor
Pepco Communications may sell any interest in Starpower for four years.
Thereafter, RCN Washington or Pepco Communications may sell any of its
membership interests with the written consent of the other subject to a right of
first offer by the other party. RCN Washington shall be restricted from
transferring its interest if Pepco Communications can demonstrate that such
assignment would have a material adverse impact on Starpower's business. Upon a
change of control of RCN Washington or Pepco Communications, which the other
party has reason to believe will have a material adverse effect on Starpower,
the other party may offer to sell its membership interests or to acquire such
party's membership interests or accept the change of control. The offeree has
the right to elect to buy or sell its interest. If a party proposes to sell its
interest to a third party, the other party has "tag-along" rights to sell a
proportionate share of its interest. Both RCN Washington and Pepco
Communications may transfer their membership interests to certain affiliates.
Under the Fiber Use Agreement, PEPCO agreed, for certain agreed upon fees, (i)
to provide construction services to develop a network and (ii) to grant
Starpower an indefeasible right of use of certain facilities and an irrevocable
right to install, maintain, use and operate its strand fiber connections to
leased facilities. Starpower has the right, at the end of the term, to purchase
not less than the whole network at the fair market value less the amount
previously paid by Starpower with respect to such facilities. The initial term
is ten years and the agreement may be renewed four times.
Under the Support Services Agreement, a subsidiary of RCN will provide support
services including customer service, billing, marketing, and certain
administrative, accounting and technical support services, each of which shall
be provided at cost. The Support Services Agreement also contains certain
indemnity provisions.
Under the Non-competition Agreement, for so long as either RCN Washington or
Pepco Communications owns an interest in Starpower, neither party nor any of
their affiliates may compete with any Relevant Business in the Washington, D.C.
Market. Neither RCN Washington nor Pepco Communications shall attempt to
solicit, divert or accept business from the customers of Starpower for any
Relevant Business in the Washington, D.C. Market or solicit any individual who
is employed by Starpower.
Starpower agreed, in the Agency Agreement, to serve as RCN Washington's
exclusive agent for the provision of telephony services in the Washington, D.C.
Market until Starpower receives sufficient authorization for it to provide
telephony services in the Washington, D.C. Market. All revenues and customers
under this Agency Agreement belong to Starpower. Starpower must indemnify RCN
Washington for any tax liability resulting from its obligations under this
Agency Agreement. The Agency Agreement also contains certain other indemnity
provisions.
Pursuant to the Assignment of Benefits Agreement, RCN Washington assigned the
benefits of all of the agreements (the "Assigned Agreements") with suppliers of
programming and entertainment, voice, video and data services,
telecommunications equipment and other products and services useful in the
conduct of the Relevant Business in the Washington, D.C. Market to Starpower.
RCN Washington may not transfer or assign its interest in the Assigned
Agreements if doing so would have a material adverse effect on Starpower's
ability to conduct the Relevant Business in the Washington, D.C. Market. In
addition, RCN Washington may not amend, modify or assign the Assigned Agreements
without the prior written consent of Starpower and Starpower has the right to
terminate any agreement amended, modified or assigned without its consent. RCN
Washington has agreed to take all reasonable steps necessary to obtain consent
for Starpower to use programming agreements prior to the date Starpower begins
offering OVS services. The Assignment of Benefits Agreement expires on December
19, 1998 and Starpower has certain renewal rights. Starpower may terminate the
Assignment of Benefits Agreement on 60 days notice.
<PAGE>
RCN has agreed to unconditionally guarantee the due and punctual performance
and discharge all of its affiliates' material covenants, warranties,
undertakings and other obligations under the agreements signed at the Starpower
Closing. PCI has agreed to unconditionally guarantee the due and punctual
performance and discharge by Pepco Communications of all its material covenants,
warranties, undertakings and other obligations under the Operating Agreement.
RECENT ACQUISITION TRANSACTIONS
Merger with Erols Internet, Inc.
Erols is a leading regional ISP with approximately 293,000 residential and
business subscribers as of December 31, 1997 in targeted markets, including New
York City, Philadelphia, Washington, D.C. and Boston. Erols currently operates
57 physical points of presence ("POPs") throughout its geographic markets, and
also currently utilizes 32 "Virtual POPs," which permit subscribers located
adjacent to, but outside of the local calling areas of, physical POPs to dial
into the Erols network on a local basis through arrangements with the relevant
local exchange carrier ("LEC"). Erols offers a broad range of Internet-based
services, including (i) Global Trader , Erols' turn-key e-commerce product for
small businesses, (ii) Internet security services, including security consulting
and virtual private networks, and (iii) Web hosting, design and development
services.
On January 21, 1998, RCN entered into the Agreement and Plan of Merger (the
"Erols Merger Agreement") among RCN, Erols, Erol Onaran, Gold & Appel Transfer,
S.A., a British Virgin Islands corporation ("Gold & Appel"), and ENET Holding,
Inc., a Delaware corporation and a wholly owned subsidiary of RCN ("ENET"), to
acquire all of the outstanding shares of common stock of Erols. On February 20,
1998 Erols merged with and into ENET (the "Erols Merger"), with ENET as the
surviving corporation. The total consideration paid by RCN in the Erols Merger
was $29.2 million in cash, 1,730,648 shares of RCN Common Stock plus the
assumption and repayment of $5.8 million of debt (including repayment of accrued
interest). Additionally, the Company is converting approximately 999,000 Erols
stock options to approximately 699,000 RCN stock options with an average
exercise price of $3.424 per share.
The Erols Merger Agreement contains customary representations, warranties, and
covenants by each party, which representations and warranties will survive until
March 31, 1999, except for certain specified representations and warranties
which will survive indefinitely or until the expiration of the applicable
statute of limitations. Pursuant to the Erols Merger Agreement, each party has
agreed to provide indemnification from damages arising out of any
misrepresentation or breach of warranty, covenant or agreement made or to be
performed by such party pursuant to the Erols Merger Agreement. In addition,
Erol Onaran has agreed to provide indemnification from damages arising out of
any misrepresentation or breach of warranty, covenant or agreement made or to be
performed by Erols on or before the Effective Time, subject to certain
thresholds and limitations, and arising from certain matters set forth in the
Erols Merger Agreement.
Pursuant to the Erols Merger Agreement, at the Effective Time both an escrow
agreement (the "Erols Escrow Agreement") and a registration rights agreement
(the "Erols Registration Rights Agreement") were executed and delivered. Under
the terms of the Erols Escrow Agreement, RCN delivered to the Erols Escrow Agent
an aggregate of approximately $5.84 million in cash and 93,210 shares of RCN
Common Stock to be held, invested and distributed by the Erols Escrow Agent
pursuant to the Erols Escrow Agreement. Under the terms of the Erols
Registration Rights Agreement, Erol Onaran and Gold & Appel will each receive
customary demand and piggy-back registration rights, subject to certain
limitations as set forth in the Erols Registration Rights Agreement.
<PAGE>
RCN expects to contribute to Starpower, the joint venture with Pepco
Communications, the subscribers acquired in the acquisition of Erols located in
the Washington, D.C. area in which Starpower operates. The joint venture
partners of Starpower are currently negotiating the terms of such contribution.
On February 20, 1998, approximately 61% of all of Erols' subscribers were
located in the relevant Washington, D.C. area. RCN anticipates that PCI will
make a contribution equal to the value of such subscribers.
Merger With Ultranet Communications, Inc.
Ultranet is a leading ISP in the Boston area with more than 32,000 residential
and business customers in New England. Ultranet provides Internet service to
over 500 schools, and is presently building a network which will provide access
throughout New Hampshire's universities and colleges. Ultranet has a wide
network of 42 POPs. Services Ultranet offers to subscribers include (i) virtual
hosting, which gives customers a corporate presence on the Internet, (ii)
firewall security, which provides high quality control in monitoring access to
documents and visitors to the customer's websites, and (iii) UltraFax, which
allows customers to send faxes from their desktops. Ultranet also offers its
customers access to its network via an 800 number which allows access from every
major city in the world.
On January 21, 1998, RCN, UNET Holdings, Inc., a wholly-owned subsidiary of
RCN, and Ultranet entered into an Agreement and Plan of Merger (the "Ultranet
Merger Agreement"). The transaction was completed in February 1998. The total
consideration for the acquisition was approximately $7.3 million in cash,
approximately 890,384 shares of RCN Common Stock and $3.0 million in deferred
compensation. Additionally, the Company is converting approximately 63,500
Ultranet stock options to 117,052 RCN stock options at an average exercise price
of $1.825 per share and making cash payments aggregating approximately $.5
million to certain other holders of UltraNet stock options.
RCN also agrees to indemnify Ultranet and its directors, officers and
stockholders from and against liabilities or expenses incurred (i) in connection
with the severance benefits under any severance arrangement applying to any
former employee of Ultranet employed by RCN after the Ultranet Merger is
consummated, (ii) relating to a former employee's employment and/or termination
by RCN after the Ultranet Merger is consummated and (iii) incurred by an
indemnified person with respect thereto.
RCN expects to contribute to its joint venture with BECO the subscribers
acquired in the acquisition of Ultranet located in the Boston area in which the
BECO joint venture operates as well as 1.36% (or all of Erols' subscribers
located in Boston) of the subscribers acquired in the acquisition of Erols. On
February 27, 1998, approximately 27% of all of Ultranet's subscribers were
located in the relevant Boston area. RCN anticipates that BECO will make a
corresponding contribution to the joint venture in the form of a note in the
principal amount of 49/51 of the agreed value of the subscribers contributed by
RCN.
Indemnification and Noncompetition Agreement
Certain stockholders holding at least 95% of the Ultranet Common Stock, Series
A Preferred Stock and Series B Preferred Stock executed an Indemnification and
Noncompetition Agreement (the "Indemnification Agreement") which provides that
certain representations and warranties included in the Ultranet Merger Agreement
will survive the consummation of the merger. Such stockholders agree to
indemnify RCN, severally and on a pro rata basis, and RCN agrees to indemnify
the stockholders against all losses incurred by any of them arising out of any
breach of any tax representation in the Ultranet Merger Agreement insofar as
such breach causes the merger not to qualify as a reorganization or any material
failure to perform any of its covenants or agreements contained in the Ultranet
Merger Agreement. The maximum amount of indemnification by the stockholders on
one hand and by RCN on the other hand is $7.5 million plus certain amounts up to
$2.5 million with respect to breach of tax representations.
The Indemnification Agreement will provide that the stockholders will not
knowingly take any action which would cause the merger not to qualify as a
reorganization. Certain employees will also agree not to engage in any activity
which would compete with Ultranet in the geographic region identified as the
"Boston-Washington" corridor for a period ending the earlier of five years after
the consummation of the merger or one year after his or her termination (or two
years in the case of termination for cause or voluntary termination).
<PAGE>
As a result of the expansion of the Company's Internet business, the Company
is exposed to certain uncertainties regarding Internet businesses. The
Company's Internet business will depend in part upon the continuing development
and expansion of the Internet and the market for Internet access. Important
issues concerning business and personal use of the Internet (including security,
reliability, cost, ease of use, access and quality of service) remain unresolved
and may significantly affect the acceptance of the Internet for commerce and
communication and the growth of Internet use. Internet network infrastructure is
vulnerable to computer viruses and other similar disruptive problems caused by
its users, other Internet users or other third parties. Computer viruses and
other problems could lead to interruptions of, delays in, or cessation of
service, by the Company, as well as corruption of the Company's or its
subscribers' computer systems. In addition, there can be no assurance that
subscribers or others will not assert claims of liability against the Company as
a result of events such as computer viruses, other inappropriate uses or
security breaches. The Company's ability to provide Internet service will depend
in part on its ability to provide sufficient capacity, both at the level of
particular POPs (affecting only subscribers attempting to use that POP) and in
connection with system-wide services (such as e-mail and news services, which
can effect all subscribers). In addition, the Company will be dependent in part
on the availability of equipment such as modems, servers and other equipment.
Furthermore, ISPs participate in the Internet through contractual "peering
arrangements" with Internet companies. These contractual arrangements are not
subject to regulation and could be subject to revision in terms, conditions or
costs over time.
Acquisition of Lancit Media Entertainment, Ltd.
On February 27, 1998, RCN entered into an Agreement and Plan of Merger
("Lancit Merger Agreement") with Lancit Media Entertainment, Ltd., a New York
corporation ("Lancit"), and LME Acquisition Corporation, a New York corporation
and a wholly owned subsidiary of RCN ("LME"). Pursuant to the Lancit Merger
Agreement, LME will merge with and into Lancit, with Lancit surviving the merger
and becoming a wholly owned subsidiary of RCN (the "Lancit Merger"). Lancit is a
producer of high-quality children's programming, which has won 11 Emmy Awards.
The consummation of the Lancit Merger is subject to customary conditions,
including the approval by Lancit shareholders of the Lancit Merger.
HYBRID FIBER/COAXIAL CABLE SYSTEMS
RCN's hybrid fiber/coaxial cable systems were operated by C-TEC prior to the
Distribution. The following table summarizes the development of the hybrid
fiber/coaxial cable systems over the last five years:
<TABLE>
<CAPTION>
AS OF DECEMBER 31,
1993 1994 1995 1996 1997
<S> <C> <C> <C> <C> <C> <C>
Homes passed 118,216 119,761 282,836 283,940 290,612
Basic subscribers 87,660 92,140 176,131 179,932 184,938
Basic penetration 74.2% 76.9% 62.3% (1) 63.4% 63.6%
Average monthly revenue per
subscriber for last month $ 40.98 $ 37.67 $ 36.73 (1) $ 39.99 $ 43.08
period
</TABLE>
(1) Decline in basic penetration levels and average monthly revenue per
subscriber in 1995 reflects the acquisition of the Pennsylvania cable systems,
which are in a market in which a competing franchisee also offers service.
The service areas for these cable television networks enjoy favorable customer
demographics. The New York and New Jersey systems primarily serve high growth
affluent bedroom communities in suburban New York City, with 28,411 and 76,127
connections at December 31, 1997 respectively. The system in New York State
serves ten
<PAGE>
municipalities in Duchess, Putnam and Westchester Counties, approximately 45
miles north of New York City. The New Jersey system serves 31 contiguous
municipalities in Hunterdon, Mercer, Morris and Somerset Counties, approximately
50 miles west of Manhattan. The Pennsylvania system, which is the largest
competitive cable television system in the United States, serves Pennsylvania's
Lehigh Valley area including the cities of Allentown, Bethlehem and Easton, and
virtually all of Lehigh and Northampton Counties, and is located less than 10
miles west of the Company's New Jersey system.
INTERCONNECTION
Because access to the public switched telephone network is an essential
component of any regional or national telecommunications network,
interconnection is critical to RCN's ability to provide voice and data services.
Bell Atlantic and the other incumbent local exchange carriers ("LECs") and
independent telephone companies are required to provide interconnection to
competitive local exchange carriers ("CLECs") such as RCN pursuant to the
facilities-based interconnection requirements of Section 251 of the 1996 Act.
Under the 1996 Act, the Regional Bell Operating Companies' ("RBOC's") ability to
offer long-distance service between local access and transport areas ("LATA") is
contingent upon their ability to create an environment allowing economically-
efficient competition in their local markets for both business and residential
services.
RCN has achieved interconnection through comprehensive telephone service co-
carrier interconnection agreements with Bell Atlantic and Sprint-New Jersey
covering their service areas in ten states and the District of Columbia in the
Northeast and New England-Middle Atlantic corridor areas. These agreements will
remain in effect regardless of the outcome of the proceedings regarding Section
251 regulations of the Federal Communications Commission ("FCC"). RCN's
interconnection agreements with Bell Atlantic cover its service areas in the
states of Massachusetts, New York, Vermont, New Hampshire, Maine, Rhode Island,
Delaware, Maryland, New Jersey, Pennsylvania and Virginia and the District of
Columbia. The agreement with Sprint-New Jersey covers its service area in the
State of New Jersey. All of these agreements have been approved by the state
regulatory commissions pursuant to Section 252 of the Communications Act of
1934, as amended by the 1996 Act (the "Communications Act"). RCN believes it has
more interconnection agreements with incumbent LECs than any other company
focused primarily on the residential telecommunications market.
The terms of RCN's interconnection agreements with the incumbent LECs include
the following provisions: (i) interconnection at any technically feasible point
within their networks, equal in quality to what the incumbent LEC provides to
itself or to affiliates, (ii) exchange of all local traffic at a fully
reciprocal and identical rate; (iii) receipt by RCN of access charges for long
distance calls made to and from its customers, including full "pass through" to
RCN of such compensation on number portability; (iv) interim number portability
arrangements to allow customers to keep their telephone numbers when they switch
carriers; (v) unbundled network elements, including local loop transmission from
the incumbent LEC's central offices to the customer's premises distinct from
local switching or other services; (vi) nondiscriminatory access to 911 and
emergency 911 services; directory assistance services to allow RCN's customers
to obtain telephone numbers; operator call completion services and white pages
directory listings for RCN's customers; and (vii) access to the poles, ducts,
conduits and rights-of-way owned or controlled by the incumbent LEC at
nondiscriminatory rates. The interconnection agreements generally have an
initial term of three years and are cancelable thereafter at 90 days' notice.
RESALE ARRANGEMENTS
Resale of Bell Atlantic Local Telephone Services
RCN provides local telephone service on a resale basis to customers not
connected to the advanced fiber optic facilities. As of December 31, 1997 RCN
had 24,900 customers for local telephone services provided through agreements to
act as a reseller of Bell Atlantic local telephone services. RCN offers its
resale customers competitive telephone rates and RCN's superior customer
service. Resale customers are billed by RCN and RCN personnel provision customer
service requests by coordinating with the incumbent LECs on the customers'
behalf.
RCN has entered into agreements to act as a reseller of Bell Atlantic local
telephone services, which enable RCN to grow its subscriber base by offering
telephone services in advance of connecting the customers to an
<PAGE>
advanced fiber optic network. RCN's agreements with Bell Atlantic allow RCN to
purchase at a "wholesale" discount (the amount of which is determined by
regulatory commissions in each state) any telephone services that those
companies offer to their end users, such as local exchange services, vertical
features including Caller ID, Call Waiting, etc., and regional toll calls. The
agreements provide that RCN will be entitled to the most favorable terms and
conditions, including wholesale discounts, available to any telecommunications
carrier reselling similar services.
Long Distance Resale
RCN Long Distance provides long distance telephone services, including private
line, operator and calling card services, to residential and business customers
throughout the United States. Such services are provided through an owned and
leased switching network utilizing leased interconnection facilities and long
distance resale. RCN provides on network origination and termination of long
distance telephone services throughout the Mid-Atlantic and New England states.
For call origination and completion throughout the rest of the country, RCN has
various resale agreements. Specifically, RCN has contracted with Level 3
Communications, Inc. ("LCI") for 800/888 origination, Frontier for off network
origination of outbound calling and various carriers for terminating calls.
DirecTV
In October 1996, RCN signed an agreement with DirecTV to deliver DirecTV's
high-power direct broadcast satellite service to multiple dwelling units
("MDUs") in New York City. DirecTV allows RCN to offer an additional 175
channels of programming including exclusive sports programming.
CUSTOMER SERVICE AND BILLING
RCN has implemented a flexible, customer-service oriented approach which RCN
believes differentiates it from the mass-market strategy of the incumbent
providers. RCN provides customer service 24 hours a day, seven days a week from
established central call centers. The facilities utilize state of the art
technology which allows communication with subscribers, field technicians and
the Company's field offices. The largest of these facilities is located in
Dallas, Pennsylvania and handles the majority of the customer service calls.
RCN's advanced fiber optic network is continuously monitored for quality
control and capacity issues, pursuant to a control system featuring 16 alarm
monitor points per hub site and automated housekeeping alarms.
Billing services for video are provided by CableData while RCN telephony
billing services are provided by Consolidated Communications Systems and
Services. At the present time, RCN customers receive separate billing statements
for video and telephone service although RCN intends to offer a single billing
option in the future.
Account piracy is monitored by ongoing field audits and, in RCN's advanced
fiber optic networks, through use of state of the art scrambling systems.
Potential new customers are generally screened for credit history before being
authorized for service. RCN employs a full-time credit and collection staff as
well as a group that seeks to minimize toll fraud by detecting and monitoring
suspicious calling patterns.
PROGRAMMING AND SUPPLIERS
RCN has secured license arrangements with all of its desired programming
suppliers, some of which provide volume discount pricing structures and/or offer
marketing support to the Company. Many of these arrangements are extensions of
long-standing agreements entered into by or on behalf of the Company's hybrid
fiber/coaxial cable systems, and some are newly negotiated based upon RCN's
"open video system" ("OVS") certifications. RCN has generally obtained these
license arrangements on terms and conditions that it considers favorable.
RCN programming arrangements include arrangements for basic video channels,
premium channels including multi-plexing, pay-per-view movies and events, adult
entertainment, electronic program guide services and digital music services, as
well as retransmission arrangements for relevant network broadcasters.
<PAGE>
The Company generally pays a monthly fee per subscriber per channel for
programming purchased from its suppliers. Programming costs increase in the
ordinary course of the Company's business as a result of increases in the number
of subscribers, expansion of the number of channels provided to customers and
contractual rate increases from programming suppliers. The Company anticipates
that future contract renewals for video providers such as the Company will
result in programming costs exceeding current levels, particularly for sports
programming.
A wide range of national manufacturers are the primary sources of supplies,
equipment and materials utilized in the development and enhancement of the
Company's networks. RCN has entered into Master Purchase Agreements with certain
equipment suppliers which enable it to purchase video and switching equipment on
terms which it considers favorable. The Company anticipates that the costs for
these supplies, equipment and materials will be significant in future periods.
The amount of such costs will depend on numerous factors, many of which are
beyond the Company's control.
RCN LONG DISTANCE
RCN Long Distance Company, a wholly-owned subsidiary of RCN, provides
switched-based resale long distance services to customers on the advanced fiber
optic network as well as other customers. RCN Long Distance operates the long
distance business formerly operated by C-TEC, except within the Commonwealth
Service Territory. During 1996, RCN obtained certification in forty-seven
states. RCN Long Distance also provides local telephone service to commercial
customers. As of December 31, 1997 RCN Long Distance had approximately 13,595
long distance customers.
INTERNATIONAL
The Company owns a 40% interest in Megacable, the second largest cable
television provider in Mexico. Megacable owns 22 wireline cable systems, and one
multi-channel multipoint distribution service ("MMDS") cable system, in Mexico,
principally on the Pacific and Gulf coasts and including Guadalajara, the second
largest city in Mexico, Hermosillo, the largest city in the state of Sonora and
Veracruz, the largest city in the state of Veracruz. At December 31, 1997
Megacable's wireline systems passed approximately 635,350 homes and served
approximately 209,300 subscribers. Megacable had revenues of $23.2 million for
the years ended December 31, 1996 and $30.4 million for the year ended December
31, 1997.
Additionally, Megacable presently holds a 99% interest in Megacable
Comunicaciones de Mexico S.A. ("MCM"). MCM has received a license from the
Mexican government to allow it to build a fiber optic network in Mexico City,
Monterrey and Guadalajara. MCM intends to use this network to provide local
voice and high-speed data service in these cities, principally to commercial
customers in Mexico City.
COMPETITION
Overview
RCN competes with a wide range of service providers for each of the services
that it provides. Virtually all markets for voice and video services are
extremely competitive, and RCN expects that competition will intensify in the
future. In each of the markets in which it offers voice and video programming
services, RCN faces significant competition often from larger, better-financed
incumbent local telephone carriers and cable companies, and RCN often competes
directly with incumbent providers which have historically dominated their
respective local telephone and cable television markets. These incumbents
presently have numerous advantages as a result of their historic monopoly
control of their respective markets. However, RCN believes that most existing
and potential competitors will, at least initially, provide narrower service
offerings over limited delivery platforms as compared to the wide range of
voice, video and data services that will be provided over RCN's fiber-based
networks, thereby providing RCN with an opportunity to achieve important market
penetration.
With respect to local telephone services, RCN competes with the incumbent
LECs, and alternative service providers including CLECs. Commercial mobile radio
services providers, including cellular carriers (such as Bell
<PAGE>
Atlantic Mobile Services), personal communications services ("PCS") carriers
(such as Sprint Spectrum), and enhanced specialized mobile radio services
("ESMRS") providers (such as NexTel), may also become a source of competitive
local and long distance telephone service. However, RCN believes these operators
may primarily use competitive access services to transport their calls among
their radio transmitter/receiver sites through networks that avoid the incumbent
LECs with whom they compete.
With respect to long distance telephone services, RCN faces, and expects to
continue to face, significant competition from the interexchange carriers
("IXCs"), including AT&T, Sprint and MCI, which account for the majority of all
long distance revenue. The major long distance service providers benefit from
established market share and from established trade names brought about by
nationwide advertising. RCN, however, regards its long-distance service as a
complementary service rather than a principal source of revenue. Certain IXCs,
including AT&T, MCI and Sprint, have also announced their intention to offer
local services in major U.S. markets using their existing infrastructure in
combination with resale of incumbent LEC service, lease of unbundled local loops
or other providers' services.
All of the Company's video services face competition from alternative methods
of receiving and distributing television signals and from other sources of news,
information and entertainment such as off-air television broadcast programming,
newspapers, movie theaters, live sporting events, interactive online computer
services and home video products, including videotape cassette recorders. Among
the alternative video distribution technologies are home satellite dish earth
stations ("HSDs") which enable individual households to receive many of the
satellite-delivered program services formerly available only to cable
subscribers. Furthermore, the Cable Television Consumer Protection and
Competition Act of 1992 ("1992 Act") contains provisions, which the FCC has
implemented with regulations, to enhance the ability of cable competitors to
purchase and make available to HSD owners certain satellite-delivered cable
programming at competitive costs. RCN faces additional competition from private
satellite master antenna television ("SMATV") systems that serve condominiums,
apartment and office complexes and private residential developments. The FCC and
Congress have adopted policies providing a more favorable operating environment
for new and existing technologies that provide, or have the potential to
provide, substantial competition to the Company's various video distribution
systems. These technologies include, among others, DBS service whereby signals
are transmitted by satellite to receiving facilities located on customer
premises. The Company expects that its video programming services will face
growing competition from current and new DBS service providers. RCN also
competes with wireless program distribution services such as multi-channel
multipoint distribution service ("MMDS") which use low-power microwave
frequencies to transmit video programming over-the-air to subscribers. The
Company is unable to predict whether wireless video services will have a
material impact on its operations.
Other new technologies, including Internet-based services, may become
competitive with services that RCN can offer. Advances in communications
technology as well as changes in the marketplace and the regulatory and
legislative environment are constantly occurring. Thus, it is not possible to
predict the effect that ongoing or future developments might have on the video
industry or on the operations of the Company.
RCN believes that among the existing competitors, the incumbent LECs,
incumbent cable providers and the CLECs provide the most direct competition to
RCN in the delivery of "last mile" connections for voice and video services.
Incumbent LECs
In each of its target markets for advanced fiber optic networks, RCN faces,
and expects to continue to face, significant competition from the incumbent LECs
(including Bell Atlantic in New York City and Boston), which currently dominate
their local telephone markets. RCN competes with the incumbent LECs in its
markets for local exchange services on the basis of product offerings (including
the ability to offer bundled voice and video services), reliability, state-of-
the-art technology and superior customer service, as well as price. RCN believes
that its advanced fiber optic networks provide superior technology for
delivering high-speed, high-capacity voice, video and data services as compared
to the primarily copper wire based networks of the incumbent LECs. However, the
incumbent LECs have begun to expand the amount of fiber facilities in their
networks and to prepare to re-enter the long distance telephone service market
and, in addition, have long-standing relationships with their customers.
<PAGE>
In addition, under the 1996 Act, and ensuing federal and state regulatory
initiatives, barriers to local exchange competition are being removed. The
introduction of such competition, however, also establishes the predicate for
the incumbent RBOCs, such as Bell Atlantic, to provide in-region interexchange
long distance services. The incumbent RBOCs are currently allowed to offer
"incidental" long distance service in-region and to offer out-of-region long
distance service. Once the incumbent RBOCs are allowed to offer in-region long
distance services, they will also be in a position to offer single source local
and long distance service similar to that offered by RCN and proposed by the
three largest IXCs (AT&T, MCI and Sprint). The Company expects that the
increased competition made possible by regulatory reform will result in certain
pricing and margin pressures in the telecommunications services business.
RCN has sought, and will continue to seek, to provide a full range of local
voice services in competition with incumbent LECs in its service areas. The
Company expects that competition for local telephone services will be based
primarily on quality, capacity and reliability of network facilities, customer
service, response to customer needs, service features and price, and will not be
based on any proprietary technology. As a result of the comparatively recent
installation of RCN's advanced fiber optic networks, its dual path architecture
and the state-of-the-art technology used in its networks, RCN may have capital
cost and service quality advantages over some currently available local networks
relied upon by the incumbent LECs, as well as the competitive advantage provided
by the ability to deliver a bundled voice and video service.
The 1996 Act permits the incumbent LECs and others to provide a wide variety
of video services directly to subscribers in competition with RCN. Various LECs
currently are providing video services within and outside their telephone
service areas through a variety of distribution methods, including both the
deployment of broadband wire facilities and the use of wireless transmission
facilities. The Company cannot predict the likelihood of success of video
service ventures by LECs or the impact on the Company of such competitive
ventures.
Incumbent Cable Television Service Providers
Certain of RCN's video service businesses compete with incumbent wireline
cable companies in their respective service areas. In particular, RCN's advanced
fiber optic networks compete for cable subscribers with the major wireline cable
operators in New York City and Boston, primarily Time-Warner Cable in New York
City and Cablevision in Boston. RCN's wireless video service in New York City
competes primarily with Time-Warner Cable. RCN believes that the expanded
capacity and fiber-to-node architecture of its advanced fiber optic networks in
New York City and Boston make it better equipped to provide high-capacity
communications services than coaxial cable based networks utilizing "tree and
branch" architecture. RCN's Pennsylvania hybrid fiber/coaxial cable television
system competes with an alternate service provider, Service Electric, which also
holds a franchise for the relevant service area.
Since cable television systems generally operate pursuant to franchises
granted on a non-exclusive basis, and the 1992 Act prohibits franchising
authorities from unreasonably denying requests for additional franchises and
permits franchising authorities to operate cable systems, well-financed
businesses from outside the cable industry (such as the public utilities that
own certain of the poles on which cable is attached) may become competitors for
franchises or providers of competing services.
CLECs and Other Competitors
RCN also faces, and expects to continue to face, competition from other
potential competitors in certain of the markets in which RCN offers its
services. Other CLECs such as Teleport Communications Group, compete for local
telephone services, although they have to date focused primarily on the market
for commercial customers rather than residential customers. In addition,
potential competitors capable of offering private line and special access
services also include other smaller long distance carriers, cable television
companies, electric utilities, microwave carriers, wireless telephone system
operators and private networks built by large end-users, including Winstar,
Dualstar and New Vision. However, RCN believes that, at least initially, it is
relatively unique in its markets in offering bundled voice, video and data
services to customers in residential areas, and in striving to connect
residential customers directly to its advanced fiber optic network.
<PAGE>
Internet Services
The market for Internet access services is extremely competitive and highly
fragmented. No significant barriers to entry exist, and accordingly competition
in this market is expected to intensify. The Company competes (or in the future
may compete) directly or indirectly with (i) national and regional ISPs; (ii)
established online services; (iii) computer software and technology companies;
(iv) national telecommunications companies; (v) LECs; (vi) cable operators; and
(vii) nonprofit or educational ISPs, and some of these present or potential
future competitors have or can be expected to have substantially greater market
presence and financial, technical, marketing and other resources than the
Company. Certain of the Company's online competitors, including America Online,
the Microsoft Network and Prodigy, have introduced unlimited access to the
Internet and their proprietary content at flat rates, and certain of the LECs
have also introduced competitive flat-rate pricing for unlimited access (without
a set-up fee for at least some period of time). Bell Atlantic has recently filed
with the Federal Communications Commission (the "FCC") a petition for an
exemption from a regulation prohibiting it from building a high-speed network.
Bell Atlantic's petition requests that such network, which would serve as an
Internet backbone, not be subject to pricing and other regulatory restriction.
The network would span the states from Maine to Virginia. There can be no
assurance that competition will not lead to pricing pressures in the Internet
business.
New Technologies
Other new technologies may become competitive with services that RCN can
offer. Cellularvision, a provider of local multipoint distribution service
("LMDS"), recently began offering wireless Internet and video programming
services in New York City and has announced plans to offer telephone service in
the future. Advances in communications technology as well as changes in the
marketplace and the regulatory and legislative environment are constantly
occurring. In addition, a continuing trend toward business combinations and
alliances in the telecommunications industry may also create significant new
competitors to RCN. The Company cannot predict whether competition from such
developing and future technologies or from such future competitors will have a
material impact on its operations.
REGULATION
The telephone and video programming transmission services offered by the
Company are subject to federal, state and local government regulation. The 1996
Act, which became effective in February 1996, introduced widespread changes in
the regulation of the communications industry, including the local telephone,
long distance telephone, data services, and television entertainment segments in
which the Company operates. The 1996 Act was intended to promote competition and
decrease regulation of these segments of the industry. The law delegates to both
the FCC and the states broad regulatory and administrative authority to
implement the 1996 Act.
Telecommunications Act of 1996
The 1996 Act eliminates many of the pre-existing legal barriers to competition
in the telephone and video programming communications businesses, preempts many
of the state barriers to local telephone service competition that previously
existed in state and local laws and regulations, and sets basic standards for
relationships between telecommunications providers.
Among other things, the 1996 Act removes barriers to entry in the local
exchange telephone market by preempting state and local laws that restrict
competition and by requiring LECs to provide nondiscriminatory access and
interconnection to potential competitors, such as cable operators, wireless
telecommunications providers, and long distance companies. In addition, the 1996
Act provides relief from the earnings restrictions and price controls that have
governed the local telephone business for many years. The 1996 Act will also,
once certain thresholds are met, allow incumbent RBOCs to enter the long
distance market within their own local service regions.
Regulations promulgated by the FCC under the 1996 Act require LECs to open
their telephone networks to competition by providing competitors
interconnection, access to unbundled network elements and retail services at
wholesale rates. As a result of these changes, companies such as RCN are now
able to interconnect with the incumbent LECs in order to provide local exchange
services. Numerous parties appealed certain aspects of these
<PAGE>
regulations, and the appeals were consolidated in the United States Court of
Appeals for the Eighth Circuit. On July 18, 1997, the Eighth Circuit found
constitutional challenges to certain practices implementing cost provisions of
the Telecommunications Act that were ordered by certain state PUCs to be
premature; vacated significant portions of the FCC's nationwide pricing rules;
and confined the use of combined unbundled network elements to instances where
the requesting carrier itself would do the combining. On October 14, 1997, the
Eighth Circuit issued a decision vacating additional FCC rules that will likely
have the effect of increasing the cost of obtaining the use of combinations of
an incumbent LEC's unbundled network elements. On January 26, 1998, the Supreme
Court granted a writ of certiorari under which it will review the July 18 Eighth
Circuit decision; it is expected (but not yet certain) that the Court will hear
arguments on this case in the fall of 1998. The Eighth Circuit decisions create
uncertainty about the rules governing pricing and terms and conditions of
interconnection agreements, and could make negotiating and enforcing such
agreements more difficult and protracted and may require renegotiation of
existing agreements. Prior to the Eighth Circuit decisions, the Company had
entered into interconnection agreements with Bell Atlantic, covering all of its
target market area, that are generally consistent with the FCC guidelines, and
those agreements remain in effect notwithstanding the reversal of the FCC rules.
There can be no assurance, however, that the Company will be able to obtain or
enforce future interconnection agreements, or obtain renewal of existing
agreements, on terms acceptable to the Company.
Certain Bell Operating Companies ("BOCs") have also raised constitutional
challenges to restrictions in the 1996 Act preventing BOCs from entering the
long distance market in their home region. On December 31, 1997, the U.S.
District Court for the Northern District of Texas issued a decision (the "SBC
Decision") finding that Sections 271 to 275 of the 1996 Act are
unconstitutional. SBC Communications, Inc., et al. v. Federal Communications
Commission, et al., Civil Action No. 7:97-CV-163-X. These sections of the Act
impose restrictions on the lines of business in which the RBOCs may engage,
including establishing the conditions they must satisfy before they may provide
in-region interLATA telecommunications services. The District Court has stayed
the SBC Decision pending appeal. If the stay is lifted, the RBOCs (including
Bell Atlantic, which was permitted to intervene in the case) would be able to
provide interLATA services immediately without satisfying the statutory
conditions. Although the Company believes the factual assumptions and legal
reasoning in the SBC Decision are erroneous and therefore the decision will
likely be reversed on appeal, there can be no assurance of this outcome. If the
SBC Decision were upheld on appeal it may have an unfavorable effect on the
Company's business for at least two reasons. First, RBOCs currently have an
incentive to foster competition within their service areas so that they can
qualify to offer interLATA services. The SBC Decision removes this incentive by
allowing RBOCs to offer interLATA service without regard to their progress in
opening their local markets to competition. However, the SBC Decision would not
affect other provisions of the Act which create legal obligations for all ILECs
to offer interconnection and network access, and therefore will not impair the
Company's ability to compete in local exchange markets. Second, the Company is
legally able to offer its customers both long distance and local exchange
services, which the RBOCs currently may not do. This ability to offer "one-stop
shopping" gives the Company a marketing advantage that it would no longer enjoy
if the SBC Decision were upheld on appeal. The Company cannot predict either the
outcome of these or future challenges to the 1996 Act, any related appeal of
regulation or court decision, or the eventual effect on its business or the
industry in general.
<PAGE>
The 1996 Act also makes far-reaching changes in the regulation of the video
programming transmission services offered by RCN, including changes to the
regulations applicable to video operators, the elimination of restrictions on
telephone company entry into the video business, and the establishment of a new
OVS regulatory structure for telephone companies and others to offer such
services. Under the 1996 Act, local telephone companies, including both
incumbent LECs such as Bell Atlantic, and CLECs such as RCN, may provide service
as traditional cable television operators subject to municipal cable television
franchises, or they may opt to provide their programming over non-franchised
open video systems subject to certain conditions, including, but not limited to,
making available a portion of their channel capacity for use by unaffiliated
program distributors and satisfying certain other requirements, including
providing capacity for public, educational and government channels, and payment
of a gross receipts fee equivalent to the franchise fee paid by the incumbent
cable television operator. RCN is one of the first CLECs to provide television
programming over an advanced fiber optic network pursuant to the OVS regulations
implemented by the FCC under the 1996 Act. As discussed below, RCN is currently
providing OVS service in the City of Boston, in the City of New York and in a
number of communities surrounding Boston. Starpower is negotiating similar
agreements in Washington and surrounding communities.
Regulation of Voice Services
RCN's voice business is subject to regulation by the FCC at the federal level
with respect to interstate telephone services (i.e., those that originate in one
state and terminate in a different state). State regulatory commissions have
jurisdiction over intrastate communications (i.e., those that originate and
terminate in the same state).
State Regulation of Intrastate Local and Long Distance Telephone Services.
RCN's intrastate telephone services in Boston, New York City, and the Lehigh
Valley are (and Starpower's similar services in the Washington area will be)
regulated by the public service commissions or comparable agencies of the
various states in which these services are offered. RCN subsidiaries have
received either permanent or interim authority to offer intrastate telephone
services, including local exchange service, in Massachusetts, New York,
Pennsylvania, Maryland, the District of Columbia, and Virginia (as well as in
some neighboring jurisdictions where the Company does not currently operate but
may expand in the future). Starpower has filed separately applications for
similar authority in Maryland, the District of Columbia, and Virginia.
Starpower's application in Maryland has been granted. RCN's resale agreements
with Bell Atlantic have been approved, pursuant to Section 252 of the
Communications Act, by state regulatory commissions in Delaware, the District of
Columbia, Maine, Maryland, Massachusetts, New York, New Jersey, New Hampshire,
Pennsylvania, Rhode Island, Vermont, and Virginia.
RCN Long Distance Company is authorized to offer intrastate long distance
services in Pennsylvania, New York and Massachusetts and, in addition, has
received state regulatory authority to offer such services in 45 other states
nationwide. Pursuant to such authorizations, RCN Long Distance Company is
permitted to resell intrastate long distance services both to other carriers,
including RCN's local operating subsidiaries and Starpower for resale to their
end user subscribers, and to its own end user customers.
FCC Regulation of Interstate and International Telephone Services. RCN,
through several of its subsidiaries, including RCN Long Distance Company, may
also provide domestic interstate telephone services nationwide pursuant to
tariffs on file at the FCC, and has been authorized by the FCC under Section 214
of the 1996 Act to offer worldwide international services as well. RCN is
authorized to resell in-state long-distance services in 48 states (all except
Alaska and Hawaii), and, where required, has registered with or obtained
licenses or certificates from state regulatory agencies for the provision of
this service.
<PAGE>
Local Regulation of Telephone Services. Municipalities also regulate limited
aspects of RCN's voice business by, for example, imposing various zoning
requirements and, in some instances, requiring telecommunications licenses,
franchise agreements and/or installation permits for access to local streets and
rights-of-way. In New York City, for example, RCN will be required to obtain a
telephone franchise in order to provide voice services using its advanced fiber
optic network facilities located in the streets of New York City (although
services may be provided over certain leased or resold facilities pending
receipt of a franchise).
Regulation of Video Services
Open Video Systems. In February 1997, RCN subsidiaries were certified to
operate OVS networks in the five boroughs of New York City and, as part of the
BECO joint venture, in Boston and 47 surrounding communities. Initiation of OVS
services is subject to completion of an open enrollment period for non-
affiliated video programmers to seek capacity on the systems and upon
negotiation of certain agreements with local governments. The initial open
enrollment period for both the New York City and Boston area systems has
expired. RCN executed an agreement with the City of Boston on June 2, 1997, and
initiated OVS service in the City on that day. Pursuant to its agreement with
the City of Boston, RCN will be required to pay a fee to the City equal to 5% of
video revenues. RCN has entered into similar OVS agreements or is in the process
of negotiating agreements with certain other Boston-area municipalities, either
to offer OVS services or franchised cable television services. RCN executed an
agreement with the City of New York on December 29, 1997, and has initiated OVS
service in the Borough of Manhattan pursuant to that agreement.
In areas where it offers video programming services as an OVS operator, RCN is
required to hold a 90-day open enrollment period every three years, during which
times RCN will be required to offer capacity on its network to other VPPs. Under
the OVS regulations, RCN must offer at least two-thirds of its capacity to
unaffiliated parties, if demand for such capacity exists during the open
enrollment period. In certain areas, RCN is in discussions with local municipal
authorities to explore the feasibility of obtaining a cable franchise in lieu of
an OVS agreement, and will consider providing RCN video service pursuant to
franchise agreements rather than OVS certification, if franchise agreements can
be obtained on terms and conditions acceptable to RCN. However, RCN will
consider the relative benefits of OVS certification versus local franchise
agreements, including the possible imposition of universal service requirements,
before making any such decisions. In addition, the current FCC rules concerning
OVS are subject to appeal in the United States Court of Appeals and, to the
extent that certain favorable aspects of the FCC's rules are overturned on
appeal, the determination of whether to operate as an OVS provider versus as a
franchised cable television operator may be affected. Moreover, the incumbent
cable television provider in Boston, Cablevision Systems, has requested that the
FCC permit it to obtain capacity on RCN's Boston area OVS network, and Time
Warner, the incumbent cable television provider in certain communities in the
Boston area, has made a similar filing at the FCC with respect to its request
for capacity on the Boston OVS network. RCN will continue to oppose these
requests, but to the extent that the FCC were to grant any such request(s), such
a result would likely affect the Company's determination as to whether to
operate as an OVS provider versus as a franchised cable television operator.
Prior to its certification as an OVS provider, RCN offered limited video
programming services using the video dial tone ("VDT") services offered by
MFS/WorldCom in Manhattan and the City of Boston. In February 1997, the FCC held
that MFS/WorldCom's facilities did not qualify as video dialtone facilities
entitled to an extension of time to comply with the newly adopted OVS rules;
nonetheless, the FCC did not direct MFS/WorldCom and RCN to cease video
programming distribution operations over the MFS/WorldCom platform. One of the
incumbent cable television companies in New York City has filed a complaint with
the New York Public Service Commission challenging the former (pre-OVS)
operations of RCN and WorldCom under the VDT framework, which remains pending
before that Commission.
Wireless Video Services. RCN's 18 GHz wireless video services in New York
City are distributed using microwave facilities provided by Bartholdi Cable
pursuant to temporary authorizations issued to Bartholdi Cable by the FCC.
Bartholdi Cable has agreed to provide transmission services to RCN until RCN has
either converted the wireless video subscribers to its advanced fiber optic
network facilities or has obtained FCC authority to provide such services
pursuant to its own wireless radio licenses. In addition, Bartholdi Cable has
agreed to transfer to RCN the transmission equipment on demand. Bartholdi
Cable's obligation to provide transmission services is subject to
<PAGE>
Bartholdi Cable having licenses from the FCC to provide such services. The
qualifications of Bartholdi Cable to hold certain of the licenses needed to
provide transmission services to RCN are at issue in an FCC proceeding in which
an Initial Decision was released on March 6, 1998. In the Initial Decision, the
Administrative Law Judge found Bartholdi unqualified with respect to 15 such
licenses. The Initial Decision will become effective 50 days after its release
unless Bartholdi, as expected, files exceptions to the Initial Decision within
30 days of its release or the Commission elects to review the case on its own
motion. Because of the uncertainty as to Bartholdi Cable's right in the future
to offer transmission services to RCN, the Company filed its own license
applications at the FCC for all of the microwave transmission paths which are
currently being used by Bartholdi Cable to provide transmission services to RCN
and, in light of the increased uncertainties resulting from the Initial Decision
in the FCC proceeding involving certain of Bartholdi's licenses, the Company
expects now actively to pursue its license applications. While the Company
expects to receive authorizations to transmit over these microwave paths, there
can be no assurance that RCN will be able to offer wireless video services
pursuant to its own FCC licenses or that the FCC's investigation will be
resolved favorably. The failure to obtain such license or resolve such
proceedings would materially adversely affect the Company's wireless video
operations in New York City.
There can be no assurance that RCN will be able to obtain or retain all
necessary authorizations needed to construct advanced fiber optic network
facilities, to convert its wireless video subscribers to an advanced fiber optic
network or to offer wireless video services pursuant to its own FCC licenses.
Hybrid Fiber/Coaxial Cable. RCN's hybrid fiber/coaxial cable systems are
subject to regulation under the Cable Television Consumer Protection and
Competition Act of 1992, as amended (the "1992 Act"), which provides, among
other things, for rate regulation for cable services in communities that are not
subject to "effective competition," certain programming requirements, and
broadcast signal carriage requirements that allow local commercial television
broadcast stations to require a cable system to carry the station. Local
commercial television broadcast stations may elect once every three years to
require a cable system to carry the station ("must-carry"), subject to certain
exceptions, or to withhold consent and negotiate the terms of carriage
("retransmission consent"). A cable system generally is required to devote up to
one-third of its activated channel capacity for the carriage of local commercial
television stations whether pursuant to the mandatory carriage or retransmission
consent requirements of the 1992 Act. Local non-commercial television stations
are also given mandatory carriage rights. The FCC recently issued rules
establishing standards for digital television ("DTV"). Among other provisions,
the FCC's rules require television stations to simulcast their NTSC and DTV
signals for a period of years. During this simulcast period, it is unclear
whether must-carry rules will apply to DTV signals. The Communications Act
permits franchising authorities to require cable operators to set aside certain
channels for public, educational and governmental access programming. Cable
systems with 36 or more channels must designate a portion of their channel
capacity for commercial leased access by third parties to provide programming
that may compete with services offered by the cable operator.
On September 8, 1997, the Company was notified by the FCC that it has ruled
that certain of the Company's upper levels of service for its New Jersey systems
are regulated levels of service and that the Company's rates for such levels of
service have exceeded the allowable rates under the FCC rate regulation rules
which have been effective since September 1993. The Company had treated these
levels of service as unregulated. The Company intends to contest this decision.
The Company does not believe that the ultimate resolution of this matter will
have a material impact on its results of operations or financial condition.
Because a cable communications system uses local streets and rights-of-way,
such cable systems are generally subject to state and local regulation,
typically imposed through the franchising process. The terms and conditions of
state or local government franchises vary materially from jurisdiction to
jurisdiction and generally contain provisions governing cable service rates,
franchise fees, franchise term, system construction and maintenance obligations,
customer service standards, franchise renewal, sale or transfer of the
franchise, territory of the franchisee and use and occupancy of public streets
and types of cable services provided. Local franchising authorities (state or
local, depending on the practice in individual states) may award one or more
franchises within their jurisdictions and prohibit non-grandfathered cable
systems from operating without a franchise in such jurisdictions. The
Communications Act also provides that in granting or renewing franchises, local
authorities may establish requirements for cable-related facilities and
equipment, but not for video programming or information services other than in
broad categories. The Communications Act limits the payment of franchise fees to
5%
<PAGE>
of revenues derived from cable operations and permits the cable operator to
obtain modification of franchise requirements by the franchise authority or
judicial action if warranted by changed circumstances.
RCN's ability to provide franchised cable television services is dependent to
a large extent on its ability to obtain and renew its franchise agreements from
local government authorities on generally acceptable terms. RCN currently has 91
franchise agreements relating to the hybrid fiber/coaxial cable systems in New
York (outside New York City), New Jersey and Pennsylvania. These franchises
typically contain many conditions, such as time limitations on commencement and
completion of construction, conditions of service, including the number of
channels, the provision of free service to schools and certain other public
institutions, and the maintenance of insurance and indemnity bonds. These
franchises provide for the payment of fees to the issuing authorities and
generally range from 3% to 5% of revenues. The duration of these outstanding
franchises presently varies up to the year 2011. To date, all of RCN's cable
franchises have been renewed or extended, generally at or prior to their stated
expirations and on acceptable terms. Approximately 39 of RCN's hybrid
fiber/coaxial cable systems' franchises are due for renewal within the next
three years. No assurance can be given that RCN will be able to renew its
franchises on acceptable terms. No one franchise accounts for more than 7% of
RCN's total revenue. RCN's five largest franchises account for approximately 27%
of RCN's total revenue.
The hybrid fiber/coaxial cable systems are also subject to certain service
quality standards and other obligations imposed by the FCC and, where effective
competition has not been demonstrated to exist, to rate regulation by the FCC as
well. RCN's cable television system in Pennsylvania has been operating in a
competitive cable environment for almost 30 years, with approximately 80% of the
homes passed having access to an alternate cable operator, Service Electric
Cable TV. As a result, the Company's Pennsylvania cable system is exempt from
many FCC cable television regulations, including rate regulation. Its other
cable television systems in New York State and New Jersey currently remain
subject to FCC rate regulation. With the passage of the 1996 Act, however, all
cable systems rates will be deregulated as effective competition is shown to
exist in the franchise area, or by March 31, 1999, whichever date is sooner. RCN
anticipates that the remaining provisions of the 1992 Act that do not relate to
rate regulation, such as the provisions relating to retransmission consent and
customer service standards, will remain in place and may serve to reduce the
future operating margins of RCN's hybrid fiber/coaxial cable television
businesses as video programming competition develops in its cable television
service markets.
The Communications Act requires the FCC to regulate the rates, terms and
conditions imposed by public utilities for cable systems' use of utility pole
and conduit space unless state authorities can demonstrate that they adequately
regulate pole attachment rates. In the absence of state regulation, the FCC
administers pole attachment rates on a formula basis. In some cases, utility
companies have increased pole attachment fees for cable systems that have
installed fiber optic cables and that are using such cables for the distribution
of non-video services. The FCC concluded that, in the absence of state
regulation, it has jurisdiction to determine whether utility companies have
justified their demand for additional rental fees and that the Communications
Act does not permit disparate rates based on the type of service provided over
the equipment attached to the utility's pole. The 1996 Act and the FCC's
implementing regulations modify the current pole attachment provisions of the
Communications Act by immediately permitting certain providers of
telecommunications services to rely upon the protections of the current law and
by requiring that utilities provide cable systems and telecommunications
carriers with nondiscriminatory access to any pole, conduit or right-of-way
controlled by the utility. The FCC has recently adopted new regulations to
govern the charges for pole attachments used by companies provided
telecommunications services, including cable operators. These new pole
attachment rate regulations will become effective five years after enactment of
the 1996 Act, and any increase in attachment rates resulting from the FCC's new
regulations will be phased in equal annual increments over a period of five
years beginning on the effective date of the new FCC regulations. The ultimate
outcome of these rulemakings and the ultimate impact of any revised FCC rate
formula or of any new pole attachment rate regulations on the Company or its
businesses cannot be determined at this time.
The 1992 Act, the 1996 Act and FCC regulations preclude any satellite video
programmer affiliated with a cable company, or with a common carrier providing
video programming directly to its subscribers, from favoring an affiliated
company over competitors and require such programmers to sell their programming
to other multichannel video distributors. These provisions limit the ability of
program suppliers affiliated with cable companies or with common carriers
providing satellite delivered video programming directly to their subscribers to
offer exclusive programming arrangements to their affiliates. The Communications
Act also includes provisions, among others,
<PAGE>
concerning horizontal and vertical ownership of cable systems, customer service,
subscriber privacy, marketing practices, equal employment opportunity, obscene
or indecent programming, regulation of technical standards and equipment
compatibility.
In addition to the FCC regulations noted above, there are other FCC
regulations covering such areas as equal employment opportunity, syndicated
program exclusivity, network program non-duplication, registration of cable
systems, maintenance of various records and public inspection files, microwave
frequency usage, lockbox availability, sponsorship identification, antenna
structure notification, tower marking and lighting, carriage of local sports
broadcast programming, application of rules governing political broadcasts,
limitations on advertising contained in non-broadcast children's programming,
consumer protection and customer service, ownership of home wiring, indecent
programming, programmer access to cable systems, programming agreements,
technical standards, consumer electronics equipment compatibility and closed
captioning. The FCC has the authority to enforce its regulations through the
imposition of substantial fines, the issuance of cease and desist orders and/or
the imposition of other administrative sanctions, such as the revocation of FCC
licenses needed to operate certain transmission facilities often used in
connection with cable operations.
Other bills and administrative proposals pertaining to cable television have
previously been introduced in Congress or considered by other governmental
bodies over the past several years. It is probable that there will be
legislative proposals in the future by Congress and other governmental bodies
relating to the regulation of communications services.
Cable television systems are subject to federal compulsory copyright licensing
covering the retransmission of television and radio broadcast signals. In
exchange for filing certain reports and contributing a percentage of their basic
revenues to a federal copyright royalty pool, cable operators can obtain blanket
licenses to retransmit the copyrighted material on broadcast signals.
The data services business, including Internet access, is largely unregulated
at this time (apart from federal, state, and local laws and regulations
applicable to businesses in general). However, there can be no assurance that
this business will not become subject to regulatory restraints. Some
jurisdictions have sought to impose taxes and other burdens on providers of data
services, and to regulate content provided via the Internet and other
information services. RCN expects that proposals of this nature will continue to
be debated in Congress and state legislatures in the future. In addition,
although the FCC has on several occasions rejected proposals to impose
additional costs on providers of Internet access service and other data services
to the extent they use local exchange telephone network facilities for access to
their customers, similar proposals may well be considered by the FCC or Congress
in the future.
The foregoing does not purport to describe all present and proposed federal,
state, and local regulations and legislation affecting the telephone, video
programming and internet access industries. Other existing federal regulations,
copyright licensing, and, in many jurisdictions, state and local franchise
requirements, are currently the subject of judicial proceedings, legislative
hearings and administrative proposals which could change, in varying degrees,
the manner in which communications companies operate. The ultimate outcome of
these proceedings, and the ultimate impact of the 1996 Act or any final
regulations adopted pursuant to the new law on RCN or its businesses cannot be
determined at this time.
RELATIONSHIP AMONG RCN, CTE AND CABLE MICHIGAN
The Distribution Agreement defines certain aspects of the relationship among
CTE, RCN and Cable Michigan and provides for the allocation of certain assets
and liabilities among CTE, RCN and Cable Michigan. CTE, RCN and Cable Michigan
have also entered into a Tax Sharing Agreement dated as of September 5, 1997
(the "Tax Sharing Agreement") to define certain aspects of their relationship
with respect to taxes and to provide for the allocation of tax assets and
liabilities.
<PAGE>
Indemnification
RCN, CTE and Cable Michigan have agreed to indemnify one another against
certain liabilities. RCN has agreed to indemnify CTE and its subsidiaries at
the time of the Distribution (collectively, the "CTE Group") and the respective
directors, officers, employees and affiliates of each person in the CTE Group
(collectively, the "CTE Indemnitees") and Cable Michigan and its subsidiaries at
the time of the Distribution (collectively, the "Cable Michigan Group") and the
respective directors, officers, employees and affiliates of each person in the
Cable Michigan Group (collectively, the "Cable Michigan Indemnitees") from and
against any and all damage, loss, liability and expense ("Losses") incurred or
suffered by any of the CTE Indemnitees or the Cable Michigan Indemnitees,
respectively, (i) arising out of, or due to the failure of RCN or any of its
subsidiaries at the time of the Distribution (collectively, the "RCN Group") to
pay, perform or otherwise discharge any of the RCN Liabilities (as defined
below), (ii) arising out of the breach by any member of the RCN Group of any
obligation under the Distribution Agreement or any of the other Distribution
Documents and (iii) in the case of the CTE Indemnitees, arising out of the
provision by the CTE Group of the services described below to the RCN Group
except to the extent that such Losses result from the gross negligence or
willful misconduct of a CTE Indemnitee. "RCN Liabilities" refers to (i) all
liabilities of the RCN Group under the Distribution Agreement or any of the
other Distribution Documents, (ii) all other liabilities of RCN, CTE or Cable
Michigan (or their respective subsidiaries), except as specifically provided in
the Distribution Agreement or any of the other Distribution Documents and
whether arising before, on or after the Distribution Date, to the extent such
liabilities arise primarily from or relate primarily to the management or
conduct of the RCN Businesses prior to the effective time of the Distribution
(the liabilities in clauses (i) and (ii) collectively, the "True RCN
Liabilities") and (iii) 30% of the Shared Liabilities (as defined below).
Cable Michigan has agreed to indemnify the RCN Group and the respective
directors, officers, employees and affiliates of each person in the RCN Group
(collectively, the "RCN Indemnitees") and the CTE Indemnitees from and against
any and all Losses incurred or suffered by any of the RCN Indemnitees or the CTE
Indemnitees, respectively, (i) arising out of, or due to the failure of any
person in the Cable Michigan Group to pay, perform or otherwise discharge any of
the Cable Michigan Liabilities (as defined below), (ii) arising out of the
breach by any member of the Cable Michigan Group of any obligation under the
Distribution Agreement or any of the other Distribution Documents, (iii) in the
case of the CTE Indemnitees, arising out of the provision by the CTE Group of
services to the Cable Michigan Group except to the extent that such Losses
result from the gross negligence or willful misconduct of a CTE Indemnitee and
(iv) in the case of the RCN Indemnitees, arising out of the provision by RCN of
the services described below to the Cable Michigan Group except to the extent
that such Losses result from the gross negligence or willful misconduct of an
RCN Indemnitee. "Cable Michigan Liabilities" refers to (i) all liabilities of
the Cable Michigan Group under the Distribution Agreement or any of the other
Distribution Documents, (ii) all other liabilities of the Cable Michigan, RCN or
CTE (or their respective subsidiaries), except as specifically provided in the
Distribution Agreement or any of the other Distribution Documents and whether
arising before, on or after the Distribution Date, to the extent such
liabilities arise primarily from or relate primarily to the management or
conduct of the business of the Cable Michigan Group prior to the effective time
of the Distribution (the liabilities in clauses (i) and (ii) collectively, the
"True Cable Michigan Liabilities") and (iii) 20% of the Shared Liabilities (as
defined below).
CTE has agreed to indemnify the Cable Michigan Indemnitees and the RCN
Indemnitees from and against any and all Losses incurred or suffered by any of
the Cable Michigan Indemnitees or the RCN Indemnitees, respectively, (i) arising
out of, or due to the failure of any person in the CTE Group to pay, perform or
otherwise discharge any of the CTE Liabilities (as defined below), (ii) arising
out of the breach by any member of the CTE Group of any obligation under the
Distribution Agreement or any of the other Distribution Documents and (iii) in
the case of the RCN Indemnitees, arising out of the provision by RCN of the
services described below to the CTE Group except to the extent that such Losses
result from the gross negligence or willful misconduct of an RCN Indemnitee.
"CTE Liabilities" refers to (i) all liabilities of the CTE Group under the
Distribution Agreement or any of the other Distribution Documents, (ii) all
other liabilities of Cable Michigan, RCN or CTE (or their respective
subsidiaries), except as specifically provided in the Distribution Agreement or
any of the other Distribution Documents and whether arising before, on or after
the Distribution Date, to the extent such liabilities arise primarily from or
relate primarily to the management or conduct of the business of the CTE Group
prior to the effective time
<PAGE>
of the Distribution (the liabilities in clauses (i) and (ii) collectively, the
"True CTE Liabilities") and (iii) 50% of the Shared Liabilities (as defined
below).
"Shared Liability" means any liability (whether arising before, on or after
the Distribution Date) of CTE, RCN or Cable Michigan or their respective
subsidiaries which (i)(a) arises from the conduct of the corporate overhead
function with respect to CTE and its subsidiaries prior to the effective time of
the Distribution with certain exceptions or (b) is one of certain fees and
expenses incurred in connection with the Restructuring and (ii) is not a True
CTE Liability, a True RCN Liability or a True Cable Michigan Liability.
RCN, Cable Michigan and CTE have also generally agreed to indemnify each other
and each other's affiliates and controlling persons from certain liabilities
under the securities laws in connection with certain information provided to
shareholders in connection with the Distribution.
The Distribution Agreement also includes procedures for notice and payment of
indemnification claims and provides that the indemnifying party may assume the
defense of claims or suits brought by third parties for non-Shared Liabilities
and may participate in the defense of claims or suits brought by third parties
for Shared Liabilities. RCN is entitled to assume the defense of claims or
suits brought by third parties for Shared Liabilities. Any indemnification paid
under the foregoing indemnities is to be paid net of the amount of any insurance
or other amounts that would be payable by any third party to the indemnified
party in the absence of such indemnity.
The Company does not believe that any of the foregoing indemnities will have a
material adverse effect on the business, financial condition or results of
operations of the Company.
Employee Matters
Under the Distribution Agreement, RCN, Cable Michigan and CTE agreed generally
to assume employee benefits-related liabilities with respect to its current and,
in some cases, former employees. Each of RCN, Cable Michigan and CTE also agreed
to an allocation of employee-related liabilities arising out of certain shared
operations prior to the Distribution on the same basis as Shared Liabilities are
allocated.
Services and Other Arrangements
RCN has agreed to provide or cause to be provided to the CTE Group the
following services: (i) accounting, (ii) payroll, (iii) management supervision,
(iv) cash management, (v) human resources and benefit plan administration, (vi)
insurance administration, (vii) legal, (viii) tax, (ix) internal audit, (x)
investor and public relations and (xi) other miscellaneous administrative
services. The fee per year for these services will be 3.5% of the first $175
million of revenue of the CTE Group and 1.75% of any additional revenue.
RCN has also agreed to provide or cause to be provided to the Cable Michigan
Group certain specified services for a transitional period after the
Distribution. The transitional services to be provided are the following: (i)
customer service, (ii) marketing, (iii) accounting, (iv) payroll, (v) management
supervision, (vi) cash management, (vii) human resources and benefit plan
administration, (viii) insurance administration, (ix) legal, (x) tax, (xi)
internal audit, (xii) programming administration, (xiii) billing, (xiv) monthly
cable guides, (xv) investor and public relations, (xvi) provision of third party
programming, and (xvii) other miscellaneous administrative services. Subject to
certain limitations, the fee per year for services listed in items (ii)-(xiii),
(xv) and (xvii) will be 4.0% of the revenues of the Cable Michigan Group plus a
direct allocation of certain consolidated cable administration functions. The
fee for customer service listed in item (i) along with the billing service
listed in item (xiii) will be a pro rata share (based on the relative number of
subscribers) of the fees and expenses incurred by RCN to provide such customer
billing services and fees to the RCN Group and the Cable Michigan Group. The
third party expense incurred by RCN to obtain third party programming and
monthly cable guides for Cable Michigan referred to in items (xiv) and (xvi)
above, are reimbursed to RCN by Cable Michigan and no additional fee is charged
with respect thereto.
CTE has agreed to provide or cause to be provided to the RCN Group and the
Cable Michigan Group financial data processing applications, lockbox services,
storage facilities, LAN and WAN support services, building maintenance and other
miscellaneous administrative services for a transitional period after the
Distribution. The
<PAGE>
fees for such services and arrangements will be an allocated portion (based on
relative usage) of the cost incurred by CTE to provide such services and
arrangements to all three groups.
The services will terminate upon 60 days notice by either the service provider
or the relevant service recipient, except that the billing, customer service,
programming administration and provision of third party programming services
provided by RCN to Cable Michigan may not be terminated by RCN on less than one
year advance notice to Cable Michigan. A service recipient may also terminate
individual services by giving 60 days notice to the applicable service provider.
The aforementioned arrangements are not the result of arm's length negotiation
between unrelated parties as Cable Michigan, CTE and RCN have certain common
officers and directors. Although the transitional service arrangements in such
agreements are designed to reflect arrangements that would have been agreed upon
by parties negotiating at arm's length, there can be no assurance that Cable
Michigan would not be able to obtain similar services at a lower cost from
unrelated third parties. Additional or modified agreements, arrangements and
transactions may be entered into between the Cable Michigan and either or both
of CTE and RCN after the Distribution, which will be negotiated at arm's length.
Miscellaneous
The Distribution Agreement also contains provisions concerning access to
information and records and rights to technology, software, intellectual
property, know-how or other proprietary rights owned, licensed or held for use
by the respective Groups. The Distribution Agreement provides that any dispute
arising out of or in connection with the Distribution Agreement will be
submitted to arbitration in accordance with the procedures described in the
Agreement.
There exist relationships among CTE, RCN and Cable Michigan that may lead to
conflicts of interest. Each of CTE, RCN and Cable Michigan is effectively
controlled by Kiewit Telecom. In addition, the majority of the Company's named
executive officers will also be acting as directors and/or executive officers of
one or more group companies. See "Item 10: Directors and Executive Officers of
the Registrant." The success of the Company may be affected by the degree of
involvement of its officers and directors in the Company's business and the
abilities of the Company's officers, directors and employees in managing both
the Company and the operations of other group companies. Potential conflicts of
interest will be dealt with on a case-by-case basis taking into consideration
relevant factors including the requirements of NASDAQ and prevailing corporate
practices.
Tax Sharing Agreement
The Tax Sharing Agreement governs contingent tax liabilities and benefits, tax
contests and other tax matters with respect to tax returns filed with respect to
tax periods, in the case of Cable Michigan, ending or deemed to end on or before
the Distribution Date. Under the Tax Sharing Agreement, Adjustments (as defined
in the Tax Sharing Agreement) to taxes that are clearly attributable to the
Cable Michigan Group, the RCN Group, or the CTE Group will be allocated solely
to such group. Adjustments to all other tax liabilities will generally be
allocated 50% to CTE, 20% to Cable Michigan and 30% to RCN.
EMPLOYEES
As of December 31, 1997, the Company had 1,150 full-time employees including
general office and administrative personnel. The Company considers relations
with its employees to be good.
INDUSTRY SEGMENTS
Financial information regarding the Registrant's industry segments is not
applicable as set forth in Note 2 to the consolidated financial statements
included herein.
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the Registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.
Date: April 9, 1999 RCN Corporation
By: \s\ David C. McCourt
-------------------------
David C. McCourt
Chairman and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the Registrant and
in the capacities and on the dates indicated.
Signature Title Date
- --------- ----- ----
PRINCIPAL EXECUTIVE AND ACCOUNTING OFFICERS:
\s\ David C. McCourt Chairman and Chief April 9, 1999
- -------------------------- Executive Officer
David C. McCourt
\s\ Michael J. Mahoney President and Chief April 9, 1999
- -------------------------- Operating Officer
Michael J. Mahoney
\s\ Bruce C. Godfrey Executive Vice President April 9, 1999
- -------------------------- and Chief Financial Officer
Bruce C. Godfrey
\s\ Ralph S. Hromisin Vice President and April 9, 1999
- -------------------------- Chief Accounting Officer
Ralph S. Hromisin
<PAGE>
RCN CORPORATION
SELECTED FINANCIAL DATA
Thousands of Dollars Except Per Share Amounts
For the Years Ended December 31,
<TABLE>
<CAPTION>
1997 1996 1995 1994 1993
---------- -------- -------- -------- --------
<S> <C> <C> <C> <C> <C>
Sales $ 127,297 $104,910 $ 91,997 $ 59,500 $ 49,504
Income (loss) from continuing operations $ (49,181) $ (5,989) $ 2,114 $ 3,736 $ 10,459
Income (loss) per average common share
from continuing operations $ (0.89) $ (0.11) $ 0.04 $ 0.11 $ 0.32
Dividends per share - - - - -
Total assets $1,150,992 $628,085 $649,610 $568,586 $291,634
Long-term debt, net of current maturities $ 686,103 $131,250 $135,250 $154,000 $181,500
</TABLE>
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
Certain statements contained in this Annual Report are "forward-looking
statements" within the meaning of the Private Securities Litigation Reform Act
of 1995 and are thus prospective. Such forward-looking statements include, in
particular, statements made as to plans to develop networks and upgrade
facilities, the market opportunity presented by markets targeted by the Company,
the Company's intention to connect certain wireless video, resale telephone and
Internet service customers to its advanced fiber optic networks, the development
of the Company's businesses, the markets for the Company's services and
products, the Company's anticipated capital expenditures, the Company's
anticipated sources of capital and effects of regulatory reform and competitive
and technological developments. No assurance can be given that the future
results covered by the forward-looking statements will be achieved. Such
statements are subject to risks, uncertainties and other factors which could
cause actual results to differ materially from future results expressed or
implied by such forward-looking statements.
The following discussion should be read in conjunction with the Company's
historical Consolidated Financial Statements and Notes thereto:
GENERAL
The Company is developing networks that are capable of providing a full range
of high speed, high capacity telecommunications services, including voice, video
programming and data services including high speed Internet access. The Company
intends to provide these services individually or in bundled service packages
primarily to residential customers in high density areas and also seeks to serve
certain commercial accounts on or near its networks. In 1997, the Company
commenced providing service through advanced fiber optic network facilities in
New York City and Boston, and the Company is developing an advanced fiber
network in Washington, D.C. The Company also has hybrid fiber/coaxial cable
television operations in New York (outside New York City), New Jersey and
Pennsylvania, wireless video operations in New York City, and certain other
operations, including Internet as well as local and long distance telephone.
The negative operating cash flow from the Company's advanced fiber optic
network business has resulted primarily from expenditures associated with the
development of the Company's operational infrastructure and marketing expenses.
The Company expects it will continue to experience negative operating cash flow
while it continues to invest in its networks and until such time as revenue
growth is sufficient to fund operating expenses. The Company expects to achieve
positive operating margins over time by (i) increasing the number of customers
it serves, (ii) increasing the number of connections per customer by cross
marketing its services and promoting bundled service options and therefore
increasing the revenue per customer, (iii) lowering the costs associated with
new subscriber additions and (iv) reducing the cost of providing services by
capturing economies of scale. The Company expects its operating revenues will
increase in 1998 through internal growth of its current advanced fiber optic
networks; however, the Company also expects negative operating cash flow will
increase for some period of time as the Company initiates network development in
Washington, D.C. and expands its current networks. When the Company makes its
initial investment in a new market, the operating losses typically increase as
the network and sales force are expanded to facilitate growth. The Company's
ability to generate positive cash flow in the future will depend on the extent
of capital expenditures in current and additional markets, the ability of the
joint ventures to generate revenues and cash flow, competition in the Company's
markets and any potential adverse regulatory developments. The Company will be
dependent on various financing sources to fund its growth as well as continued
losses from operations. There can be no assurance that such funding will be
available, or available on terms acceptable to the Company. See "Liquidity and
Capital Resources."
<PAGE>
The terms of the Company's joint ventures require the mutual consent of the
Company and its joint venture partner to distribute or advance funds to the
Company. The Company's debt agreements allow subsidiaries and joint ventures to
incur indebtedness for network buildout costs, which indebtedness may contain
limitations on the subsidiaries' and the joint venture's ability to pay
dividends and distributions to the Company. Although the joint ventures have
not had a significant impact on the Company's cash flows in the periods
presented, cash flows available to the Company in future periods will be
affected by the extent to which operations are conducted through joint ventures.
Due to the degree of control that the Company has in the joint ventures, RCN
accounts for the BECO joint venture on a consolidated basis and Starpower under
the equity method of accounting.
Prior to September 30, 1997, the Company was operated as part of C-TEC. On
September 30, 1997, C-TEC distributed 100% of the outstanding shares of common
stock of its wholly owned subsidiaries, RCN Corporation ("RCN") and Cable
Michigan, Inc. ("Cable Michigan") to holders of record of C-TEC's Common Stock
and C-TEC's Class B Common Stock as of the close of business on September 19,
1997 (the "Distribution") in accordance with the terms of a Distribution
Agreement dated September 5, 1997 among C-TEC, RCN and Cable Michigan. RCN
consists primarily of C-TEC's high growth bundled residential voice, video and
Internet access operations in the Boston to Washington, D.C. corridor, its
existing New York, New Jersey and Pennsylvania cable television operations, a
portion of its long distance operations and its international investment in
Megacable, S.A. de C.V. ("Megacable"). C-TEC, RCN and Cable Michigan have
entered into certain agreements providing for the Distribution, and governing
various ongoing relationships between the three companies, including a
distribution agreement and a tax-sharing agreement. The historical financial
information presented herein reflects periods during which the Company did not
operate as an independent company and accordingly, certain assumptions were made
in preparing such financial information. Such information, therefore, may not
necessarily reflect the results of operations or the financial condition of the
Company which would have resulted had the Company been an independent, public
company during the reporting periods, and are not necessarily indicative of the
Company's future operating results or financial condition.
Certain of the Company's businesses were acquired by C-TEC and transferred to
the Company in connection with the Distribution. On August 30, 1996, a
subsidiary of C-TEC acquired an 80.1% interest in Freedom New York, L.L.C.
("Freedom") and all related rights and liabilities from Kiewit Telecom Holdings,
Inc. Freedom held the wireless cable television business of Liberty Cable
Television, Inc. The Company acquired the remaining minority interest in
Freedom in March 1997. The acquisition was accounted for as a purchase and is
reflected in the Company's consolidated financial statements since September
1996. On May 15, 1995, C-TEC Cable Systems, Inc., a wholly owned subsidiary of
C-TEC ("RCN Cable"), acquired 40% of the outstanding common stock of Twin County
Trans-Video, Inc. ("Twin County"). The remaining shares were subject to an
escrow agreement, pending completion of the merger, and were required to be
voted under the direction of the Company. As of May 15, 1995, the Company also
assumed management of Twin County. As a result, the Company had control of Twin
County and accordingly has fully consolidated Twin County in the Company's
financial statements since May 1995, the date of the original acquisition. The
remaining outstanding common stock of Twin County was acquired in September
1995. Goodwill relating to this acquisition is being amortized over a period of
approximately 10 years. In January 1995, RCN International Holdings, Inc.
(formerly C-TEC International, Inc.), a wholly owned subsidiary of C-TEC,
purchased a 40% equity position in Megacable, the second largest cable
television provider in Mexico. The Company accounts for its investment by the
equity method of accounting and is amortizing the original excess cost over the
underlying equity in the net assets on a straight-line basis over 15 years.
2. SEGMENT INFORMATION
In June 1997 the Financial Accounting Standards Board (FASB) issued Statement of
Financial Accounting Standard No. 131 - "Disclosure about Segments of an
Enterprise and Related Information" ("SFAS 131"). This statement, which
establishes standards for the reporting of information about operating segments
and requires the reporting of selected information about operating segments in
interim and year end financial statements, is effective for fiscal years
beginning after December 15, 1997. If applicable, this statement would only
require additional disclosures in the Company's consolidated financial
statements and as such, its adoption will not have any impact on the Company's
consolidated financial position or results of operations. The Company's
operations involve developing an advanced fiber network to provide a bundled
service package of voice, video and data services to new customers in high
density markets and migrating as many customers as is economically justified
which were served by the Company's previously separate lines of business, for
which profitability was separately measurable and monitored, to the single
source network. While the Company's chief decision makers monitor the revenue
streams of the various products, operations are managed and financial
performance is evaluated based upon the delivery of multiple services to
customers over a single network. This allows the Company to leverage its network
costs to maximum profitability. It is management's belief that the Company
operates as one reportable operating segment which contains many shared expenses
generated by the Company's various revenue streams and that any segment
allocation of shared expenses incurred on a single network to multiple revenue
streams would be impractical and arbitrary; furthermore, the Company currently
does not make such allocations internally. The Company's chief decision makers
do, however, monitor financial performance in a way which is different from that
depicted in the historical general purpose financial statements in that such
measurement includes the consolidation of all joint ventures, including
Starpower which is not consolidated under generally accepted accounting
principles. Such information, however, does not represent a separate segment
under generally accepted accounting principles and therefore it is not
separately disclosed.
<PAGE>
Results of Operations
Year Ended December 31, 1997 Compared to Year Ended December 31, 1996:
For the year ended December 31, 1997, operating income before depreciation and
amortization and nonrecurring charge was ($7,670) as compared to $25,803 for the
year ended December 31, 1996. Sales increased 21.3% to $127,297 for the year
ended December 31, 1997 from $104,910 for the same period in 1996.
Sales. Video sales are comprised primarily of subscription fees for basic,
premium and pay-per-view cable television services: for both wireless and hybrid
fiber/coaxial cable customers in New York, New Jersey and Pennsylvania which the
Company expects to migrate to its advanced fiber networks over time. Voice sales
include local telephone service fees consisting primarily of monthly line
charges, local toll and special features and long-distance telephone service
fees based on minutes of traffic and tariffed rates or contacted fees. Data
sales represent Internet access fees billed at contracted rates. For the year
ended December 31, 1997, total sales were $127,297, an increase of $22,387 or
21.3%, from $104,910 for the year ended December 31, 1996, primarily due to
higher total service connections which increased 20.6% to approximately 268,000
at December 31, 1997 from approximately 222,000 at December 31, 1996. The
increase is due to the commencement of service through advanced fiber optic
network facilities as well as growth in resold voice and off-net video
connections.
Voice revenues increased $3,177 to $4,007 for the year ended December 31, 1997
from $830 for the year ended December 31, 1996. The increase was primarily due
to an increase in off-net connections. Off-net connections were 24,900 and
1,875 at December 31, 1997 and 1996, respectively.
Video revenue increased $15,901 or 18.2% to $103,371 for the year ended
December 31, 1997 from $87,470 for the year ended December 31, 1996. The
increase was due to an increase in off-net video sales principally resulting
from higher basic service revenue resulting from approximately 4,850 additional
average monthly subscribers over 1996, the effects of a rate increase in the
first quarter of 1997 and cash incentives related to the launch of certain new
channels. Additionally, other video sales increased primarily due to the
acquisition of Freedom on August 30, 1996 (the "Freedom Acquisition"), which
resulted in approximately 38,000 wireless video connections for a full year in
1997 as compared to four months in 1996. The Company also began providing video
service over its advanced fiber network during 1997 and had approximately 11,800
advanced fiber connections at December 31, 1997.
Commercial and other revenues increased $3,272, or 19.7% to $19,878 for the
year ended December 31, 1997 from $16,606 for the year ended December 31, 1996.
The increase primarily results from terminating access provided to Commonwealth
Telecom Services, Inc. ("CTSI"), a subsidiary of Commonwealth Telephone. CTSI is
a CLEC which operates in areas adjacent to the traditional service area of
Commonwealth Telephone Company (also a wholly-owned subsidiary of Commonwealth
Telephone). An increase in commercial main access lines of approximately 5,200
over 1996 accounted for approximately $1,100 of the increase in commercial and
other revenues.
<PAGE>
Cost and Expenses, Excluding Depreciation and Amortization and Nonrecurring
Charges. Costs and expenses, excluding depreciation and amortization are
comprised of direct costs and operating, selling, and general and administrative
expenses. Direct expenses include direct costs of providing services, primarily
video programming and franchise costs, network access fees, and video
transmission licensing fees. For the year ended December 31, 1997, direct
expenses were $51,757, an increase of $16,531 or 46.9% as compared to direct
expenses of $35,226 in 1996. The increase is primarily attributable to higher
sales and a change in overall revenue mix to a higher volume of resold voice,
which has a lower margin than the Company's other products. The resold voice
increase represents planned marketing primarily in the Boston and New York City
markets ahead of construction of the advanced fiber network to build a customer
base which is intended to be migrated to the advanced fiber network. Origination
and programming costs increased approximately $7,200 primarily due to higher
video connections, rate increases and additional channels. The remaining
increase in direct costs and expenses is principally attributable to higher
commercial long distance network capacity in anticipation of volume growth in
the Company's markets resulting in higher recurring costs.
Operating, selling, general and administrative expenses primarily include
customers service costs, advertising, sales and marketing expenses, plant
maintenance and repair ("technical expenses"), salaries and benefits, and other
corporate overhead.
Operating, selling, general and administrative expenses increased $39,329 or
89.6% to $83,210 for the year ended December 31, 1997 from $43,881 for the year
ended December 31, 1996. Advertising costs increased approximately $9,000 for
the year ended December 31, 1997 primarily due to a high visibility multi-media
campaign to promote name recognition primarily in New York City and Boston.
Customer service costs increased approximately $4,100, or 60.3% primarily
related to headcount additions to support the increase in the customer base and
to meet the Company's objectives for world class customer service. Technical
expense increased approximately $8,300, or 75.1% for the year ended December 31,
1997. The increase is primarily related to salaries and benefits associated
with increased network engineering staff, responsible for planning the
development and construction of the advanced fiber network, and increased
installation and repair technicians. Sales and marketing costs increased
approximately $8,500, or 116.7%, for the year ended December 31, 1997. The
increase relates to higher sales staff to increase penetration in the Company's
markets, higher marketing staff to monitor and coordinate the Company's direct
advertising efforts and plan sales promotions and to higher telemarketing
expenses. The remaining increase in operating, selling, general and
administrative expenses is attributable to several factors including costs
associated with the spin-off of the Company from C-TEC. Additionally, in
connection with the Distribution (Note 1), C-TEC completed a comprehensive study
of its employee benefit plans in 1996. As a result of this study, effective
December 31, 1996, in general, employees of RCN no longer accrued benefits under
the defined benefit pension plan, but became fully vested in their defined
pension benefits accrued through that date. C-TEC notified affected
participants in December 1996. In December 1996, C-TEC allocated pension plan
assets of $6,984 to a separate plan for employees who no longer accrue benefits
after December 31, 1996. The underlying liabilities were also allocated. The
allocation of assets and liabilities resulted in a curtailment/settlement gain
of $4,292. The Company's allocable share of this gain was $3,437. Such gain
did not recur in 1997.
Depreciation and Amortization. Depreciation and amortization is comprised
principally of depreciation related to the Company's advanced fiber network, its
wireless network, and its hybrid fiber/coaxial cable systems; and amortization
of subscriber lists, building access rights and goodwill resulting primarily
from its acquisition of Freedom, Twin County. Depreciation and amortization
increased $14,324, or 36.8% to $53,205 for the year ended December 31, 1997 as
compared to $38,881 for 1996. The increase is principally due to the additional
depreciation and amortization resulting from the Freedom Acquisition and
depreciation related to the Company's advanced fiber optic networks in New York
City and Boston.
In future periods, depreciation and amortization are expected to exceed
amounts recorded in 1997 due to depreciation with respect to the Company's
advanced fiber optic networks in New York City and Boston and due to
depreciation and amortization with respect to the Company's acquisitions in
February 1998 of Erols and UltraNet (Note 19).
Nonrecurring Charges. Nonrecurring charges of $10,000 in 1997 represent costs
incurred with respect to the termination of a marketing services agreement held
by Freedom.
Interest Income. For the year ended December 31, 1997, interest income was
$22,824, a decrease of $2,778, or 10.9% primarily due to lower average cash
balances and lower average notes receivable with related parties. Average cash
balances decreased principally as a result of the Freedom Acquisition in August
1996 (as well as the
<PAGE>
acquisition in March 1997 of the remaining 19.9% ownership interest in Freedom)
and capital expenditures, partially offset by the proceeds of the Company's high
yield debt offering in October 1997 (Note 10).
Interest Expense. For the year ended December 31, 1997, interest expense was
$25,602, an increase of $9,556, or 59.6% primarily due to interest expense on
the Company's $225,000 of 10% Senior Notes and $601,045 aggregate principal
amount at maturity of 11 1/8% Senior Discount Notes placed in October 1997 (Note
10). This was partially offset by lower interest expense resulting from the
required principal payment in December 1996 of $18,750 on 9.65% Senior Secured
Notes. Additionally, the Company paid $922 to Kiewit Telecom Holdings, Inc. in
1996 in connection with the Company's August 1996 acquisition of Kiewit Telecom
Holdings, Inc.'s 80.1% interest in Freedom. This portion of the consideration
represents an amount to compensate Kiewit Telecom Holdings, Inc. for forgone
interest on the amount which it had invested in Freedom.
Income Tax. Benefit for income taxes increased $21,828 primarily due to the
increase of $65,020 in loss after minority interest and equity in
unconsolidated entities before income taxes. For an analysis of the change in
income taxes, see the reconciliation of the effective income tax rate in Note 11
to the Consolidated Financial Statements.
Minority Interest. Minority interest in the loss of consolidated entities
increased $5,956 primarily as a result of the minority share of the losses of
the BECO joint venture (Note 7), which began operations in June 1997.
Additionally, the minority share of the losses of Freedom from January 1 through
March 21, at which time the Company acquired the remaining 19.9% ownership
interest, was $966.
Equity in loss of Unconsolidated Entities. The Company's equity in the (loss)
of unconsolidated entities was ($3,804) in 1997 and ($2,282) in 1996, and is
comprised principally of the Company's share of the operating results of
Megacable. In January 1995, the Company purchased a forty percent equity
position in Megacable, a Mexican cable television provider, for cash of $84,115.
The Company is exposed to foreign currency translation adjustments resulting
from translation into U.S. dollars of the financial statements of Megacable,
which through December 1996 utilized the peso as the local and functional
currency. Such adjustments have historically been included as a separate
component of shareholders' equity. Effective January 1, 1997, since the three
year cumulative rate of inflation at December 31, 1996 exceeded 100% , Mexico is
being treated for accounting purposes under Statement of Financial Accounting
Standards No. 52 - "Foreign Currency Translation" as having a highly
inflationary economy. As a result, the financial statements of Megacable are
remeasured as if the functional currency were the U.S. dollar. The
remeasurement of the Mexican peso into U.S. dollars creates translation
adjustments which are included in net income. The Company is also exposed to
foreign currency transaction losses resulting from transactions of Megacable
which are made in currencies different from Megacable's own. The Company's
proportionate share of transaction gains (losses) are included in income as they
occur. The Company does not hedge its foreign currency exchange risk and it is
not possible to determine what effect future currency fluctuations will have on
the Company's operating results. Exchange gains (losses) of ($12), $247, and
($932) in 1997, 1996, and 1995, respectively, including translation losses in
1997, are included in the respective statements of operations through the
Company's proportionate share of losses of Megacable.
In 1997, Megacable had sales of $30,441, operating income before depreciation
and amortization of $10,504 and net income of $6,653. In 1996, Megacable had
sales of $23,225, operating income before depreciation and amortization of
$10,183 and net income of $10,226. Year end subscriber counts were 211,627 at
December 31, 1997 as compared to 178,664 at December 31, 1996. In 1997 and
1996, the Company's share of the income of Megacable was $2,411 and $4,090,
respectively, which includes the exchange gains (losses) as discussed above.
The Company's investment in Megacable exceeded its underlying equity in the net
assets of Megacable when acquired by approximately $94,000, which goodwill is
being amortized on a straight-line basis over 15 years. In 1997 and 1996,
amortization of the Company's excess purchase price over the net assets of
Megacable when acquired was $6,280 in each year.
<PAGE>
Extraordinary Charge. In September 1997, the Company prepaid Senior Secured
Notes with the proceeds of new credit facilities (Note 10). The early
extinguishment of the Senior Secured Notes resulted in an extraordinary charge
of $3,210, net of taxes.
Year Ended December 31, 1996 Compared to Year Ended December 31, 1995
For the year ended December 31, 1996, operating income before depreciation and
amortization was $25,803 as compared to $16,994 for the year ended December 31,
1995. Sales increased 14.0% to $104,910 for 1996 from $91,997 in 1995. The
improvement in operating income before depreciation and amortization of $8,809
was offset by higher depreciation and amortization of $16,545, as discussed
below, resulting in a net loss of ($5,989) for the year ended December 31, 1996
as compared to net income of $2,114 in 1995.
Sales. For the year ended December 31, 1996, total sales were $104,910, an
increase of $12,913 or 14.0% from $91,997 for the year ended December 31, 1995.
Video sales increased $21,771, or 33.1% to $87,470 in 1996 from $65,699 in 1995,
primarily due to the acquisition of the Pennsylvania cable system (formerly Twin
County Trans Video, Inc.) in May 1995, which resulted in $13,530 of the increase
in sales in 1996. The Pennsylvania cable system serves approximately 74,000
subscribers in the Greater Lehigh Valley area of Pennsylvania. The remaining
increase in video sales is due to higher basic service revenues resulting from
an increase in average subscribers of 4,995 or 5.3% and the full year impact, in
1996, of the 9.6% rate increase in April 1995 and the impact of 5.9% rate
increase in February 1996. The 14.0% increase in total sales in 1996 was lower
than the increase of 54.6% in 1995, principally due to the consolidation of the
Pennsylvania cable system for seven months (from acquisition in May 1995).
Since the Pennsylvania cable system was consolidated for seven months in 1995,
consolidation for a full year in 1996 reflects only incremental five months
revenue as compared to incremental seven months revenue in 1995.
Commercial and other revenues decreased $9,455, or 36.3%, to $16,606 in 1996
from $26,061 in 1995 principally as a result of termination of AT&T Tariff 12
resale services in the second quarter of 1995.
Cost and Expenses, Excluding Depreciation and Amortization and Nonrecurring
Charges. For the year ended December 31, 1996, direct expenses were $35,226, a
decrease of $4,378 or 11.1% as compared to direct expenses of $39,604 in 1995.
Lower costs associated with the reduction in AT&T Tariff 12 resale services were
partially offset primarily by higher origination, programming and franchise
costs principally resulting from the acquisition of the Pennsylvania cable
system, the Freedom Acquisition, other subscriber growth, channel additions and
programming fee increases.
Operating, selling, general and administrative expenses increased $8,482 or
24.0% to $43,881 for the year ended December 31, 1996 from $35,399 for the year
ended December 31, 1995. Customer service costs increased approximately $2,700
or 66.1% primarily due to increased staff to support the start-up and expected
growth of bundled service operations in New York City and Boston. Technical
expenses increased approximately $3,000 or 38.3% primarily as a result of the
Freedom Acquisition in August 1996. Additionally, technical expense increased
as a result of the acquisition of the Pennsylvania cable system in May 1995,
resulting in consolidation for seven months in 1995 as compared to a full year
in 1996. Sales and marketing costs increased approximately $1,500 or 26.6% for
the year ended December 31, 1996. The increase is primarily related to the
Freedom Acquisition and the start-up of sales and marketing efforts for the
bundled service product in New York City and Boston. The remaining increase in
operating, selling, general and administrative expenses is comprised of an
increase of approximately $250 in advertising, the Company's allocable share of
costs associated with investigation of the feasibility of various restructuring
alternatives of C-TEC to enhance shareholder value, and other increases in
general and administrative expenses of approximately $3,900 resulting from the
Freedom Acquisition. These other increases were partially offset by the
Company's allocable share of the gain on the partial curtailment and settlement
of C-TEC's defined benefit pension plan of $3,437.
Depreciation and Amortization. For 1996, depreciation and amortization
expense was $38,881, an increase of $16,545 or 74.1% as compared to 1995
primarily due to purchase accounting effects of the acquisition of the
Pennsylvania cable system in May 1995 and the Freedom Acquisition on August 30,
1996. (See Note 4 to the
<PAGE>
Consolidated Financial Statements.) In addition, the Company incurred $3,756 in
depreciation related to the Company's advanced fiber optic networks in New York
City and Boston.
Interest Income. For the year ended December 31, 1996, interest income was
$25,602, a decrease of $3,399, or 11.7% due primarily to a reduction in average
cash balances in 1996 as compared to 1995 and a decrease in the average yield on
invested cash, partially offset by interest income of $2,222 accrued on a
$13,088 note receivable acquired from Mazon Corporativo S.A. de C.V. in January
1996. Average cash balances decreased in 1996 primarily due to cash used in the
Freedom Acquisition and the purchase of the loan receivable from Mazon
Corporativo S. A. de C.V. Additionally, lower balances on notes receivable-
affiliates contributed to the decrease.
Interest Expense. Interest expense for 1996 was $16,046, a decrease of $471,
or 2.9% in 1996 as compared to 1995. This decrease is due to lower average
rates on outstanding debt and includes approximately $922 paid to Kiewit Telecom
Holdings, Inc., the Company's controlling shareholder, in connection with the
Freedom Acquisition. This portion of the consideration represents an amount to
compensate Kiewit Telecom Holdings, Inc. for forgone interest on the amount
invested in Freedom.
Income Taxes. The Company's effective income tax rate was (19.5%) in 1996 and
34.6% in 1995. For an analysis of the change in income taxes, see the
reconciliation of the effective income tax rate in Note 11 to the Consolidated
Financial Statements.
Minority Interest. As a result of the Freedom Acquisition, Freedom's
financial results are consolidated with the Company since August 30, 1996, the
date of acquisition. This resulted in minority interest in the loss of Freedom
of $1,546 for 1996. Additionally, the 20% minority interest in the income of
HomeLink Limited Partnership, a Hybrid Fiber/Coaxial subsidiary, was ($206) in
1996 as compared to ($144) in 1995.
<PAGE>
Equity in loss of Unconsolidated Entities. In 1996, Megacable had sales of
$23,225, operating income before depreciation and amortization of $10,183 and
net income of $10,226. In 1995, Megacable had sales of $20,841, operating
income before depreciation and amortization of $8,154 and net income of $5,802.
Year end subscriber counts were 178,664 at December 31, 1996 as compared to
177,317 at December 31, 1995. In 1996 and 1995, the Company's share of the
income of Megacable was $4,090 and $2,696, respectively, which includes foreign
currency transaction losses as noted in the 1997 discussion. In 1996 and 1995,
amortization of the Company's excess purchase price over the net assets of
Megacable when acquired was $6,280 and $5,757, respectively.
LIQUIDITY AND CAPITAL RESOURCES
The Company expects that it will require a substantial amount of capital to
fund the network development and operations in the Boston to Washington, D.C.
corridor, including funding the development of its advanced fiber optic
networks, upgrading its Hybrid Fiber/Coaxial plant, funding operating losses and
debt service requirements. The Company currently estimates that its capital
requirements for the period from January 1, 1998 through 1999 will be
approximately $785,000, which includes capital expenditures (including
connection costs which will only be incurred as the Company obtains revenue-
generating customer connections) of approximately $300,000 in 1998 and
approximately $485,000 in 1999. The Company's capital expenditure plan has been
accelerated due to more rapid deployment of its network development plan, in
part due to the Erols and UltraNet acquisitions. These capital expenditures
will be used principally to fund the buildout of the Company's fiber optic
network in high density areas in the Boston, New York and Washington, D.C.
markets and to upgrade its Hybrid Fiber/Coaxial cable systems. To build out
these areas on an efficient basis, the Company undertakes a subscriber-driven
capital expenditure strategy whereby it (i) closely monitors development of its
subscriber base in order to direct network deployment in each target market, and
(ii) seeks to establish a customer base in advance of or concurrently with its
network deployment. For example, the Company offers Internet and resale
telephone services on an interim basis to customers located near its advanced
fiber optic networks. Depending upon factors such as subscriber density,
proximity to the advanced fiber optic network and development costs and the
degree of success achieved in its initial markets, the Company will determine
whether extending its advanced fiber optic network to additional high density
target markets can be achieved on an attractive economic basis. In addition to
its own capital requirements, the Company's joint venture partners are each
expected to contribute approximately $150,000 in capital to the joint ventures
in connection with development of the Boston and Washington, D.C. markets from
September 1997 through 2000 of which approximately $50,900 has been contributed.
The Company expects to have sufficient liquidity to meet its capital
requirements through mid-2000. The Company will continue to require additional
capital for planned increases in network coverage and other capital
expenditures, working capital, debt service requirements, and anticipated
further operating losses. The actual timing and amount of capital required to
roll out the Company's network and to fund operating losses may vary materially
from the Company's estimates and additional funds will be required in the event
of significant departures from the current business plan, unforeseen delays,
cost overruns, engineering design changes and other technological risks or other
unanticipated expenses. Due to its subscriber-driven investment strategy,
should the Company encounter a successful rollout in its initial markets, and/or
decide to enter new markets, the Company may accelerate the rollout and/or
extend the reach of its network; such acceleration could increase the Company's
capital requirements. In addition, the commencement of operations and buildout
in new markets would substantially increase the Company's capital requirements.
Conversely, should the Company be less successful than anticipated, the
operating losses associated with the installed network may be higher than
anticipated. The Company presently intends to judge the success of its initial
rollout in deciding whether to undertake additional capital expenditures to
rollout the network to additional areas. Since the Company anticipates that, if
it is successful, it will continue to extend its network coverage into
additional areas within and potentially beyond the Boston-Washington, D.C.
corridor, it expects to continue to experience losses and negative cash flow on
an aggregate basis for an extended period of time.
The Company's current joint venture agreements reduce the amount of
expenditures required by RCN to develop the network due both to access to the
joint venture partners' existing facilities and to the anticipated joint venture
partners' equity contributions. However, the joint venture arrangements will
also reduce the potential cash flows to be realized from operation of the
networks in the markets in which the joint ventures operate and restrict the
Company's access to cash flow generated by the joint ventures (which will be
paid in the form of dividends). The Company may enter into additional joint
ventures in the future as the Company begins to develop new markets.
<PAGE>
RCN and BECO are presently in discussions with respect to the conversion of a
portion of BECO's interest in the BECO joint venture into RCN Common Stock.
Sources of funding for the Company's further financing requirements may
include vendor financing, public offerings or private placements of equity
and/or debt securities, and bank loans. The Company continually evaluates its
capital raising opportunities, and is considering, subject to market conditions,
a possible public offering or private placement of additional debt securities
during the second or third quarter of 1998. There can be no assurance that
additional financing will be available to the Company or, if available, that it
can be obtained on a timely basis and on acceptable terms. Failure to obtain
such financing could result in the delay or curtailment of the Company's
development and expansion plans and expenditures. Any of these events could
impair the Company's ability to meet its debt service requirements and could
have a material adverse effect on its business.
In October 1997, the Company raised $575,000 in gross proceeds from an
offering of two tranches of debt securities. The offering was comprised of
$225,000 principal amount of 10% Senior Notes and $601,000 principal amount at
maturity of 11 1/8% Senior Discount Notes, both due in 2007. The proceeds
include $61,000 of restricted cash to be used to fund the Escrow Account to pay
interest on the 10% Senior Notes for three years. In February 1998, the Company
raised $350,587 in gross proceeds from an offering of $567,000 principal amount
at maturity of 9.80% Senior Discount Notes, due in 2008. The Indentures which
govern the 1997 Notes and the 1998 Notes contain similar provisions. The Chase
Manhattan Bank acts as Trustee for each of the Indentures. The 1997 Notes and
the 1998 Notes are general senior unsecured obligations of RCN. The 9.80% Senior
Discount Notes will mature on February 15, 2008. The 9.80% Senior Discount Notes
will not bear cash interest prior to February 15, 2003. The 1997 Notes will
mature on October 15, 2007. Interest on the 10% Senior Notes are payable in cash
at a rate of 10% per annum semi-annually in arrears on each April 15 and October
15, commencing April 15, 1998. The 11 1/8% Senior Discount Notes will not bear
cash interest prior to October 15, 2002.
RCN Cable and certain of its subsidiaries have in place secured credit
facilities comprised of a five-year revolving credit facility in the amount of
$25,000 (the "Revolving Credit Facility") and an eight-year term credit facility
in the amount of $100,000 (the "Term Credit Facility"), both of which facilities
are governed by a single credit agreement dated as of July 1, 1997 (the "Credit
Agreement"). As of December 31,1997, $100,000 of the Term Credit Facility was
outstanding. The term loan must be repaid over six years in quarterly
installments, at the end of September, December, March and June of each year
from September 30, 1999 through June 30, 2005. As of December 31, 1997, $3,000
principal was outstanding under the Revolving Credit Facility. Revolving loans
may be repaid and reborrowed from time to time. All borrowings under the Credit
Agreement will be pari passu and will be secured under a common collateral
package.
<PAGE>
The Company has indebtedness that is substantial in relation to its
shareholders' equity and cash flow. At December 31, 1997, the Company had an
aggregate of approximately $1,036,000 of indebtedness outstanding, and the
ability to borrow up to an additional $22,000 under the Credit Agreement. As a
result of the substantial indebtedness of the Company, the Company's fixed
charges are expected to exceed its earnings for the foreseeable future. In
addition, the Company will require substantial additional indebtedness
particularly in connection with the buildout of the Company's networks and the
introduction of its telecommunications services to new markets. The leveraged
nature of the Company could limit its ability to effect future financing or may
otherwise restrict the Company's business activities.
The extent of the Company's leverage may have the following consequences: (i)
limit the ability of the Company to obtain necessary financing in the future for
working capital, capital expenditures, debt service requirements or other
purposes; (ii) require that a substantial portion of the Company's cash flows
from operations be dedicated to the payment of principal and interest on its
indebtedness and therefore not be available for other purposes; (iii) limit the
Company's flexibility in planning for, or reacting to, changes in its business;
(iv) place the Company at a competitive disadvantage as compared with less
leveraged competitors; and (v) render the Company more vulnerable in the event
of a downturn in its business.
On a historical basis, for the year ended December 31, 1997, the Company's net
cash provided by operating activities was $1,661, comprised primarily of a net
loss of ($52,391) adjusted by non-cash depreciation and amortization of $53,205,
other non-cash items totaling ($611) , working capital changes of $377 and
changes in other deferred expenses of $1,081. Net cash used in investing
activities of $475,860 consisted primarily of purchases of short-term
investments of $445,137, additions to property, plant and equipment of $79,042
and acquisitions of $30,490 (primarily acquisition of the minority interest of
Freedom) partially offset by sales and maturities of short-term investments of
$76,923. Net cash provided by financing activities of $635,266 consisted
primarily of issuance of long-term debt of $688,000, change in affiliate notes
of $97,624 and transfers from C-TEC of $89,324 partially offset by redemption of
long-term debt of $141,250, transfers to C-TEC of $23,474, payments made for
debt financing costs of $19,743 and an increase related to cash restricted for
debt service of $61,250.
<PAGE>
On a historical basis, for the year ended December 31, 1996, the Company's net
cash provided by operating activities was $23,831 comprised primarily of a net
loss of $5,989 adjusted by non-cash depreciation and amortization of $38,881 and
other non-cash items totaling ($7,184). Net cash used in investing activities
of $9,377 consisted primarily of additions to property, plant and equipment of
$38,548, the purchase of a loan receivable of $13,088 and acquisitions of
$30,090 (primarily the Freedom Acquisition), partially offset by net sales and
maturities of short-term investments of $73,995. Net cash provided by financing
activities of $9,391 included the issuance of long-term debt of $19,000 and
change in affiliate notes of $32,802 partially offset by the redemption of long-
term debt of $44,750.
IMPACT OF THE YEAR 2000 ISSUE
The Company has certain financial, administrative and operational systems
which are subject to Year 2000 exposures. The Company has performed a study to
identify those specific systems which require remediation and developed a plan
to correct such situations in a timely fashion. The Company's plan is
proceeding on target. The plan includes ensuring that those systems for which
the Company is dependent on external vendors, such as certain billing systems,
will be Year 2000 compliant by the end of 1999 based on the status of external
vendors' remediation efforts. For those internal systems that require
corrective action, the Company has contracted with its information systems
services provider to rewrite the relevant programming code. Finally, the
Company is well along on a conversion of its suite of financial systems to a
state-of-the-art Oracle system. Such system is expected to ensure Year 2000
compliance in financial applications, enable the Company to process and report
its financial transactions more efficiently and provide a greater level of
detailed information to facilitate management's analysis which is critical to
its business decisions.
The Company is employing a team approach across its management information
systems, financial and operational groups in addressing the above issues, as
well as utilizing the assistance of external consultants in the case of the
Oracle implementation. Such team approach facilitates a consistent progress
along plans without disruption of other areas of the business.
There is no assurance that the Company's plans will continue to progress as
intended. The Company estimates that its cost of Year 2000 remediation will not
be material.
<PAGE>
<TABLE>
<CAPTION>
RCN Corporation and Subsidiaries
CONSOLIDATED STATEMENTS OF OPERATIONS
(Thousands of Dollars Except Per Share Amounts) For the Years Ended December 31,
1997 1996 1995
-------------------------------------------
<S> <C> <C> <C>
Sales $127,297 $104,910 $91,997
Costs and expenses, excluding depreciation and amortization 134,967 79,107 75,003
Nonrecurring charges 10,000 - -
Depreciation and amortization 53,205 38,881 22,336
-------------------------------------------
Operating (loss) (70,875) (13,078) (5,342)
Interest income 22,824 25,602 29,001
Interest expense (25,602) (16,046) (16,517)
Other income (expense), net 131 (546) (304)
-------------------------------------------
(Loss) income before income taxes (73,522) (4,068) 6,838
(Benefit) provision for income taxes (20,849) 979 1,119
-------------------------------------------
(Loss) income before minority interest and equity in
unconsolidated entities (52,673) (5,047) 5,719
Minority interest in loss (income) of consolidated entities 7,296 1,340 (144)
Equity in (loss) of unconsolidated entities (3,804) (2,282) (3,461)
-------------------------------------------
(Loss) income before extraordinary item (49,181) (5,989) 2,114
Extraordinary charge - debt prepayment penalty, net of tax of $1,728 (3,210) - -
-------------------------------------------
Net (loss) income ($52,391) ($5,989) $2,114
===========================================
Basic earnings per average common share:
Income (loss) before extraordinary charge ($0.89) ($0.11) $0.04
Extraordinary charge - debt prepayment penalty ($0.06) - -
Net income (loss) to shareholders ($0.95) ($0.11) $0.04
Weighted average shares outstanding 54,965,716 54,918,394 54,890,334
Diluted earnings per average common share:
Income (loss) before extraordinary charge ($0.89) ($0.11) $0.04
Extraordinary charge - debt prepayment penalty ($0.06) - -
Net income (loss) to shareholders ($0.95) ($0.11) $0.04
Weighted average shares and common stock equivalents outstanding 54,965,716 54,918,394 54,890,334
See accompanying notes to Consolidated Financial Statements.
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
RCN Corporation and Subsidiaries
CONSOLIDATED BALANCE SHEETS
(Thousands of Dollars) December 31,
1997 1996
---------------------
<S> <C> <C>
ASSETS
Current assets
Cash and temporary cash investments $222,910 $61,843
Short-term investments 415,603 46,831
Accounts receivable from related parties 9,829 12,614
Accounts receivable, net of reserve for doubtful accounts
of $2,134 in 1997 and $861 in 1996 17,815 10,413
Unbilled revenues 1,695 844
Material and supply inventory, at average cost 2,745 1,140
Prepayments and other 5,314 4,556
Deferred income taxes 4,821 4,371
Investments restricted for debt service 22,500 -
---------------------
Total current assets 703,232 142,612
---------------------
Notes receivable - affiliates - 155,481
Property, plant and equipment, net of accumulated depreciation
of $107,419 in 1997 and $84,529 in 1996 200,340 135,828
Investments restricted for debt service 39,411 -
Investments 70,424 76,547
Intangible assets, net 96,547 93,471
Deferred charges and other assets 41,038 24,146
---------------------
Total assets $1,150,992 $628,085
=====================
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities
Accounts payable to related parties $3,748 $4,880
Accounts payable 24,835 13,642
Advance billings and customer deposits 7,318 6,859
Accrued taxes 488 1,950
Accrued interest 5,549 5,041
Accrued contract settlements 3,126 3,565
Accrued cable programming expense 3,498 3,188
Accrued expenses 21,143 18,167
---------------------
Total current liabilities 69,705 57,292
---------------------
Long-term debt 686,103 131,250
Notes payable - affiliates - 11,854
Deferred income taxes 19,612 28,245
Other deferred credits 2,596 3,290
Minority interest 16,392 5,389
Commitments and contingencies
Preferred stock - -
Common shareholders' equity:
Common stock, par value $1 per share
Authorized 100,000,000 shares
Issued and outstanding 54,989,870 and
1,400 shares at December 31, 1997 and
1996, respectively 54,989 1
Additional paid-in capital 321,766 -
Deficit (17,116) -
Shareholder's net investment - 393,819
Cumulative translation adjustment (3,055) (3,055)
---------------------
Total common shareholders' equity 356,584 390,765
---------------------
Total liabilities and shareholders' equity $1,150,992 $628,085
=====================
</TABLE>
See accompanying notes to Consolidated Financial Statements.
<PAGE>
<TABLE>
<CAPTION>
RCN CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(THOUSANDS OF DOLLARS)
For the Years Ended December 31,
1997 1996 1995
-----------------------------------------
<S> <C> <C> <C>
Cash flows from operating activities
Net (loss) income ($52,391) ($5,989) $2,114
Gain on pension curtailment/settlement - (3,437) -
Accretion of discounted debt 8,103 - -
Gain on sale of partnership interest (661) - -
Extraordinary item - debt prepayment penalty 3,210 - -
Depreciation and amortization 53,205 38,881 22,336
Deferred income taxes and investment tax credits, net (10,503) (6,477) 6,696
Provision for losses on accounts receivable 2,732 1,788 614
Equity in loss of unconsolidated entities 3,804 2,282 3,461
Minority interest (7,296) (1,340) 144
Net change in certain assets and liabilities, net of business acquisitions:
Accounts receivable and unbilled revenues (14,979) (3,780) (5,550)
Material and supply inventory (1,605) (814) 777
Accounts payable 11,193 2,954 3,983
Accrued expenses 3,353 4,283 2,783
Accounts receivable from related parties 3,180 1,572 11,860
Accounts payable to related parties (1,132) (5,448) (419)
Other, net 367 597 529
Other 1,081 (1,241) (769)
-----------------------------------------
Net cash provided by operating activities 1,661 23,831 48,559
-----------------------------------------
Cash flows from investing activities
Additions to property, plant and equipment (79,042) (38,548) (29,854)
Purchase of short-term investments (445,137) (75,091) (238,257)
Sales and maturities of short-term investments 76,923 149,086 245,112
Acquisitions, net of cash acquired (30,490) (30,090) (121,147)
Purchase of loan receivable - (13,088) -
Proceeds from sale of partnership interest 1,900 - -
Other (14) (1,646) (2,057)
-----------------------------------------
Net cash used in investing activities (475,860) (9,377) (146,203)
-----------------------------------------
Cash flows from financing activities
Redemption of long-term debt (141,250) (44,750) (28,741)
Issuance of long-term debt 688,000 19,000 19,300
Change in affiliate notes, net 97,624 32,802 (6,130)
Extraordinary item - debt prepayment penalty (3,210) - -
Payments made for debt financing costs (19,743) - -
Cash contribution from joint venture partner 9,016 - -
(Increase) related to investments restricted for debt service (61,250) - -
Proceeds from issuance of stock 230 - -
Transfers from C-TEC 89,323 78,550 132,707
Transfers (to) C-TEC (23,474) (76,211) (148,339)
-----------------------------------------
Net cash provided by (used in) financing activities 635,266 9,391 (31,203)
-----------------------------------------
Net increase (decrease) in cash and temporary cash investments 161,067 23,845 (128,847)
Cash and temporary cash investments at beginning of year 61,843 37,998 166,845
-----------------------------------------
Cash and temporary cash investments at end of year $222,910 $61,843 $37,998
=========================================
Supplemental disclosures of cash flow information
Cash paid during the periods for:
Income taxes $1,090 $549 $497
========================================
Interest (net of amounts capitalized) $16,536 $16,046 $16,404
========================================
See accompanying notes to Consolidated Financial Statements
</TABLE>
<PAGE>
RCN CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(THOUSANDS OF DOLLARS)
Supplemental Schedule of Non-Cash Investing and Financing Activities
In March 1997, the Company acquired the portion of Freedom which it
did not already own. The transaction was accounted for as a purchase.
A summary of the transaction is as follows:
Cash paid $40,000
Non-capitalizable costs (10,000)
Reduction of minority interest (3,812)
---------
Fair value of assets acquired $26,188
=========
In 1996, C-TEC acquired an 80.1% interest in Freedom New York, L.L.C.
The acquisition was accounted for as a purchase.
A summary of the acquisition is as follows:
Cash paid $28,906
Liabilities assumed 7,621
Deferred tax asset recognized (167)
Minority interest recognized 6,188
---------
Fair value of assets acquired $42,548
=========
In 1995, C-TEC acquired all the outstanding Common Stock of Twin County
Trans Video, Inc. and a related covenant not to compete.
The consideration for the acquisition was as follows:
Cash paid (including $1,000 deposit in 1994) $37,313
Issuance of 5% Promissory Note 4,000
Capital contribution by stockholder 39,493
Liabilities assumed 16,364
Deferred tax liability incurred 33,797
---------
Fair value of assets acquired $130,967
=========
In 1996, the $4,000 promissory note was canceled and the Company paid cash
of $500 in settlement of certain purchase price adjustments.
Certain intercompany accounts receivable and payable and intercompany note
balances were transferred to Shareholders' Net Investment in connection
with the Distribution.
BECO's contribution of the IRU to the RCN-BECOCOM joint venture (Note 7(a))
is reflected as "Advanced Fiber Plant" at its fair value.
See accompanying notes to Consolidated Financial Statements
<PAGE>
<TABLE>
<CAPTION>
RCN CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
For the Years Ended December 31, 1997, 1996 and 1995
(Thousands of Dollars)
Common Additional Shareholder's Cumulative Total
Shares Issued Common Paid Net Translation Shareholders'
and Outstanding Stock in Capital Deficit Investment Adjustment Equity
---------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
Balance, December 31, 1994 1,400 $ 1 $ - $ - $372,846 $ - $372,847
Net income 2,114 2,114
Transfers from C-TEC 21,714 21,714
Cumulative translation adjustment (2,606) (2,606)
---------------------------------------------------------------------------------------------
Balance, December 31, 1995 1,400 1 - - 396,674 (2,606) 394,069
Net loss (5,989) (5,989)
Transfers from C-TEC 3,134 3,134
Cumulative translation adjustments (449) (449)
---------------------------------------------------------------------------------------------
Balance, December 31, 1996 1,400 1 - - 393,819 (3,055) 390,765
Net loss from 1/1/97 through 9/30/97 (35,275) (35,275)
Net loss from 10/1/97 through 12/31/97 (17,116) (17,116)
Transfers from C-TEC 17,980 17,980
Common stock issued in connection
with the distribution 54,967,952 54,968 321,556 (376,524) -
Stock plan transactions 20,518 20 210 230
---------------------------------------------------------------------------------------------
Balance, December 31, 1997 54,989,870 $54,989 $321,766 ($17,116) $ - ($3,055) $356,584
=============================================================================================
See accompanying notes to Consolidated Financial Statements
</TABLE>
<PAGE>
RCN CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Thousands of Dollars Except Per Share Data)
1. BACKGROUND AND BASIS OF PRESENTATION
Prior to September 30, 1997, RCN Corporation (the "Company" or "RCN") was
operated as part of C-TEC Corporation ("C-TEC"). On September 30, 1997, C-TEC
distributed 100 percent of the outstanding shares of common stock of its wholly
owned subsidiaries, RCN Corporation ("RCN") and Cable Michigan, Inc. ("Cable
Michigan") to holders of record of C-TEC's Common Stock and C-TEC's Class B
Common Stock as of the close of business on September 19, 1997 (the
"Distribution") in accordance with the terms of a Distribution Agreement dated
September 5, 1997 among C-TEC, RCN and Cable Michigan. RCN consists primarily
of C-TEC's bundled residential voice, video and Internet access operations in
the Boston to Washington, D.C. corridor, its existing New York, New Jersey and
Pennsylvania cable television operations, a portion of its long distance
operations and its international investment in Megacable, S.A. de C.V.
("Megacable"). C-TEC's corporate services group and corporate financial
services company both became subsidiaries of RCN immediately coincident with the
Distribution. Cable Michigan, Inc. consists of C-TEC's Michigan cable
operations, including its 62% ownership in Mercom, Inc. In connection with the
Distribution, C-TEC changed its name to Commonwealth Telephone Enterprises, Inc.
("CTE").
The consolidated financial statements have been prepared using the historical
basis of assets and liabilities and historical results of operations of all
wholly and majority owned subsidiaries. However, the historical financial
information presented herein reflects periods during which the Company did not
operate as an independent company and accordingly, certain assumptions were made
in preparing such financial information. Such information, therefore, may not
necessarily reflect the results of operations, financial condition or cash flows
of the Company in the future or what they would have been had the Company been
an independent, public company during the reporting periods. All material
intercompany transactions and balances have been eliminated. Investments
accounted for by the equity method include a 40% interest in Megacable, a
Mexican cable television system operator. Joint ventures which the Company
controls and in which the minority investors do not possess significant veto
rights are consolidated. Other joint ventures are accounted for by the equity
method.
C-TEC's corporate services group has historically provided substantial support
services such as finance, cash management, legal, human resources, insurance and
risk management and its financial statements are included in the consolidated
financial statements of the Company. Prior to the Distribution, the corporate
office allocated the cost for these services pro rata among the business units
supported primarily based on assets; contribution to consolidated earnings
before interest, depreciation, amortization, and income taxes; and number of
employees. In the opinion of management, the method of allocating these costs
is reasonable; however, the costs of these services remaining with the Company
after allocation to C-TEC's other business units are not necessarily indicative
of the costs that would have been incurred by the Company on a stand-alone
basis. It is not practicable to estimate the expenditures for allocated support
services that RCN would have incurred on a stand-alone basis. The historical
expense levels for these services after allocation to CTE and Cable Michigan
were approximately $5,000, $8,000 and $8,000 for 1995, 1996 and the nine months
ending September 30, 1997, respectively. The Company expects that its expense
levels for these services on a forward-looking basis will exceed the historical
levels due to growth and increasing complexity of the business. Also included in
the Company's consolidated financial statements are the financial statements of
the corporate financial services company which invests excess cash of, and
advances funds to the Company and prior to the Distribution, CTE. The financial
services company charges interest expense on outstanding advances and pays
interest income on excess cash invested for affiliates.
CTE, RCN and Cable Michigan have entered into certain agreements providing for
the Distribution, and governing various ongoing relationships, including the
provision of support services, between the three companies, including a
distribution agreement and a tax-sharing agreement.
2. SEGMENT INFORMATION
In June 1997 the Financial Accounting Standards Board (FASB) issued Statement of
Financial Accounting Standard No. 131 - "Disclosure about Segments of an
Enterprise and Related Information" ("SFAS 131"). This statement, which
establishes standards for the reporting of information about operating segments
and requires the reporting of selected information about operating segments in
interim and year end financial statements, is effective for fiscal years
beginning after December 15, 1997. If applicable, this statement would only
require additional disclosures in the Company's consolidated financial
statements and as such, its adoption will not have any impact on the Company's
consolidated financial position or results of operations. The Company's
operations involve developing an advanced fiber network to provide a bundled
service package of voice, video and data services to new customers in high
density markets and migrating as many customers as is economically justified
which were served by the Company's previously separate lines of business, for
which profitability was separately measurable and monitored, to the single
source network. While the Company's chief decision makers monitor the revenue
streams of the various products, operations are managed and financial
performance is evaluated based upon the delivery of multiple services to
customers over a single network. This allows the Company to leverage its network
costs to maximum profitability. It is management's belief that the Company
operates as one reportable operating segment which contains many shared expenses
generated by the Company's various revenue streams and that any segment
allocation of shared expenses incurred on a single network to multiple revenue
streams would be impractical and arbitrary; furthermore, the Company currently
does not make such allocations internally. The Company's chief decision makers
do, however, monitor financial performance in a way which is different from that
depicted in the historical general purpose financial statements in that such
measurement includes the consolidation of all joint ventures, including
Starpower which is not consolidated under generally accepted accounting
principles. Such information, however, does not represent a separate segment
under generally accepted accounting principles and therefore it is not
separately disclosed.
<PAGE>
3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Use of Estimates - The preparation of financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
<PAGE>
Cash and Temporary Cash Investments - For purposes of reporting cash flows,
the Company considers all highly liquid investments purchased with an original
maturity of three months or less to be temporary cash investments. Temporary
cash investments are stated at cost which approximates market.
Short-Term Investments and Investments Restricted for Debt Service -Management
determines the appropriate classification of its investments in debt and equity
securities at the time of purchase and re-evaluates such determination at each
balance sheet date in accordance with Statement of Financial Accounting
Standards No. 115 -- "Accounting for Certain Investments in Debt and Equity
Securities." At December 31, 1997 and 1996, marketable debt and equity
securities have been categorized as available for sale. The Company states its
short-term investments at cost, which approximates market. Investments
restricted for debt service have been categorized as held to maturity since
management has the positive intent and ability to hold such securities to
maturity. At December 31, 1997, investments restricted for debt service are
comprised of Federal Agency notes and are stated at cost, which approximates
market.
Property, Plant and Equipment and Depreciation - Property, plant and equipment
reflects the original cost of acquisition or construction, including payroll and
related costs such as taxes, pensions and other fringe benefits, and certain
general administrative costs.
Depreciation is provided on the straight-line method based on the useful lives
of the various classes of depreciable property. The average estimated lives of
depreciable property, plant and equipment are:
<TABLE>
<CAPTION>
Lives
----------------------
<S> <C>
Hybrid fiber/coaxial plant 5-22 years
Advanced fiber plant 10-15 years
Wireless & other plant 5 years
Buildings and leasehold improvements 5-45 years
Furniture, fixtures and vehicles 3-10 years
Other 3 years
</TABLE>
Repairs of all property, plant and equipment and minor replacements and
renewals are charged to expense as incurred. Major replacements and betterments
are capitalized. Gain or loss is recognized on major retirements and
dispositions.
Intangible Assets - Intangible assets are amortized on a straight-line basis
over the expected period of benefit ranging from 2 to 15 years.
Accounting for Impairments - The Company follows the provisions of Statement
of Financial Accounting Standards No. 121 -- "Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to be Disposed of " ("SFAS 121").
SFAS 121 requires that long-lived assets and certain identifiable intangibles to
be held and used by an entity be reviewed for impairment whenever events or
changes in circumstances indicate that the carrying amount of an asset may not
be recoverable. In performing the review for recoverability, the Company
estimates the future cash flows expected to result from the use of the asset
and its eventual disposition. If the sum of the expected net future cash flows
(undiscounted and without interest charges) is less than the carrying amount of
the asset, an impairment loss is recognized. Measurement of an impairment loss
for long-lived assets and identifiable intangibles expected to be held and used
is based on the fair value of the asset.
No impairment losses have been recognized by the Company pursuant to SFAS 121.
Revenue Recognition - Local telephone service revenue is recorded as earned
based on tariffed rates. Long distance telephone service revenue is recorded
based on minutes of traffic processed and tariffed rates or contracted fees.
Revenues from cable programming services are recorded in the month the service
is provided. Internet access service revenues are recorded based on contracted
fees.
Advertising Expense - Advertising costs are expensed as incurred. Advertising
expense charged to operations was $12,203, $1,441 and $862 in 1997, 1996 and
1995, respectively.
Stock Based Compensation - The Company applies Accounting Principles Board
Opinion No. 25 -- "Accounting for Stock Issued to Employees" ("APB 25") in
accounting for its stock plans. The Company has
<PAGE>
adopted the disclosure - only provisions of Statement of Financial Accounting
Standards No. 123 -- "Accounting for Stock-Based Compensation" ("SFAS 123").
Earnings (loss) per share - The Company has adopted statement of Financial
Accounting Standards No. 128 -- "Earnings Per Share" ("SFAS 128"). Basic
earnings (loss) per share is computed based on net income (loss) divided by the
weighted average number of shares of common stock outstanding during the period.
Diluted earnings (loss) per share is computed based on net income (loss)
divided by the weighted average number of shares of common stock outstanding
during the period after giving effect to convertible securities considered to be
dilutive common stock equivalents. The conversion of stock options during
periods in which the Company incurs a loss from continuing operations is not
assumed since the effect is anti-dilutive. The number of stock options which
would have been converted in 1997 and have a dilutive effect if the Company had
income from continuing operations is 517,506.
For periods prior to October 1, 1997, during which the Company was a wholly
owned subsidiary of C-TEC, earnings (loss) per share was calculated by dividing
net income (loss) by the number of average common shares of C-TEC outstanding,
based upon a distribution ratio of one share of Company common equity for each
share of C-TEC common equity owned.
<TABLE>
<CAPTION>
Years Ended December 31,
----------------------------------------------------
1997 1996 1995
--------------- ---------------- ----------------
<S> <C> <C> <C>
Income (loss) before extraordinary charge $ (49,181) $ (5,989) $ 2,114
====================================================
Basic earnings per average common share:
Average shares outstanding 54,965,716 54,918,394 54,890,334
(Loss) income per average common share $ (0.89) $ (0.11) $ 0.04
Diluted earnings per average common share:
Average shares outstanding 54,965,716 54,918,394 54,890,334
Dilutive shares resulting from stock options -- -- --
----------------------------------------------------
54,965,716 54,918,394 54,890,334
====================================================
(Loss) income per average common share $ (0.89) $ (0.11) $ 0.04
</TABLE>
Income Taxes - The Company and its subsidiaries report income for federal tax
purposes on a consolidated basis. Prior to the Distribution, the Company and
its subsidiaries were included in the consolidated federal income tax return of
C-TEC. Income tax expense is allocated to subsidiaries on a separate return
basis except that the Company's subsidiaries receive benefit for the utilization
of net operating losses and investment tax credits included in the consolidated
return even if such losses and credits could not have been used on a separate
return basis. The Company accounts for income taxes using Statement of
Financial Accounting Standards No. 109 -- "Accounting for Income Taxes." The
statement requires the use of an asset and liability approach for financial
reporting purposes. The asset and liability approach requires the recognition
of deferred tax assets and liabilities for the expected future tax consequences
of temporary differences between financial reporting basis and tax basis of
assets and liabilities. If it is more likely than not that some portion or all
of a deferred tax asset will not be realized, a valuation allowance is
recognized.
Investment tax credits ("ITC") for the Company have been deferred in prior
years and are being amortized over the average lives of the applicable property.
Foreign Currency Translation - The Company has a 40% interest in Megacable.
For purposes of determining its equity in the earnings of Megacable, the Company
translates the revenues and expenses of Megacable into U.S. dollars at the
average exchange rates that prevailed during the period. Assets and liabilities
are translated into U.S. dollars at the rates in effect at the end of the fiscal
period. Prior to 1997, the Company's share of the gains or losses that result
from this process are shown in the cumulative translation adjustment account in
the common shareholders' equity section of the balance sheet. Effective January
1, 1997, since the three-year cumulative rate of inflation at December 31, 1996
exceeded 100%, Mexico is treated for accounting purposes as having a highly
inflationary economy. As a result, the financial statements of Megacable are
remeasured as if the functional currency were the U.S. dollar. The
remeasurement of the Mexican peso into U.S. dollars creates translation
<PAGE>
adjustments which are included in net income. The Company's proportionate share
of gains and losses resulting from transactions of Megacable, which are made in
currencies different from its own, are included in income as they occur.
4. BUSINESS COMBINATIONS
The following business combinations were transacted by wholly owned
subsidiaries of C-TEC. The acquired businesses were transferred to the Company
in connection with the Distribution.
On August 30, 1996, FNY Holding Company, Inc., formerly a wholly owned
subsidiary of C-TEC ("FNY") acquired from Kiewit Telecom Holdings, C-TEC's
controlling shareholder at the time, an 80.1% interest in Freedom New York, LLC
and all related rights and liabilities ("Freedom") for cash consideration of
approximately $29,000. In addition, FNY assumed liabilities of approximately
$7,600. (In March 1996, Freedom had acquired the wireless cable television
business of Liberty Cable Television). The acquisition was accounted for as a
purchase, and accordingly, Freedom is included in the Company's consolidated
financial statements since September 1996. The full fair value of assets
acquired and liabilities assumed has been reflected in the Company's financial
statements with minority interest reflecting the separate 19.9% ownership.
FNY allocated the purchase price paid on the basis of the fair value of
property, plant and equipment and identifiable intangible assets acquired and
liabilities assumed. There was no excess cost over fair value of net assets
acquired.
Contingent consideration of $15,000 was payable in cash and was to be based
upon the number of net eligible subscribers, as defined in the Acquisition
Agreement, in excess of 16,563 delivered to the Company. The contingent
consideration is not included in the acquisition cost total above but was to
have been recorded when and if the future delivery of subscribers occurred. In
addition, FNY paid $922 to Kiewit Telecom Holdings which represents compensation
for foregone interest on the amount invested by Kiewit Telecom Holdings in
Freedom. This amount has been charged to operations.
On March 21, 1997, the Company paid $15,000 in full satisfaction of contingent
consideration payable for the original acquisition of Freedom. Additionally,
pursuant to the terms of the Freedom Operating Agreement, the assets of RCN
Telecom Services of New York, Inc., a wholly-owned subsidiary of RCN, were
contributed to Freedom, in which the Company had an 80.1% ownership interest
prior to such contribution. Subsequent to this contribution, the Company paid
$15,000 to acquire the minority ownership of Freedom. These amounts were
primarily allocated to excess cost over fair value of net assets acquired and
are being amortized over a period of approximately six years. The Company also
paid $10,000 to terminate a marketing services agreement between Freedom and an
entity controlled by Freedom's former minority owners. The Company charged this
amount to operations for the quarter ended March 31, 1997.
On May 15, 1995, C-TEC Cable Systems, Inc., ("RCN Cable") formerly a wholly
owned subsidiary of C-TEC, acquired 40% of the outstanding common stock of Twin
County Trans Video, Inc. ("Twin County") in exchange for cash of approximately
$26,300, including a $1,000 deposit made in 1994, and a $4,000, 5% promissory
note of RCN Cable. In addition, RCN Cable paid $11,000 in consideration of a
noncompete agreement and assumed liabilities of approximately $16,400. The
remaining shares were subject to an escrow agreement, pending completion of the
merger, and were required to be voted under the direction of RCN Cable. As of
May 15, 1995, RCN Cable also assumed management of Twin County. As a result,
RCN Cable had control of Twin County and accordingly Twin County is consolidated
in the Company's financial statements since May 1995, the date of the original
acquisition. The remaining outstanding common stock of Twin County was acquired
in September 1995 in exchange for $52,000 stated value redeemable convertible
preferred stock of C-TEC. The preferred stock has a stated dividend rate of 5%,
beginning January 1, 1996. The fair value of the preferred stock, as determined
by an independent appraiser was $39,500 which was recorded as additional paid-in
capital to the Company. In 1996, the $4,000 promissory note was canceled and
RCN Cable paid cash of $500 in settlement of certain purchase price adjustments.
RCN Cable has allocated the purchase price paid for Twin County on the basis
of the fair value of property, plant and equipment and identifiable intangible
assets acquired and liabilities assumed. The excess of the consideration for
the acquisition over the fair value of the net assets acquired of approximately
$16,700 has been allocated to goodwill and is being amortized over a period of
approximately 10 years.
<PAGE>
In January 1995, RCN International Holdings, Inc. (formerly C-TEC
International, Inc.), formerly a wholly owned subsidiary of C-TEC, purchased a
40% equity position in Megacable. The aggregate consideration for the purchase
was cash of $84,115. The Company accounts for its investment by the equity
method of accounting. The original excess cost over the underlying equity in
the net assets acquired is approximately $94,000, which is being amortized on a
straight-line basis over 15 years.
In January 1995, RCN Cable purchased the assets of Higgins Lake Cable, Inc.
for cash of approximately $4,750.
In June 1995, C-TEC invested approximately $2,220 for a one-third interest in
a partnership which intends to provide alternative access telephone service to
commercial subscribers. C-TEC transferred this investment to RCN Cable in 1996
at net book value of $1,977. The Company disposed of its investment in 1997 and
realized a gain of $661.
In November 1995, the Company purchased the assets used in the provision of
residential telephone services in New York by RealCom Office Communications,
Inc. for cash of approximately $1,050.
The following unaudited pro forma summary presents information as if the
acquisitions of Freedom and Twin County had occurred at the beginning of 1996.
The pro forma information is provided for information purposes only. It is
based on historical information and does not necessarily reflect the actual
results that would have occurred nor is it necessarily indicative of future
results of operations of the consolidated entities.
<PAGE>
<TABLE>
<CAPTION>
Years Ended December 31,
-----------------------------------
1997 1996
---------------- ----------------
(Unaudited)
<S> <C> <C>
Sales $127,297 $110,116
(Loss) from continuing operations before extraordinary items $(72,245) $(20,189)
Net (loss) $(53,831) $(16,807)
Pro Forma Earnings Per Share:
(Loss) from continuing operations before extraordinary items $ (1.31) $ (0.37)
Net (loss) $ (0.98) $ (0.31)
</TABLE>
5. SHORT-TERM INVESTMENTS
Short-term investments, stated at cost, include the following at December 31,
1997 and 1996:
<TABLE>
<CAPTION>
1997 1996
--------------- ---------------
<S> <C> <C>
Federal Agency notes $110,966 $ --
Commercial Paper 43,859 8,823
Corporate debt securities 222,785 38,008
Certificates of deposit 37,993 --
----------------------------------
Total $415,603 $46,831
==================================
</TABLE>
At December 31, 1997, short term investments with an amortized cost of
$329,714 have contractual maturities of one to three years. All remaining short
term investments have contractual maturities under one year.
6. PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment consists of the following at December 31,
<TABLE>
<CAPTION>
1997 1996
----------------- ----------------
<S> <C> <C>
Hybrid fiber/coaxial plant $ 157,652 $148,172
Advanced fiber plant 76,572 29,226
Wireless & other plant 4,771 4,245
Buildings, leasehold improvements and land 16,607 10,989
Furniture, fixtures and vehicles 23,399 18,119
Construction in process 28,195 9,013
Other 563 593
------------------------------------
Total property, plant and equipment 307,759 220,357
Less accumulated depreciation (107,419) (84,529)
------------------------------------
Property, plant and equipment, net $ 200,340 $135,828
====================================
</TABLE>
Depreciation expense was $24,257, $19,372 and $13,236 for the years ended
December 31, 1997, 1996 and 1995, respectively.
<PAGE>
7. INVESTMENTS AND JOINT VENTURES
Investments at December 31, are as follows:
<TABLE>
<CAPTION>
1997 1996
--------------- ---------------
<S> <C> <C>
Megacable $70,363 $74,232
Partnership -- 2,315
Other 61 --
----------------------------------
Total Investments $70,424 $76,547
==================================
</TABLE>
Investments carried on the equity method consist of the following at December
31:
<TABLE>
<CAPTION>
Percentage Owned
------------------------------
1997 1996
-------------- -------------
<S> <C> <C>
Megacable 40.00% 40.00%
Partnership Interest -- 33.33%
Starpower Communications, LLC 50.00% --
</TABLE>
a. In September 1996, RCN and Boston Edison Company ("BECO"), through wholly
owned subsidiaries, entered into a letter of intent to form a joint venture to
utilize 126 fiber miles of BECO's fiber optic network to deliver RCN's
comprehensive communications package in Greater Boston. The venture, in the
form of an unregulated entity with a term expiring in the year 2060, was formed
pursuant to a joint venture agreement dated December 23, 1996 (the "Boston Joint
Venture Agreement") providing for the organization and operation of RCN-BECOCOM,
LLC ("RCN-BECOCOM"). RCN-BECOCOM was organized to own and operate an advanced
fiber optic telecommunications network and to provide, in the market in and
around Boston, Massachusetts , voice, video and data services, as well as the
communications support component of energy related customer services offered by
BECO. RCN owns 51% of the equity interest in RCN-BECOCOM and BECO, owns the
remaining 49% interest. Future capital contributions are required to be made on
a 51% and 49% basis for RCN and BECO, respectively.
The closing of the transactions contemplated by the Boston Joint Venture
Agreement occurred on June 17, 1997. RCN will manage the business of RCN-
BECOCOM pursuant to the terms of the Management Agreement and, in consideration
therefor, will receive reimbursement for its reasonable costs, and a
performance-based fee (based on factors including the number of subscribers and
operating cash flow) to be determined by agreement of RCN and RCN-BECOCOM. The
initial term of the agreement expires on December 31, 2001. The agreement
provides for automatic successive three-year renewal periods, unless notice is
given ninety days before the end of the period. As a result of its ownership,
management and control, this joint venture with BECO is consolidated in RCN's
financial statements.
Pursuant to an Indefeasible Right of Use Agreement ("IRU Agreement") , BECO
will, for certain agreed upon fees, (i) provide construction services to build
out the Network, (ii) make available to RCN-BECOCOM (a) all of the available
capacity of BECO's existing fiber backbone, and (b) the ability to use BECO's
real estate, poles, easements and other interests for the construction and
operation of the Network and (iii) maintain the Network. BECO's construction
obligations expire on June 17, 2007 and the term of the IRU Agreement expires on
December 31, 2060. One year before each respective expiration date, BECO agrees
to commence good-faith negotiations to extend construction obligations beyond
June 17, 2007 and to allow continued use of BECO's facilities beyond December
31, 2060. The fair value of the IRU transferred by BECO to the joint venture is
reflected as "Advanced Fiber Plant" in property, plant and equipment.
BECO will have the right at the time of the Distribution and every two years
thereafter to convert its ownership interest in RCN-BECOCOM into the Common
Stock of RCN pursuant to specific terms and conditions. If BECO exercises its
conversion rights, BECO will remain obligated to make 49% of all cash
contributions by the parties and any cash contributions made after conversion
will result in it owning a portion of RCN-BECOCOM based on the value of RCN-
BECOCOM at the time of the contribution. BECO may exercise its conversion
rights in whole or in part from time to time. In January 1998, BECO notified
RCN that it has elected to exercise its option to the full extent permitted by
the Exchange Agreement with respect to 1997. RCN and BECO are presently in
discussions with respect to the calculation of the agreed upon value for the
exercise of such option.
<PAGE>
b. On August 1, 1997, RCN and Potomac Capital Investment Corporation
("PCI"), a wholly owned subsidiary of PEPCO, entered into a letter of intent
(the "Letter of Intent") to form a joint venture which will own and operate a
communications network to provide voice, video, data and other communications
services to residential and commercial customers in the greater Washington,
D.C., Virginia and Maryland area (the "Washington, D.C. Market"). Starpower, an
unregulated limited liability company with a perpetual term, was formed on
October 28, 1997 to construct, own, lease, operate and market a network for the
selling of voice, video, data and other telecommunications services to all
potential commercial and residential customers in the Washington, D.C. Market.
RCN owns 50% of the equity interest in Starpower and PCI owns the remaining 50%
interest.
The closing of the Starpower joint venture (the "Starpower Closing") occurred
on December 19, 1997.
Pursuant to the Amended and Restated Operating Agreement, RCN and Pepco
Communications are each required to make additional capital contributions in
accordance with a schedule set forth in such agreement on a 50%/50% basis.
Failure of either RCN or Pepco Communications to make a scheduled capital
contribution or to vote in favor of certain additional capital contributions may
result in the recalculation of equity interests. The business and affairs of
Starpower is to be managed by RCN and Pepco Communications. So long as RCN and
Pepco Communications maintain a 50%/50% equity interest in the joint venture,
each of RCN and Pepco Communications will appoint three members to the
operating committee, the approval of which is required for any business action.
Certain fundamental business actions, such as mergers, acquisitions, sales of
substantially all of the assets, liquidation and amendments to the certificate
of organization or any agreement signed at the Starpower Closing, require the
unanimous approval of the operating committee regardless of whether the parties
continue to maintain a 50%/50% ownership interest. As a result of the joint
control, Starpower is accounted for under the equity method of accounting.
A subsidiary of RCN will provide support services including customer service,
billing, marketing and certain administrative, accounting and technical support
services, each of which shall be provided at cost.
c. The basis of the Company's investment in Megacable exceeded its underlying
equity in the net assets of Megacable when acquired by approximately $94,000
which excess is being amortized on a straight-line basis over 15 years. At
December 31, 1997, the unamortized excess over the underlying equity in the net
assets was $75,886. The Company recorded its proportionate share of (losses)
and amortization of excess cost over net assets of ($3,869), ($2,190) and
($3,061) in 1997, 1996 and 1995, respectively.
Effective January 1, 1997, since the three-year cumulative rate of inflation
at December 31, 1996 exceeded 100%, Mexico is being treated for accounting
purposes under Statement of Financial Accounting Standards No. 52 -- "Foreign
Currency Translation", as having a highly inflationary economy. As a result,
the financial statements of Megacable are remeasured as if the functional
currency were the U.S. dollar. The remeasurement of the Mexican peso into U.S.
dollars creates translation adjustments which are included in net income.
Exchange gains (losses) of $(12), $247, and $(932) in 1997, 1996 and 1995,
respectively, including translation losses in 1997, are included in the
respective statements of operations through the Company's proportionate share of
losses of Megacable.
The following table reflects the summarized financial position and results of
operations of Megacable as of and for the years ended December 31, 1997 and
1996:
<TABLE>
<CAPTION>
1997 1996
---------------- ---------------
<S> <C> <C>
Assets $76,323 $67,672
Liabilities 8,347 6,455
Stockholders' equity 67,976 61,217
Sales 30,441 23,225
Costs and expenses 23,389 15,689
Foreign currency transaction gains (losses) (31) 618
Net income 6,653 10,226
</TABLE>
<PAGE>
8. INTANGIBLE ASSETS
Intangible assets consist of the following at December 31,
<TABLE>
<CAPTION> Amortization
Period 1997 1996
--------------- ----------------- -----------------
<S> <C> <C> <C>
Franchises and subscriber lists 2-10.5 years $ 79,273 $ 78,720
Noncompete agreements 5-8 years 11,209 11,209
Goodwill 5-10 years 42,787 16,830
Building access rights 3-4 years 15,197 14,920
Other intangible assets 5-15 years 1,469 520
-------------------------------------
Total intangible assets 149,935 122,199
Less accumulated amortization (53,388) (28,728)
-------------------------------------
Intangible assets, net $ 96,547 $ 93,471
=====================================
</TABLE>
Amortization expense charged to operations in 1997, 1996 and 1995 was $28,948,
$19,509 and $9,100, respectively.
9. DEFERRED CHARGES AND OTHER ASSETS
Deferred charges and other assets consist of the following at December 31:
<TABLE>
<CAPTION>
1997 1996
--------------- ---------------
<S> <C> <C>
Note and interest receivable - Mazon Corporativo, S.A. de C.V. $17,682 $15,310
Debt issuance costs 19,743 309
Prepaid pension costs -- 2,967
Prepaid professional services 938 3,439
Other 2,675 2,121
----------------------------------
Total $41,038 $24,146
==================================
</TABLE>
10. DEBT
a. Long-term debt
Long-term debt outstanding at December 31 is as follows:
<TABLE>
<CAPTION>
1997 1996
--------------- ---------------
<S> <C> <C>
Senior Secured Notes 9.65% due 1999 $ -- $131,250
Revolving Credit Agreement 3,000 --
Term Credit Agreement 100,000 --
Senior Notes 10% due 2007 225,000 --
Senior Discount Notes 11 1/8% due 2007 358,103 --
----------------------------------
Total 686,103 131,250
Due within one year -- --
----------------------------------
Total Long -Term Debt $686,103 $131,250
==================================
</TABLE>
In October 1997, pursuant to Rule 144A of the Securities Exchange Act of 1933,
the Company completed an offering of 10% Senior Notes with an aggregate
principal amount of $225,000 and 11 1/8% Senior Discount Notes with an aggregate
principal amount at maturity of $601,045, both due 2007, to qualified
institutional buyers as defined in Rule 144A. The Senior Discount Notes were
issued at a discount and generated gross proceeds to the Company of $350,000.
In December 1997, the Company commenced an SEC registered Exchange Offer of its
10% Senior Notes due 2007, Series B for any and all outstanding 10% Senior Notes
due 2007, Series A and its 11 1/8% Senior Discount Notes due 2007, Series B for
any and all outstanding 11 1/8% Senior Discount Notes due 2007 Series A. The
Exchange Offer closed in January of 1998. All outstanding notes were exchanged.
<PAGE>
The 10% Senior Notes were issued under an indenture dated October 17, 1997
(the "10% Indenture") between the Company and The Chase Manhattan Bank, as
Trustee. The 10% Senior Notes are general senior obligations of the Company
which mature on October 15, 2007 and are collateralized by a pledge of the
Escrow Account which contains approximately $61,000 of the net proceeds from the
sale of the 10% Senior Notes plus approximately $1,000 of aggregate interest,
representing funds that, together with the future proceeds from the investment
thereof, will be sufficient to pay interest on the 10% Senior Notes for six
scheduled interest payments. Interest on the 10% Senior Notes is payable in
cash semi-annually in arrears on each April 15 and October 15, commencing April
15, 1998.
The 10% Indenture contains certain covenants that, among other things, limit
the ability of the Company and its subsidiaries to incur indebtedness, pay
dividends, prepay subordinated indebtedness, repurchase capital stock, engage in
transactions with stockholders and affiliates, create liens, sell assets and
engage in mergers and consolidations.
The 10% Senior Notes are redeemable, in whole or in part, at any time on or
after October 15, 2002 at the option of the Company. The 10% Senior Notes have
redemption prices starting at 105% of the principal amount and declining to 100%
of the principal amount, plus any accrued interest.
The 11 1/8% Senior Discount Notes were issued under an indenture dated October
17, 1997 (the "11 1/8% Indenture") between the Company and The Chase Manhattan
Bank, as Trustee. The 11 1/8% Senior Discount Notes are general senior
obligations of the Company, limited to $601,045 aggregate principal amount at
maturity and will mature on October 15, 2007. The 11 1/8% Senior Discount Notes
were issued at a discount to yield gross proceeds of $350,000. The 11 1/8%
Senior Discount Notes will not bear cash interest prior to October 15, 2002.
The 11 1/8% Indenture contains certain covenants that, among other things,
limit the ability of the Company and its subsidiaries to incur indebtedness, pay
dividends, prepay subordinated indebtedness, repurchase capital stock, engage in
transactions with stockholders and affiliates, create liens, sell assets and
engage in mergers and consolidations.
The 11 1/8% Senior Discount Notes are redeemable, in whole or in part, at any
time on or after October 15, 2002 at the option of the Company. The 11 1/8%
Senior Discount Notes have redemption prices starting at 105.562% of the
principal amount at maturity and declining to 100% of the principal amount at
maturity, plus any accrued interest.
The 10% Senior Notes and 11 1/8% Senior Discount Notes contain restrictions on
the Company's ability to pay dividends. At December 31, the Company was
restricted from making dividend payments under the terms of the 10% Indenture.
Certain subsidiaries of the Company, including RCN Cable, have in place a
$125,000 credit agreement0 comprised of two credit facilities. The first is a
five year revolving credit facility in the amount of $25,000 which provides
credit availability through June 30, 2002. Revolving loans may be repaid and
reborrowed from time to time. The second is a term credit facility in the amount
of $100,000 which is to be repaid over six years in quarterly installments from
September 30, 1999 through June 30, 2005. Interest only is due through September
29, 1999. The interest rate is based on either a LIBOR or Base Rate option, at
the election of the Company (6.82% at December 31, 1997). The credit agreement
is collateralized by a pledge by the Company of its stock in RCN Cable and may,
in the future, be secured by pledges of stock of subsidiaries of the Company. At
December 31, 1997, the entire $100,000 term credit facility is outstanding and
$3,000 of the revolving credit facility is outstanding. RCN Cable used a portion
of its initial borrowings under the credit facilities to prepay higher priced
Senior Secured Notes. The early extinguishment of the Senior Secured Notes
resulted in an extraordinary charge of $3,210, net of taxes of $1,728. The
credit agreement contains restrictive covenants which, among other things,
require the Company to maintain certain debt to cash flow and interest coverage
ratios and place certain limitations on additional debt and investments. The
Company does not believe that these covenants will materially restrict its
activities.
In 1989, in order to complete the August 29, 1989 Michigan Cable Television
acquisition, RCN Cable entered into a private placement of Senior Secured Notes
for $150,000 and a $70,000 Revolving Secured Credit Agreement, which was
voluntarily reduced to $60,000 in 1990 and which, in accordance with its terms,
reduced on a quarterly basis, through original scheduled maturity in September
1996. In August 1996, RCN Cable obtained an amendment and waiver related to
this Revolving Secured Credit Agreement which extended final maturity to
December 1996 and increased the amount of available borrowings. Additionally,
the restrictive covenant relating to limitations on the amount of capital
expenditures was waived for the year ending December 31, 1996. The Senior
Secured Notes were collateralized by the stock of certain cable subsidiaries of
the Company. On September 1, 1996 and on each
<PAGE>
September 1 thereafter, a mandatory principal repayment was required on the
Senior Secured Notes. The Senior Secured Notes contained restrictive covenants
which, among other things, required maintenance of a specified debt to cash flow
ratio. These notes were prepaid in 1997 as discussed above. The Senior Secured
Notes were classified as long-term at December 31, 1996 since the Company had
the intent and the ability to refinance this obligation on a long-term basis
through the above credit facilities.
In connection with the acquisition of Twin County Trans-Video, Inc., RCN Cable
issued a $4,000 promissory note at 5% due in May 2003. The note was unsecured.
In September 1996, the note was canceled in settlement of certain purchase price
adjustments.
Contractual maturities of long-term debt are as follows:
<TABLE>
<CAPTION>
Year Ending December 31, Aggregate Amounts
------------------------ --------------------
<S> <C>
1998 $ --
1999 $ 3,750
2000 $11,250
2001 $16,250
2002 $20,500
</TABLE>
b. Short-term debt
At December 31, 1997, the Company had unused lines of credit for $5,500 at
prime (8.50% at December 31, 1997). Short-term unsecured borrowings may be made
under these lines of credit. The amounts available under these lines of credit
are reduced by outstanding letters of credit ($3,060 at December 31,1997). All
unused lines of credit are cancellable at the option of the banks. There are no
commitment or facility fees associated with maintaining availability of the
above-mentioned lines of credit.
11. INCOME TAXES
The (benefit) provision for income taxes is reflected in the Consolidated
Statements of Operations as follows:
<TABLE>
<CAPTION>
1997 1996 1995
--------- -------- --------
<S> <C> <C> <C>
Current:
Federal $(11,795) $ 5,730 $(5,713)
State 1,449 1,102 375
------------------------------
Total Current (10,346) 6,832 (5,338)
------------------------------
Deferred:
Federal (10,161) (4,751) 7,016
State (342) (1,000) (377)
------------------------------
Total Deferred (10,503) (5,751) 6,639
------------------------------
Amortization of ITC -- (102) (182)
------------------------------
Provision (benefit) for income taxes:
Before extraordinary item (20,849) 979 1,119
Extraordinary item (1,728) -- --
------------------------------
Total (benefit) provision for income taxes $(22,577) $ 979 $ 1,119
==============================
</TABLE>
At December 31, 1997 and 1995, the Company had tax related balances due from
affiliates of $3,186 and $501, respectively. At December 31, 1996, the Company
had tax related balances due to affiliates of $817.
<PAGE>
Temporary differences that give rise to a significant portion of deferred tax
assets and liabilities at December 31, are as follows:
<TABLE>
<CAPTION>
1997 1996
--------- ---------
<S> <C> <C>
Net operating loss carryforwards $ 10,078 $ 2,130
Alternative minimum tax credits 167 219
Employee benefit plans 1,031 882
Reserve for bad debt 844 693
Start-up costs 586 959
Investment in unconsolidated entity 3,985 4,771
Accruals for nonrecurring charges and contract settlements 2,368 2,299
Other, net 1,823 1,888
---------------------
Total deferred tax assets 20,882 13,841
---------------------
(14,759) (15,019)
Property, plant and equipment
Intangible assets (11,253) (17,776)
All other (1,257) (1,229)
---------------------
Total deferred liabilities (27,269) (34,024)
---------------------
Subtotal (6,387) (20,183)
Valuation allowance (8,404) (3,691)
---------------------
Total deferred taxes $(14,791) $(23,874)
=====================
</TABLE>
In the opinion of management, based on the future turnaround of existing
temporary differences for the consolidated taxpaying group, primarily
depreciation, the Company will more likely than not be able to realize
substantially all of its deferred tax assets.
A valuation allowance has been provided for the portion of deferred tax assets
which, in the opinion of management is uncertain as to their realization. The
valuation allowance relates primarily to state net operating loss carryforwards
generated by certain subsidiaries.
The net change in the valuation allowance for deferred tax assets during 1997
was an increase of $4,713.
Net operating losses will expire as follows:
<TABLE>
<CAPTION>
Federal State
------- -------
<C> <S> <C>
1999 $ -- $ 2,793
2000 3,087
2001 14,532
2002 3,141
2003 10,244
2004 3,767
2011 38,116
2012 8,028
2017 8,218 --
------------------
Total $8,218 $83,708
==================
</TABLE>
<PAGE>
The provision (benefit) for income taxes is different from the amounts
computed by applying the U.S. statutory federal tax rate of 35%. The
differences are as follows:
<TABLE>
<CAPTION>
For the Years Ended December 31,
---------------------------------------------------
1997 1996 1995
---------------- ---------------- ----------------
<S> <C> <C> <C>
(Loss) income before (benefit) provision for the income taxes and
extraordinary item $(70,030) $(5,010) $3,233
=====================================================
Federal income tax benefit at statutory rate $(24,511) $(1,753) $1,131
State income taxes net of federal income tax benefit 719 66 (33)
Investment tax credits amortized -- (102) (50)
Amortization of goodwill 830 779 388
Estimated nondeductible expenses 1,913 1,564 (93)
Adjustment to prior year accrual (197) 421 (161)
Other, net 397 4 (63)
-----------------------------------------------------
Total (benefit) provision for income taxes $(20,849) $ 979 $1,119
=====================================================
</TABLE>
In 1995, C-TEC received official notification of final settlement from the
Internal Revenue Service relating to the examination of C-TEC's consolidated
federal income tax returns for 1989, 1990 and 1991. The most significant
adjustment relates to the disallowance of the claimed amortization of certain
intangible assets. As a result of the disallowance, the Company's taxes payable
for prior years increased approximately $580. The amount accrued in previous
years was sufficient to satisfy the above adjustment. No additional accrual
during 1995 was required.
In 1997 and 1996, estimated non-deductible expenses relate primarily to
charges in connection with the restructuring of the Company.
12. STOCKHOLDERS' EQUITY AND STOCK PLANS
The Company has authorized 100,000,000 shares of $1 par value common stock and
200,000,000 shares of $1 par value Class B nonvoting common stock. The Company
also has authorized 25,000,000 shares of $1 par value preferred stock. At
December 31, 1997, 54,989,870 shares of common stock are issued and outstanding.
In March 1998, the Company's Board of Directors approved a two-for-one stock
split, payable in the form of a 100% stock dividend. The record date for the
stock split is March 20, 1998. Stockholders of record at the market close on
that date will receive an additional share of RCN common stock for each share
held. The distribution date for the stock dividend will be April 3, 1998. All
share and per share data, stock option data, and market prices of the Company's
common stock have been restated to reflect this stock split.
In connection with the Distribution, the Company Board adopted the 1997 RCN
Corporation Stock Option Plan ("the 1997 Plan"), designed to provide equity
based compensation opportunities to key employees when shareholders of the
Company have received a corresponding benefit through appreciation in the value
of RCN Common Stock.
The 1997 Plan contemplates the issuance of incentive stock options, as well as
stock options that are not designated as incentive stock options, performance-
based stock options, stock appreciation rights, performance share units,
restricted stock, phantom stock units and other stock-based awards
(collectively, "Awards"). Up to 5,000,000 shares of Common Stock, plus
3,040,100 shares of Common Stock issuable in connection with the Distribution
related option adjustments, may be issued pursuant to Awards granted under the
1997 Plan.
Unless earlier terminated by the Company Board, the 1997 Plan will expire on
the tenth anniversary of the Distribution. The Company Board or the
Compensation Committee may, at any time, or from time to time, amend or suspend
and, if suspended, reinstate, the 1997 Plan in whole or in part.
Prior to the Distribution, certain employees of RCN were granted stock option
awards under C-TEC's stock option plans. In connection with the Distribution
3,040,100 options covering Common Stock were issued. Each C-TEC option was
adjusted so that each holder would currently hold options to purchase shares of
CTE Common Stock, RCN Common Stock and Cable Michigan Common Stock. The number
of shares subject to, and the exercise
<PAGE>
price of, such options were adjusted to take into account the Distribution and
to ensure that the aggregate intrinsic value of the resulting RCN, Cable
Michigan and CTE options immediately after the Distribution was equal to the
aggregate intrinsic value of the C-TEC options immediately prior to the
Distribution.
Information relating to stock options is as follows:
<TABLE>
<CAPTION>
Weighted Average
Number of Shares Exercise Price
---------------- ---------------
<S> <C> <C>
Outstanding December 31, 1994 1,431,000
Granted 1,257,000
Exercised --
Canceled 280,000
-----------------
Outstanding December 31, 1995 2,408,000
Granted 190,000
Exercised 58,000
Canceled 272,000
-----------------
Outstanding December 31, 1996 2,268,000 $ 7.10
Granted 4,862,100 $14.31
Exercised 20,000 $ 8.07
Canceled 3,000 $ 8.36
-----------------
Outstanding December 31, 1997 7,107,100 $11.95
=================
Shares exercisable December 31, 1997 1,221,000 $ 7.05
</TABLE>
The following table summarizes stock options outstanding and exercisable at
December 31, 1997:
<TABLE>
<CAPTION>
Stock Options Outstanding Stock Options Exercisable
------------------------------------------------------------ -----------------------------------
Weighted Average Weighted Average Weighted Average
Range of Exercise Prices Shares Remaining Contractual Life Exercise Price Shares Exercise Price
- -------------------------- ------------- -------------------------- ---------------- --------------- ----------------
<S> <C> <C> <C> <C> <C>
$6.24 to $8.40 3,017,100 7.5 years $ 7.36 1,221,000 $7.05
$15.32 to $16.82 4,090,000 9.8 years 15.33 -- --
--------------- ---------------
Total 7,107,100 1,221,000
=============== ===============
</TABLE>
No compensation expense related to stock option grants was recorded in 1997 as
the option exercise prices were equal to fair market value on the date granted.
Pro forma information regarding net income and earnings per share is required
by SFAS 123, and has been determined as if the Company had accounted for its
stock options under the fair value method of SFAS 123. The fair value for these
options was estimated at the date of grant using a Black Scholes option pricing
model with weighted average assumptions for dividend yield of 0% for 1997, 1996
and 1995; expected volatility of 38.6% prior to the Distribution and 49.8%
subsequent to the Distribution for 1997, 39.5% for 1996, and 35.9% for 1995;
risk-free interest rate of 6.52%, 5.95% and 6.32% for 1997, 1996 and 1995,
respectively; and expected lives of 5 years for 1997, 1996 and 1995.
The weighted-average fair value of options granted during 1997 was $7.46.
For purposes of pro forma disclosures, the estimated fair value of the options
is amortized to expense over the options' vesting period. The Company's pro
forma net earnings and earnings per share were as follows:
<TABLE>
<CAPTION>
1997 1996 1995
--------------- --------------- -------------
<S> <C> <C> <C>
Net earnings - as reported $(52,391) $(5,989) $2,114
Net earnings - pro forma $(54,419) $(6,612) $1,695
Basic earnings per share - as reported $ (0.95) $ (0.11) $ 0.04
Basic earnings per share - pro forma $ (0.99) $ (0.12) $ 0.03
Diluted earnings per share - as reported $ (0.95) $ (0.11) $ 0.04
Diluted earnings per share - pro forma $ (0.99) $ (0.12) $ 0.03
</TABLE>
<PAGE>
In November 1996, the C-TEC shareholders approved a stock purchase plan for
certain key executives (the C-TEC "Executive Stock Purchase Plan" or "C-TEC
ESPP"). Under the C-TEC ESPP, participants may purchase shares of C-TEC Common
Stock in an amount of between 1% and 20% of their annual base compensation and
between 1% and 100% of their annual bonus compensation provided, however, that
in no event shall the participant's total contribution exceed 20% of the sum of
their annual compensation, as defined by the C-TEC ESPP. Participant's accounts
are credited with the number of share units derived by dividing the amount of
the participant's contribution by the average price of a share of C-TEC Common
Stock at approximately the time such contribution is made. The share units
credited to a participant's account do not give such participant any rights as a
shareholder with respect to, or any rights as a holder or record owner of, any
shares of C-TEC Common Stock. Amounts representing share units that have been
credited to a participant's account will be distributed, either in a lump sum or
in installments, as elected by the participant, following the earlier of the
participant's termination of employment or three calendar years following the
date on which the share units were initially credited to the participant's
account. It is anticipated that, at the time of distribution, a participant
will receive one share of C-TEC Common Stock for each share unit being
distributed.
Following the crediting of each share unit to a participant's account, a
matching share of Common Stock is issued in the participant's name. Each
matching share is subject to forfeiture as provided in the C-TEC ESPP. The
issuance of matching shares will be subject to the participant's execution of an
escrow agreement. A participant will be deemed to be the holder of, and may
exercise all the rights of a record owner of, the matching shares issued to such
participant while such matching shares are held in escrow.
Shares of restricted C-TEC Common Stock awarded under the C-TEC Executive
Stock Purchase Plan and share units awarded under the C-TEC ESPP that relate to
C-TEC Common Stock were adjusted so that following the Distribution, each such
participant was credited with an aggregate equivalent value of restricted shares
of common stock of Commonwealth Telephone Enterprises, the Company and Cable
Michigan. In 1997, the Company's Board of Directors approved the RCN
Corporation Executive Stock Purchase Plan (the "RCN ESPP"), with terms
substantially the same as the C-TEC ESPP. The number of shares which may be
distributed under the RCN ESPP as matching shares or in payment of share units
is 250,000. At December 31, 1997, 61,412 matching shares have been issued under
the RCN ESPP, none of which are vested. The Company recognizes the cost of the
matching shares over the vesting period. Expense recognized in 1997 and 1996
was $80 and $145, respectively.
13. PENSIONS AND EMPLOYEE BENEFITS
Prior to the Distribution, the Company's financial statements reflect the
costs experienced for its employees and retirees while included in the C-TEC
plans.
Through December 31, 1996, substantially all employees of the Company were
included in a trusteed noncontributory defined benefit pension plan, maintained
by C-TEC. Upon retirement, employees are provided a monthly pension based on
length of service and compensation. C-TEC funds pension costs to the extent
necessary to meet the minimum funding requirements of ERISA. Substantially, all
employees of C-TEC's Pennsylvania cable television operations (formerly Twin
County Trans Video, Inc.) were covered by an underfunded plan which was merged
into C-TEC's overfunded plan on February 28, 1996.
The information that follows relates to the entire C-TEC noncontributory
defined benefit plan. The components of C-TEC's pension cost are as follows:
<TABLE>
<CAPTION>
1996 1995
----------------- -----------------
<S> <C> <C>
Benefits earned during the year (service cost) $ 2,365 $ 1,656
Interest cost on projected benefit obligation 3,412 3,083
Actual return on plan assets (3,880) (12,897)
Other components net (1,456) 8,482
-------------------------------------
Net periodic pension cost $ 441 $ 324
=====================================
</TABLE>
<PAGE>
The following assumptions were used in the determination of the consolidated
projected benefit obligation and net periodic pension cost:
<TABLE>
<CAPTION>
December 31,
----------------------------------
1996 1995
---------------- ----------------
<S> <C> <C>
Discount rate 7.5% 7.0%
Expected long-term rate of return on plan assets 8.0% 8.0%
Weighted average long-term rate of compensation increases 6.0% 6.0%
</TABLE>
The Company's allocable share of the consolidated net periodic pension costs,
based on the Company's proportionate share of consolidated annualized salaries
as of the valuation date, was approximately $158 and $251 for 1996 and 1995,
respectively. These amounts are reflected in operating expenses. As discussed
below, no pension cost (credit) was recognized in 1997.
In connection with the restructuring, C-TEC completed a comprehensive study of
its employee benefit plans in 1996. As a result of this study, effective
December 31, 1996, in general, employees of the Company no longer accrue
benefits under the defined benefit pension plans and became fully vested in
their benefit accrued through that date. C-TEC notified affected participants
in December 1996. In December 1996, C-TEC allocated pension plan assets of
$6,984 and the related liabilities to a separate plan for employees who no
longer accrue benefits after lump sum distributions. The allocation of assets
and liabilities resulted in a curtailment/settlement gain of $4,292. The
Company's allocable share of this gain was $3,437. This gain results primarily
from the reduction of the related projected benefit obligation. The curtailed
plan has assets in excess of the projected benefit obligation. Such excess
amounts to $3,917 which, along with unrecognized items of $1,148 results in
prepaid pension cost of $2,769, which is included in "Prepayments and other" in
the accompanying 1997 and 1996 consolidated balance sheets.
The following table sets forth the plans' funded status and amounts recognized
in C-TEC's balance sheet at December 31, 1996:
<TABLE>
<CAPTION>
<S> <C>
Plan assets at fair value $ 55,325
Actuarial present value of benefit obligations:
Accumulated benefit obligations:
Vested 32,372
Nonvested 1,704
------------------
Total 34,076
Effect of increases in compensation 6,042
------------------
Plan assets in excess of (less than) projected benefit obligation 15,207
Unrecognized transition asset (3,463)
Unrecognized prior service cost 2,438
Unrecognized net gain (11,215)
------------------
Prepaid pension cost $ 2,967
==================
</TABLE>
C-TEC's pension plan has assets in excess of the accumulated benefit
obligation. Plan assets include cash, equity, fixed income securities and
pooled funds under management by an insurance company. Plan assets include
common stock of C-TEC with a fair value of approximately $5,835 at December 31,
1996.
Prepaid pension cost is included in "Deferred Charges and Other Assets" in
the accompanying 1996 consolidated balance sheet. The prepaid pension asset was
transferred to CTE in connection with the Distribution in 1997.
C-TEC sponsors a 401(k) savings plan covering substantially all employees of
the Company who are not covered by collective bargaining agreements.
Contributions made by the Company to the 401(k) plan are based on a specific
percentage of employees contributions. Contributions charged to expense were
$354 and $268 in 1996 and 1995, respectively. Contributions charged to expense
in 1997 prior to the Distribution were $515.
In connection with the Distribution, RCN established a qualified savings plan
under Section 401(k) of the Code that will also qualify as an ESOP under
Sections 401(a) and 4975(e)(7) of the Code (the "ESOP"). Eligible active
<PAGE>
employees under the ESOP, employees of the Company Businesses who make Section
401(k) contributions and certain other employees will be allocated shares of
Company Common Stock. Contributions charged to expense in 1997 were $306.
The Company provides certain postemployment benefits to former or inactive
employees of the Company who are not retirees. These benefits are primarily
short-term disability salary continuance. The Company accrues the cost of
postemployment benefits over employees' service lives. The Company uses the
services of an enrolled actuary to calculate the expense. Prior to the
Distribution, C-TEC allocated the cost of these benefits to the Company based on
the Company's proportionate share of consolidated annualized salaries. The
Company reimbursed C-TEC for its allocable share of the consolidated
postemployment benefit cost. The net periodic postemployment benefit cost
(credit) was approximately $458, $539 and ($106) in 1997, 1996 and 1995,
respectively.
14. COMMITMENTS AND CONTINGENCIES
a. The Company had various purchase commitments at December 31, 1997 related
to its 1998 construction budget.
b. Total rental expense, primarily for office space and pole rentals, was
$3,505, $3,632 and $2,846 for 1997, 1996 and 1995, respectively. At December
31, 1997, rental commitments under noncancellable leases, excluding annual pole
rental commitments of approximately $794 that are expected to continue
indefinitely, are as follows:
<TABLE>
<CAPTION>
Aggregate
Year Amounts
------------ ------------------
<S> <C>
1998 $3,725
1999 $3,314
2000 $2,939
2001 $2,826
2002 $2,848
Thereafter $8,501
</TABLE>
c. The Company has outstanding letters of credit aggregating $3,060 at
December 31, 1997.
d. The Company has entered into various noncancellable contracts for
network services. Future obligations under these agreements are as
follows:
<TABLE>
<CAPTION>
Network
Year Services
-------------------------- --------------
<S> <C>
1998 $3,026
1999 $3,064
2000 $3,012
2001 $2,762
2002 $ 12
Thereafter $ 14
</TABLE>
e. The Company is subject to the provisions of the Cable Television Consumer
Protection and Competition Act of 1992, as amended, and the Telecommunications
Act of 1996. The Company has either settled challenges or accrued for
anticipated exposures related to rate regulation. However, there is no
assurance that there will not be additional challenges to its rates.
f. In the normal course of business, there are various legal proceedings
outstanding. In the opinion of management, these proceedings will not have a
material adverse effect on the financial position or results of operations or
liquidity of the Company.
g. The Company has agreed to indemnify Cable Michigan and CTE and their
respective subsidiaries against any and all liabilities which arise primarily
from or relate primarily to the management or conduct of the business of the
Company prior to the effective time of the Distribution. The Company has also
agreed to indemnify Cable Michigan and CTE and their respective subsidiaries
against 30% of any liability which arises from or relates to the
<PAGE>
management or conduct prior to the effective time of the Distribution of the
businesses of C-TEC and its subsidiaries and which is not a true CTE liability,
a true Cable Michigan liability or a true Company liability.
The Tax Sharing Agreement, by and among the Company, Cable Michigan and CTE
(the "Tax Sharing Agreement"), governs contingent tax liabilities and benefits,
tax contests and other tax matters with respect to tax returns filed with
respect to tax periods, in the case of the Company, ending or deemed to end on
or before the Distribution Date. Under the Tax Sharing Agreement, Adjustments
(as defined in the Tax Sharing Agreement) to taxes that are clearly attributable
to the Company Group, the Cable Michigan Group, or the CTE Group will be borne
solely by such group. Adjustments to all other tax liabilities will be borne
50% by CTE, 30% by the Company and 20% by Cable Michigan.
Notwithstanding the above, if as a result of the acquisition of all or a
portion of the Capital stock or assets of the Company, the Distribution fails to
qualify as a tax-free distribution under Section 355 of the Code, then the
Company will be liable for any and all increases in tax attributable thereto.
h. Under the Starpower Amended and Restated Operating Agreement, the Company
is committed to make quarterly capital contributions aggregating the following
in the years ended December 31:
<TABLE>
<CAPTION>
<S> <C>
1998 $56,250
1999 $68,750
2000 $25,000
</TABLE>
i. If, within five years after the Distribution, the ESOP portion of the
401(k) Plan does not hold shares representing at least 3% of the number of
shares of Company Common Stock outstanding immediately after the Distribution as
increased by the number of shares issuable to BECO pursuant to the Exchange
Agreement (collectively, "Outstanding Company Common Stock") with a market value
at such time of not less than $24,000, RCN will issue to the ESOP, in exchange
for a note from the ESOP (the "ESOP Note"), the amount of Company Common Stock
necessary to increase the ESOP's holdings of Company Common Stock to that level,
provided, however, that RCN is not obligated to issue shares to the ESOP in
excess of 5% of the number of shares of Outstanding Company Common Stock.
15. AFFILIATE AND RELATED PARTY TRANSACTIONS
The Company had the following transactions with affiliates during the years
ended December 31, 1997, 1996 and 1995:
<TABLE>
<CAPTION>
1997 1996 1995
--------------- --------------- ---------------
<S> <C> <C> <C>
Corporate office costs allocated to affiliates $12,091 $12,362 $10,009
Cable staff and customer service costs allocated to Cable Michigan 3,489 3,577 2,952
Interest income on affiliate notes 8,688 15,119 17,340
Interest expense on affiliate notes 537 354 279
Long-distance terminating access charge expense from CTE 1,312 728 862
Royalty fees charged by CTE 669 859 533
Revenue from engineering services -- 296 2,169
Other affiliate revenues 1,576 -- 6
Other affiliate expenses 2,199 1,980 2,090
</TABLE>
At December 31, 1997 and 1996, the Company has accounts receivable from
related parties of $9,829 and $12,614, respectively, for these transactions. At
December 31, 1997 and 1996, the Company has accounts payable to related parties
of $3,748 and $4,880, respectively, for these transactions.
The Company had notes receivable of $7,914 in 1996 from advances by the
Company's corporate financial services company to CTE. The Company also had
notes receivable of $147,567 at December 31, 1996, from Cable Michigan, Inc.
primarily related to the acquisition of the Michigan cable operations and
subsequent operations. All intercompany notes receivable were settled in
connection with the Distribution.
<PAGE>
The Company had notes payable of $11,854 in 1996 from excess cash advanced by
CTE to the Company's corporate financial services company for investment. All
intercompany notes payable were settled in connection with the Distribution.
16. OFF BALANCE SHEET RISK AND CONCENTRATION OF CREDIT RISK
Certain financial instruments potentially subject the Company to
concentrations of credit risk. These financial instruments consist primarily of
trade receivables, cash and temporary cash investments, and short-term
investments.
The Company places its cash and temporary investments with high credit quality
financial institutions and limits the amount of credit exposure to any one
financial institution. The Company also periodically evaluates the
creditworthiness of the institutions with which it invests. The Company does,
however, maintain unsecured cash and temporary cash investment balances in
excess of federally insured limits.
The Company's trade receivables reflect a customer base primarily centered in
the Boston to Washington, D.C. corridor of the United States. The Company
routinely assesses the financial strength of its customers. As a consequence,
concentrations of credit risk are limited.
17. DISCLOSURE ABOUT FAIR VALUE OF FINANCIAL INSTRUMENTS
a. Cash and temporary cash investments
The carrying amount approximates fair value because of the short maturity of
these instruments.
b. Short-term investments
Short-term investments consist of commercial paper, corporate debt securities,
certificates of deposit and federal agency notes. Short-term investments are
carried at amortized cost which approximates fair value due to the short period
of time to maturity.
c. Long-term investments
Long-term investments consist of investments accounted for under the equity
method for which disclosure of fair value is not required. The note and
interest receivable are carried at cost plus accrued interest which management
believes approximates fair value.
d. Investments restricted for debt service
Investments restricted for debt service consists of an amount placed in escrow
from the proceeds of the 10% Senior Notes which, together with the proceeds from
the investment thereof, will be sufficient to pay interest on the 10% Senior
Notes for six scheduled interest payments. Investments restricted for debt
service are carried at amortized cost. The fair value of investments restricted
for debt service is based on quoted market prices.
e. Long-term debt
The fair value of fixed rate long-term debt was estimated based on the
Company's current incremental borrowing rate for debt of the same remaining
maturities. The fair value of floating rate debt is considered to be equal to
the carrying value since the debt reprices at least every six months and the
Company believes that its credit risk has not changed from the time the floating
rate debt was borrowed and therefore, it would obtain similar rates in the
current market.
f. Letter of credit
The contract amount of letters of credit represents a reasonable estimate of
their value since such instruments reflect fair value as a condition of their
underlying purpose and are subject to fees competitively determined in the
marketplace.
<PAGE>
The estimated carrying fair value of the Company's financial instruments are
as follows at December 31:
<TABLE>
<CAPTION>
1997 1996
---------------------------------- ----------------------------------
Carrying Amount Fair Value Carrying Amount Fair Value
--------------- --------------- --------------- ---------------
<S> <C> <C> <C> <C>
Financial Assets:
Cash and temporary cash investments $222,910 $222,910 $ 61,843 $ 61,843
Short-term investments $415,603 $415,603 $ 46,831 $ 46,831
Note and interest receivable $ 17,682 $ 17,682 $ 15,310 $ 15,310
Investments restricted for debt service $ 61,911 $ 61,983 -- --
Financial Liabilities:
Fixed rate long-term debt:
Senior Secured Notes -- -- $131,250 $137,459
Senior Notes 10% $225,000 $233,438 -- --
Senior Discount Notes 11.125% $358,103 $377,156 -- --
Floating rate long-term debt:
Revolving Credit Agreement $ 3,000 $ 3,000 -- --
Term Credit Agreement $100,000 $100,000 -- --
Unrecognized financial instruments:
Letters of credit $ 3,060 $ 3,060 $ 3,060 $ 3,060
</TABLE>
18. QUARTERLY INFORMATION (UNAUDITED)
<TABLE>
<CAPTION>
1997 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter
- -------------------------------------------------------- ---------------- ---------------- ----------------- ----------------
<S> <C> <C> <C> <C>
Sales $ 29,677 $ 31,029 $ 31,148 $ 35,443
Operating income (loss) before depreciation,
amortization and nonrecurring charges $ 4,153 $ 850 $ (4,332) ($8,341)
Operating (loss) $(18,037) $(12,416) $(18,011) $(22,411)
Loss before extraordinary charge N/A N/A N/A $(17,116)
Loss before extraordinary charge per Average common
share N/A N/A N/A $ (0.31)
Common Stock
High N/A N/A $ 16.63 $ 21.63
Low N/A N/A $ 12.44 $ 12.50
<CAPTION>
1996 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter
- -------------------------------------------------------- ---------------- ---------------- ---------------- ----------------
<S> <C> <C> <C> <C>
Sales $24,165 $24,852 $26,746 $29,147
Operating income before depreciation and amortization $ 4,199 $ 7,777 $ 9,188 $ 4,639
Operating (loss) $(4,621) $(1,233) $ (19) $(7,205)
</TABLE>
<PAGE>
19. SUBSEQUENT EVENTS
a. In February 1998, the Company completed an offering of 9.8% Senior
Discount Notes with an aggregate principal amount at maturity of $567,000, due
February 2008. The 9.8% Senior Discount Notes were issued at a discount and
generated gross proceeds to the Company of $350,587.
The 9.8% Senior Discount Notes are general senior obligations of the Company,
limited to $567,000 aggregate principal amount at maturity and will mature on
February 15, 2008. The 9.8% Senior Discount Notes were issued at a discount to
yield gross proceeds of $350,587. The 9.8% Senior Discount Notes will not pay
cash interest prior to February 15, 2003. The yield to maturity of the 9.8%
Senior Discount Notes, determined on a semi-annual bond equivalent basis, will
be 9.8% per annum.
The 9.8% Indenture contains certain covenants that, among other things, limit
the ability of the Company and its subsidiaries to incur indebtedness, pay
dividends, prepay subordinate indebtedness, repurchase capital stock, engage in
transactions with stockholders and affiliates, create liens, sell assets and
engage in mergers and consolidations.
The 9.8% Senior Discount Notes are redeemable, in whole or in part, at any
time on or after February 15, 2003 at the option of the Company. The 9.8%
Senior Discount Notes may be redeemed at redemption prices starting at 104.9% of
the principal amount at maturity and declining to 100% of the principal amount
at maturity, plus any accrued and unpaid interest.
b. On January 21, 1998, RCN entered into the Agreement and Plan of Merger
(the "Erols Merger Agreement") among RCN, Erols Internet, Inc. ("Erols"), Erol
Onaran, Gold & Appel Transfer, S.A., a British Virgin Islands corporation ("Gold
& Appel"), and ENET Holdings, Inc., a Delaware corporation and a wholly owned
subsidiary of RCN ("ENET"), to acquire all of the outstanding shares of common
stock of Erols. The merger was consummated on February 20, 1998. Erols merged
with and into ENET (the "Erols Merger"), with ENET as the surviving corporation.
The approximate total Erols Merger consideration was $29,200 in cash, 1,730,648
shares of RCN common stock plus the assumption and repayment of $5,800 of debt.
Additionally, the Company is converting approximately 999,000 Erols stock
options to 699,104 RCN stock options at an average exercise price of $3.424 per
share. The transaction was accounted for under the purchase method of
accounting.
RCN expects to contribute to Starpower approximately 60% of the subscribers
acquired in the acquisition of Erols.
c. On January 21, 1998, RCN, UNET Holdings, Inc., a wholly owned subsidiary
of RCN, and Ultranet Communications, Inc. ("Ultranet") entered into an Agreement
and Plan of Merger (the "Ultranet Merger Agreement"). The total consideration
for the acquisition was $7,368 in cash, 890,384 shares of RCN common stock, and
$3,000 in deferred compensation. Additionally, the Company is converting 63,500
UltraNet stock options to 117,052 RCN stock options at an average exercise price
of $1.825 per share and making cash payments aggregating approximately $503 to
certain other holders of UltraNet stock options. The transaction was
consummated on February 27, 1998. The transaction was accounted for under the
purchase method of accounting.
RCN expects to contribute to RCN-BECOCOM approximately 30% of the subscribers
acquired in the acquisition of Ultranet.
d. RCN paid $12,500 in cash in January 1998 as its initial capital
contribution to Starpower.
e. In January 1998, BECO notified RCN that it has elected to exercise its
option to the full extent permitted by the Exchange Agreement (Note 7) with
respect to 1997. RCN and BECO are presently in discussions with respect to the
calculation of the agreed upon value for the exercise of such option.
<PAGE>
f. On February 27, 1998, the Company entered into an Agreement and Plan of
Merger (the "Merger Agreement") with Lancit Media Entertainment, Ltd. ("Lancit")
and LME Acquisition Corporation ("MergerSub"), a wholly owned subsidiary of RCN.
Pursuant to the terms of the Merger Agreement, MergerSub will be merged with and
into Lancit (the "Merger") such that immediately following the Merger, Lancit
will be a wholly-owned subsidiary of RCN. The consummation of the Merger is
subject to customary conditions, including the adoption and approval of the
Merger and the Merger Agreement by the stockholders of Lancit in accordance
with the provisions of applicable law and the filing and effectiveness of a
registration statement of RCN. There is no assurance that this transaction will
be consummated.
<PAGE>
REPORT OF MANAGEMENT
The integrity and objectivity of the financial information presented in these
financial statements is the responsibility of the management of RCN Corporation.
The financial statements report on management's accountability for Company
operations and assets. To this end, management maintains a system of internal
controls and procedures designed to provide reasonable assurance that the
Company's assets are protected and that all transactions are accounted for in
conformity with generally accepted accounting principles. The system includes
documented policies and guidelines, augmented by a comprehensive program of
internal and independent audits conducted to monitor overall accuracy of
financial information and compliance with established procedures.
Coopers & Lybrand, L.L.P., independent accountants, conduct a review of internal
accounting controls to the extent required by generally accepted auditing
standards and perform such tests and procedures as they deem necessary to arrive
at an opinion on the fairness of the financial statements presented herein.
The Board of Directors meets its responsibility for the Company's financial
statements through its Audit Committee which is comprised exclusively of
directors who are not officers or employees of the Company. The Audit Committee
recommends to the Board of Directors the independent auditors for election by
the shareholders. The Committee also meets periodically with management and the
independent and internal auditors to review accounting, auditing, internal
accounting controls and financial reporting matters. As a matter of policy, the
internal auditors and the independent auditors periodically meet alone with, and
have access to, the Audit Committee.
\s\ Bruce C. Godfrey
- --------------------
Bruce C. Godfrey
Executive Vice President
Chief Financial Officer
<PAGE>
REPORT OF INDEPENDENT ACCOUNTANTS
To Shareholders of RCN Corporation:
We have audited the consolidated financial statements and financial statement
schedules of RCN Corporation and Subsidiaries listed in Item 14(a) of this Form
10-K. These financial statements and financial statement schedules are the
responsibility of the Company's management. Our responsibility is to express
an opinion on these financial statements and financial statement schedules
based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of RCN
Corporation and Subsidiaries as of December 31, 1997 and 1996, and the
consolidated results of their operations and their cash flows for each of the
three years in the period ended December 31, 1997 in conformity with generally
accepted accounting principles. In addition, in our opinion, the financial
statement schedules referred to above, when considered in relation to the basic
financial statements taken as a whole, present fairly, in all material respects,
the information required to be included therein.
/s/ Coopers & Lybrand L.L.P.
- -----------------------
COOPERS & LYBRAND, L.L.P.
2400 Eleven Penn Center
Philadelphia, Pennsylvania
March 13, 1998
(except Note 2, as to which
the date is May 20, 1998)
