<PAGE>
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
-----------------------
FORM 10-Q
(Mark One)
/X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 1998
OR
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the transition period from_____________to ______________
COMMISSION FILE NUMBER 333-53953
CONVERGENT COMMUNICATIONS, INC.
(Exact name of registrant as specified in its charter)
COLORADO 84-1337265
(State or other jurisdiction (I.R.S. Employer Identification No.)
of incorporation)
400 INVERNESS DRIVE SOUTH, SUITE 400
ENGLEWOOD, COLORADO 80112
(303) 749-3000
(Address and telephone number of principal executive offices)
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.
(1) Yes X No
----- -----
(2) Yes No X
----- -----
On November 5, 1998, 27,848,270 shares of the registrant's Common Stock were
outstanding.
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
TABLE OF CONTENTS
Page No.
PART I: FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets - December 31, 1997 and September 30, 1998 1
Consolidated Statements of Operations and Comprehensive Income -
Three and Nine months ended September 30, 1997 and 1998 2
Consolidated Statement of Shareholders' Equity (Deficit)- Nine months
ended September 30, 1998 3
Consolidated Statements of Cash Flows - Nine months ended September 30,
1997 and 1998 4
Notes to Consolidated Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations 15
PART II: OTHER INFORMATION 24
Item 1. Legal Proceedings 24
Item 2. Changes in Securities 24
Item 3. Defaults Upon Senior Securities 24
Item 4. Submission of Matters to a Vote of Securities Holders 24
Item 5. Other Information 24
Item 6. Exhibits and Reports on Form 8-K
Exhibits 24
Reports on Form 8-K 24
- -----------------
WHEN USED IN THIS REPORT, THE WORDS "INTEND," "EXPECTS," "PLANS," "ESTIMATES,"
"ANTICIPATES," "PROJECTS," "BELIEVES," AND SIMILAR EXPRESSIONS ARE INTENDED TO
IDENTIFY FORWARD-LOOKING STATEMENTS. SPECIFICALLY, STATEMENTS INCLUDED IN THIS
REPORT THAT ARE NOT HISTORICAL FACTS, INCLUDING STATEMENTS ABOUT THE COMPANY'S
BELIEFS AND EXPECTATIONS ABOUT ITS BUSINESS AND ITS INDUSTRY ARE FORWARD-LOOKING
STATEMENTS. SUCH STATEMENTS ARE SUBJECT TO RISKS AND UNCERTAINTIES THAT COULD
CAUSE ACTUAL RESULTS OR OUTCOMES TO DIFFER MATERIALLY. SUCH RISKS AND
UNCERTAINTIES INCLUDE, BUT ARE NOT LIMITED TO, THE DEGREE TO WHICH THE COMPANY
IS LEVERAGED AND THE RESTRICTIONS IMPOSED ON THE COMPANY UNDER ITS EXISTING DEBT
INSTRUMENTS THAT MAY ADVERSELY AFFECT THE COMPANY'S ABILITY TO FINANCE ITS
FUTURE OPERATIONS, TO COMPETE EFFECTIVELY AGAINST BETTER CAPITALIZED COMPETITORS
AND TO WITHSTAND DOWNTURNS IN ITS BUSINESS OR THE ECONOMY GENERALLY; AND OTHER
FACTORS DISCUSSED IN THE COMPANY'S FILINGS WITH THE SECURITIES AND EXCHANGE
COMMISSION. FORWARD -LOOKING STATEMENTS INCLUDED IN THIS REPORT SPEAK ONLY AS
OF THE DATE HEREOF AND THE COMPANY UNDERTAKES NO OBLIGATION TO REVISE OR UPDATE
SUCH STATEMENTS TO REFLECT EVENTS OR CIRCUMSTANCES AFTER THE DATE HEREOF OR TO
REFLECT THE OCCURRENCE OF UNANTICIPATED EVENTS.
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
December 31, September 30,
1997 1998
------------ -------------
(unaudited)
ASSETS
<S> <C> <C>
Current assets:
Cash and cash equivalents $ 667,344 $ 1,190,116
Restricted cash - 20,800,000
Short-term investments 7,371,303 35,279,361
Trade accounts receivable, net of allowance for doubtful
accounts of $21,389 and $3,298,204 respectively 2,075,150 18,269,248
Inventory 230,809 8,468,529
Prepaid expenses, deposits and other current assets 218,349 2,298,451
----------- ------------
Total current assets 10,562,955 86,305,705
Property and equipment 5,448,183 21,468,434
Less accumulated depreciation (610,386) (3,569,956)
----------- ------------
Total property and equipment 4,837,797 17,898,478
Restricted cash, non-current 405,816 40,377,668
Goodwill, net of amortization of $475,052 and $1,708,545, respectively 6,392,600 43,633,453
Other intangible assets, net of amortization of $358,486 and
$1,205,716, respectively 1,328,676 10,040,895
Investments and other assets 1,394,325 1,002,624
----------- ------------
Total assets $24,922,169 $199,258,823
----------- ------------
----------- ------------
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Trade accounts payable $ 2,040,457 $ 11,496,496
Overdraft payable - 1,304,598
Deferred revenue and customer deposits 61,545 3,443,548
Accrued compensation 1,467,587 4,742,734
Accrued interest - 10,414,133
Other accrued liabilities 691,781 7,800,959
Current portion of long-term debt 166,965 691,537
Current portion of capital lease obligations 800,393 3,704,998
----------- ------------
Total current liabilities 5,228,728 43,599,003
Long term debt, net of discount, net of current portion 384,171 153,903,759
Long term capital lease obligations, net of current portion 581,540 3,459,326
----------- ------------
Total liabilities 6,194,439 200,962,088
Commitments
Shareholders' equity (deficit):
Preferred stock, 1 million shares authorized, none issued - -
Common stock, no par value, 100 million shares authorized,
26,859,000 and 27,820,507 issued and outstanding, respectively 24,004,297 27,327,104
Warrants 4,773,751 11,660,151
Treasury stock - 501,674
Deferred compensation obligation - (501,674)
Accumulated other comprehensive income (16,864) 936,851
Unearned compensation (204,750) (163,800)
Accumulated deficit (9,828,704) (41,463,571)
----------- ------------
Total shareholders' equity (deficit) 18,727,730 (1,703,265)
----------- ------------
Total liabilities and shareholders' equity (deficit) $24,922,169 $199,258,823
----------- ------------
----------- ------------
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements
1
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
AND COMPREHENSIVE LOSS
<TABLE>
<CAPTION>
Three months ended Nine months ended
September 30, September 30,
--------------------------- ---------------------------
1997 1998 1997 1998
------------ ------------- ------------ ------------
(unaudited)
<S> <C> <C> <C> <C>
Operating revenue
Data and voice products $ 2,319,348 $ 11,591,660 $ 3,954,625 $ 21,866,745
Data and voice services 823,314 10,724,742 1,806,429 14,954,360
------------ ------------- ------------ ------------
Total revenue 3,142,662 22,316,402 5,761,054 36,821,105
Operating costs and expenses
Operating costs 2,208,277 14,717,364 3,945,154 25,287,038
Selling, general and administrative 3,051,754 15,506,655 6,213,456 29,279,065
Depreciation and amortization 295,696 2,646,215 751,654 4,599,367
------------ ------------- ------------ ------------
Total operating costs and expenses 5,555,727 32,870,234 10,910,264 59,165,470
Operating loss (2,413,065) (10,553,832) (5,149,210) (22,344,365)
Other income (expense)
Interest expense (66,476) (5,868,531) (74,951) (11,751,121)
Interest income 17,651 1,144,892 61,581 2,525,288
Other, net (355,678) (78,009) (325,164) (64,669)
------------ ------------- ------------ ------------
(404,503) (4,801,648) (338,534) (9,290,502)
------------ ------------- ------------ ------------
Net loss (2,817,568) (15,355,480) (5,487,744) (31,634,867)
Other comprehensive income,
Unrealized holding gains on securities - 661,407 - 953,715
------------ ------------- ------------ ------------
Comprehensive loss $ (2,817,568) $ (14,694,073) $ (5,487,744) $(30,681,152)
------------ ------------- ------------ ------------
------------ ------------- ------------ ------------
Net loss per share:
Net loss per share (basic and diluted) $ (.15) $ (.55) $ (.29) $ (1.16)
------------ ------------- ------------ ------------
------------ ------------- ------------ ------------
Weighted average number of shares
outstanding (basic and diluted) 19,408,022 27,738,811 18,656,265 27,335,217
------------ ------------- ------------ ------------
------------ ------------- ------------ ------------
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements
2
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
<TABLE>
<CAPTION>
Deferred
Common Common Treasury Compensation
Shares Stock Warrants Stock Obligation
---------- ------------- ------------- ----------- -----------
<S> <C> <C> <C> <C> <C>
Balance, December 31, 1997 26,859,000 $ 24,004,297 $ 4,773,751 $ - $ -
Common stock issued for:
401K Match 110,231 297,079 - - -
Payments to consultants 20,333 55,000 - - -
Correction of private placement 20,000 - - - -
Business combinations 480,000 2,266,400 - - -
Exercise of stock options 87,000 16,500 - - -
Exercise of warrants 69,950 108,600 - - -
Stock compensation 173,993 579,228 - - -
Deferred stock compensation - - - (501,674) 501,674
Warrants issued in private
placement - - 6,886,400 - -
Amortization of unearned
compensation - - - - -
Other comprehensive income:
Unrealized gain on securities - - - - -
Net loss - - - - -
---------- ------------- ------------- ----------- ----------
Balance, September 30, 1998 27,820,507 $ 27,327,104 $ 11,660,151 $ (501,674) $ 501,674
---------- ------------- ------------- ----------- ----------
---------- ------------- ------------- ----------- ----------
<CAPTION>
Accumulated
Other
Comprehensive Unearned Accumulated
Income Compensation Deficit Total
------------- ------------ ------------- ------------
(unaudited)
<S> <C> <C> <C> <C>
Balance, December 31, 1997 $ (16,864) $ (204,750) $ (9,828,704) $ 18,727,730
Common stock issued for:
401K Match - - - 297,079
Payments to consultants - - - 55,000
Correction of private placement - - - -
Business combinations - - - 2,266,400
Exercise of stock options - - - 16,500
Exercise of warrants - - - 108,600
Stock compensation - - - 579,228
Deferred stock compensation - - - -
Warrants issued in private
placement - - - 6,886,400
Amortization of unearned
compensation - 40,950 - 40,950
Other comprehensive income:
Unrealized gain on securities 953,715 - - 953,715
Net loss - - (31,634,867) (31,634,867)
--------- ---------- ------------- ------------
Balance, September 30, 1998 $ 936,851 $ (163,800) $ (41,463,571) $ (1,703,265)
--------- ---------- ------------- ------------
--------- ---------- ------------- ------------
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements
3
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
For the nine months ended
September 30, September 30,
1997 1998
------------ -------------
(unaudited)
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss $ (5,487,744) $ (31,634,867)
Adjustments to reconcile net loss to net cash used in operating
activities:
Depreciation and amortization 751,654 4,599,367
Amortization of deferred financing costs and debt discount
included in interest expense - 1,091,006
Provision for uncollectible accounts - 755,862
Stock compensation expense 180,867 620,178
401-k contributions through the issuance of
common stock - 297,079
Change in working capital, net of the effects of business
combinations:
Trade accounts receivable (1,058,500) (7,963,549)
Inventory (30,063) (3,468,655)
Prepaid expenses and other current assets (121,054) (1,106,065)
Trade accounts payable 368,411 8,792,171
Accrued compensation 817,125 2,751,370
Accrued interest - 10,414,133
Deferred revenue - 1,531,602
Other accrued liabilities 60,128 1,042,958
------------ ------------
Net cash used in operating activities (4,519,176) (12,277,410)
CASH FLOWS FROM INVESTING ACTIVITIES:
Additions of property and equipment (665,916) (9,113,322)
Acquisitions, net of cash acquired (489,384) (42,364,328)
Investment (260,000) -
Short-term investments (4,248,760) (26,954,343)
Restricted cash (402,309) (60,771,852)
Other assets (205,954) (242,192)
------------ ------------
Net cash used in investing activities (6,272,323) (139,446,037)
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from private placement, net of offering costs - 152,922,348
Overdraft payable - 1,304,598
Payments on long-term borrowings (1,144,602) (2,215,033)
Proceeds from new borrowings 167,793 109,206
Proceeds from sale of common stock, net 12,804,256 -
Proceeds from exercise of stock options and warrants 57,000 125,100
Repurchase of common shares (12,000) -
Cash paid to retire indebtedness of predecessor company (132,380) -
------------ ------------
Net cash provided by financing activities 11,740,067 152,246,219
Net increase in cash and cash equivalents 948,568 522,772
Cash and cash equivalents at beginning of period 3,161,387 667,344
------------ ------------
Cash and cash equivalents at end of period $ 4,109,955 $ 1,190,116
------------ ------------
------------ ------------
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements
4
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
<TABLE>
<S> <C> <C>
NON-CASH DISCLOSURE:
Cash paid for interest $74,951 $245,982
Cash paid for income taxes - -
Acquisition of property and equipment through the
issuance of capital leases 1,305,529 4,059,330
Common stock issued for business combinations 2,112,500 2,266,400
Notes issued for business combinations 100,000 930,000
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements
5
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. ORGANIZATION AND BUSINESS:
Convergent Communications, Inc. ("CCI") was formed under the laws of the
State of Colorado in October 1995 and capitalized on March 1, 1996
("Inception"). Convergent is the parent of wholly owned subsidiaries,
Convergent Communications Services, Inc. ("CCSI") and Convergent Capital
Corporation ("CCC") (together, the "Company" or "Convergent").
Convergent, through its wholly-owned subsidiaries is an Enterprise Network
Carrier-TM- offering comprehensive, single-source communications services
primarily to small and medium-sized businesses. The Company provides the
following products and services:
DATA:
- DATA NETWORKING SERVICES - including the planning, design,
installation and management of networks, from simple LANs to
complex WANs.
- DATA PRODUCTS - including the sale and integration of servers,
routers, data switches and desk top computers.
- DATA TRANSPORT SERVICES - including frame relay and ATM.
- INTERNET SERVICES - including web applications, web hosting and
Internet access.
TELEPHONY:
- VOICE SERVICES - including long distance and local services.
- VOICE PRODUCTS - including the sale and integration of key
systems and PBXs.
ENTERPRISE NETWORK SERVICES:
- - - ENS - the delivery under long-term contracts of one or more of
the Company's data and telephony services utilizing the Company's
owned network inside the customer's premise.
As an Enterprise Network Carrier-TM-, the Company integrates its data and
telephony products and services into a single product offering, enabling
the Company to act as a single-source, one-stop provider of its customer's
total communications requirements. Unlike traditional telecommunications
companies that provide services from outside a customer's premise, in
providing Enterprise Network Services ("ENS"), the Company designs, buys
and builds its own network within the customer's premise, enabling the
Company to act as an outsource provider of any or all of the customer's
communications requirements.
The Company focuses on small to medium size businesses and has offices in
32 locations in the United States.
6
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
INTERIM FINANCIAL DATA:
The consolidated balance sheet as of September 30, 1998 and the
consolidated statements of operations and comprehensive income,
shareholders' equity and cash flows for the periods ended September 30,
1997 and 1998 have been prepared by the Company without audit. In the
opinion of management, all adjustments, consisting of only normal recurring
adjustments, necessary to present fairly the consolidated financial
position, results of operations and cash flows have been made. The results
of operations for the interim periods are not necessarily indicative of the
results for the full year.
The accompanying financial statements should be read with the Company's
consolidated financial statements included in the Company's S-4 filed with
the Securities and Exchange Commission on October 29, 1998.
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.
RESTRICTED CASH:
Restricted cash represents funds held in collateral accounts for
payment of semi-annual interest payments on certain indebtedness
through April 1, 2001. The cash is invested in U.S. Government
Securities which mature semi-annually on predetermined payment dates
through April 1, 2001,and, therefore, is classified as held to
maturity. Restricted cash also represents cash used to collateralize
letters of credit, which are held as collateral for certain of the
Company's office leases and capital lease obligations.
INVENTORY:
Inventories, which consist primarily of new and refurbished equipment for
resale, are valued at the lower of cost or net realizable value, using the
first-in, first-out method. The Company evaluates the need for reserves for
estimated losses related to excess and obsolete inventory.
INTANGIBLE ASSETS:
Site location contracts are exclusive rights to operate public telephones
at various locations acquired through business combinations. The site
location contracts are being amortized over the average lives of the
contracts, primarily five years. Software license fees represent
proprietary rights to software associated with the public telephones and
are being amortized over five years, the estimated life of the related
equipment. Deferred finance costs are costs associated with obtaining
certain financing arrangements and are amortized over the life of the
financing arrangement, three
7
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
years. Deferred offering costs are being amortized over the period from
inception to the earliest possible date of retirement of the debt, five
years. Customer lists are being amortized over five years. Goodwill
represents the excess purchase price over the net assets acquired in
acquisitions and is being amortized over ten years.
REVENUE RECOGNITION:
Revenue is recognized for product sales when the product is shipped.
Revenue from non-recurring services is recognized when the services are
provided. Revenue for long-term service contracts is recognized on a
straight-line basis over the term of the contract as services are provided.
RECENTLY ADOPTED ACCOUNTING STANDARDS:
Effective January 1, 1998, the Company adopted Statement of Accounting
Standards ("SFAS") No. 130, "Reporting Comprehensive Income." This
statement establishes standards for reporting and display of comprehensive
income and its components. Comprehensive income generally includes changes
in separately reported components of equity along with net income.
The Company will adopt SFAS No. 131, "Disclosures about Segments of an
Enterprise and Related Information" for the year ended December 31, 1998.
The Company is currently evaluating the financial information used by
senior management in making strategic operating decisions to determine the
operating segments to be disclosed This statement will not affect the
results of operations, financial position or cash flows of the Company and
has no effect on the financial statements as previously presented.
RECLASSIFICATIONS:
Certain prior period amounts have been reclassified to conform to the
current period's presentation.
3. ACQUISITIONS:
TELEPHONE COMMUNICATIONS CORPORATION. In February 1998, the Company
acquired the assets and assumed certain liabilities of Telephone
Communications Corporation (TCC) of Vail, Colorado. TCC is a long distance
switchless reseller providing 1+, 0+, 800, and Calling Card services to
cities such as Dillon, Frisco and the Vail Valley. The Company paid
$400,000 in cash, issued a $200,000 one-year note at 8% and issued 10,000
shares of Common Stock which for purchase accounting purposes were assigned
a value of $4.00 per share. The Company also assumed a note with National
Network Corporation of approximately $287,000, which will be paid down
monthly in equal installments through 1998. Total consideration for the
purchase was $927,000.
NETWORK COMPUTER SOLUTIONS, LLC. In February 1998, the Company acquired
the assets and liabilities of Network Computer Solutions (NCS) of Greenwood
Village, Colorado. NCS provides network integration services. The company
paid $500,000 in cash, and issued 100,000 shares of Common Stock which for
purchase accounting purposes were assigned a value of $4.00 per share,
8
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
assumed liabilities of $438,372 and paid a finders fee of $150,000 for
total consideration of $1,488,372.
COMMUNICATION SERVICES OF COLORADO. In May 1998, the Company completed a
merger with Communication Services of Colorado (CSC) of Englewood,
Colorado. CSC is a long distance switchless reseller providing 1+, 0+,
800, and Calling Card services. The purchase price consisted of $475,000
in cash and the issuance of a $530,000 one-year note at 8% and assumed
liabilities of $341,054 for total consideration of $1,346,054. The
acquisition of CSC, combined with the acquisition of TCC, is designed to
further enhance the Company's long distance offering.
HH&H COMMUNICATIONS TECHNOLOGIES, INC. In May 1998, the company completed
the acquisition of the assets and certain liabilities of HH&H Communication
Technologies, Inc. (CTI), a voice equipment provider in Texas. The Company
paid $200,000 in cash, issued 30,000 shares of Common Stock which for
accounting purposes were assigned a value at $4.25 per share and assumed
liabilities of $151,383 for total consideration of $478,883.
CMB HOLDINGS, INC. d/b/a INDEPENDENT EQUIPMENT COMPANY. In June 1998, the
Company completed the acquisition of substantially all of the assets of CMB
Holdings, Inc. d/b/a Independent Equipment Company (IEC), an equipment
remarketer in Florida. The purchase price consisted of the issuance of
340,000 shares of Common Stock which for accounting purposes were assigned
a value of $5.00 per share for total consideration of $1.7 million.
Through the IEC acquisition, the Company enhanced the ability of its wholly
owned subsidiary, Convergent Capital Corporation (C3), to remarket less
technologically advanced equipment obtained from new customers when their
existing equipment is updated.
TIE COMMUNICATIONS, INC. Effective August 1, 1998, the Company
completed the acquisition of substantially all of the assets and
certain of the liabilities of Tie Communications, Inc. ("Tie"). The
purchase price consisted of $40.0 million in cash and the assumption of
certain liabilities, which, with legal and professional and other costs
resulted in a total purchase price of approximately $50.1 million. Tie
was a telecommunications equipment provider and a nationwide reseller
of long-distance service. It is anticipated that the acquisition will
accelerate the Company's growth by adding approximately 55,000
customers in 24 new markets and providing the Company with extensive
experience in telephony services including digital telephone systems,
larger telephone systems (PBXs), computer-telephony integration
hardware and software, video teleconferencing and data networking
services.
The above acquisitions have been accounted for using the purchase method of
accounting. The acquisitions were valued at the fair market value of the
consideration given which, in the case of the Company's Common Stock and
warrants, was determined by the Company based upon a number of factors
including a market analysis of publicly traded companies and a discounted
cash flow analysis and, as to the warrants, the Black-Scholes Option
Pricing Model. The consideration paid for acquisitions has been allocated
to the acquired assets based on fair market value. In connection with the
acquisitions, the excess of consideration paid over the fair market value
of the net assets acquired is being amortized on the straight-line basis
over the estimated life of the intangible assets acquired, five to ten
years. The accompanying financial statement include the accounts of the
acquired companies from the effective dates of the acquisitions.
9
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The allocation of consideration given during the nine months ended
September 30, 1998 to the acquired assets is as follows:
<TABLE>
<S> <C>
Purchase Price:
Cash paid for the assets $ 42,364,328
Notes payable issued to former owners 907,500
Common stock issued to the former owners 2,266,400
-------------
Total purchase price $ 45,538,228
-------------
-------------
</TABLE>
Allocation of the purchase price to acquired assets and assumed
liabilities:
<TABLE>
<S> <C>
Accounts receivable $ 8,986,411
Inventory 4,769,068
Other assets 975,067
Equipment 2,853,676
Customer lists 1,683,696
Goodwill 38,579,824
Liabilities and debt assumed (12,309,511)
-------------
Amounts allocated to acquired assets $ 45,538,228
-------------
-------------
</TABLE>
On a pro forma basis for the nine months ended September 30, 1998, as
though the above combinations had taken place as of January 1, 1998,
revenue, net loss and net loss per share would have been as follows
(unaudited):
<TABLE>
<S> <C>
Revenue $ 85,152,185
Net loss $ (41,423,322)
Net loss per share $ 1.50
Weighted average shares 27,590,773
</TABLE>
4. PROPERTY AND EQUIPMENT:
Property and equipment consists of the following at September 30, 1998:
<TABLE>
<S> <C>
Network equipment $ 12,369,727
Office furniture & equipment 8,180,993
Leasehold improvements 679,920
Company vehicles 237,794
--------------
21,468,434
Less: accumulated depreciation (3,569,956)
--------------
Net property and equipment $ 17,898,478
--------------
--------------
</TABLE>
Depreciation expense was $272,099 and $2,959,570 for the nine months ended
September 30, 1997 and 1998, respectively.
10
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
5. NOTES PAYABLE AND CAPITAL LEASES:
NOTES PAYABLE
On April 2, 1998 the Company completed a private offering of $160.0 million of
13% Senior Notes ("13% Notes") and 640,000 warrants to purchase 1,728,000 common
shares of the Company (the "Warrants") (collectively, the "13% Notes Offering").
The 13% Notes mature on April 1, 2008 and interest is payable semi-annually in
arrears on April 1 and October 1 of each year beginning October 1, 1998.
Concurrent with the closing of the 13% Notes Offering, the Company deposited in
a collateral account U.S. Government Securities, which, together with the
interest received thereon, will be sufficient to pay the first six interest
payments on the 13% Notes. Each Warrant entitles the holder to purchase 2.7
shares of Common Stock of the Company at an exercise price of $.01 per share.
The warrants are exercisable upon the earlier of the occurrence of certain
events or October 2, 1999 and expire on April 1, 2008. Each warrant was a
assigned a value of $10.76 utilizing the Black-Scholes Option Pricing Model, a
market analysis of publicly traded companies and a discounted cash flow
analysis. Proceeds available to the Company, net of offering costs of
approximately $7.1 million and the deposit into the collateral account of $56.8
million, were approximately $96.1 million. As of September 30, 1998 the amount
outstanding, net of unaccreted discount of $6.1 million resulting from the
allocation of the warrants, was $153.9 million.
CAPITAL LEASES
The Company has acquired certain equipment under capital leases which is either
used by it or provided to its customers. During the nine months ended September
30, 1998 the Company entered into capital leases totaling approximately $4.1
million and assumed capital leases of approximately $2.6 million as a result of
business combinations.
6. DEFERRED COMPENSATION:
The Company has a Deferred Compensation plan whereby its management employees
can elect to defer a portion of their compensation which will be paid in Common
Stock of the Company at a future date. The plan requires the Company to issue
shares of Common Stock into a trust account which will then be distributed to
the employee at a specified date in the future not less than one year from the
deferral date. The Company has recorded the deferred compensation amount as
treasury stock and as a deferred compensation obligation in the shareholders'
equity section of the balance sheet. As of September 30, 1998, 154,344 shares of
Common Stock are being held in the trust account.
11
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
7. NET LOSS PER SHARE:
The net loss available to Common shareholders and weighted average shares
consists of the following:
<TABLE>
<CAPTION>
Three months ended Nine months ended
September 30, September 30,
----------------------------- --------------------------------
1997 1998 1997 1998
------------- -------------- ------------- --------------
<S> <C> <C> <C> <C>
Net loss $ (2,817,568) $ (15,355,480) $ (5,487,744) $ (31,634,867)
------------- -------------- ------------- --------------
------------- -------------- ------------- --------------
Weighted average common shares
used for basic earnings per share 19,408,022 27,738,811 18,656,265 27,335,217
Warrants - - - -
Stock Options - - - -
------------- -------------- ------------- --------------
Weighted average number of shares
outstanding (basic and diluted) 19,408,022 27,738,811 18,656,265 27,335,217
------------- -------------- ------------- --------------
------------- -------------- ------------- --------------
</TABLE>
For the nine months ended September 30, 1997 and 1998 a total of 6,056,080
and 14,734,222 weighted average options and warrants were not included in
the above calculations as their effect would be anti-dilutive.
8. SUBSEQUENT EVENTS:
Pursuant to the Notes Registration Rights Agreement entered into at the time of
the sale of the 13% Notes, the Company filed a registration statement with
regard to the 13% Notes which was declared effective by the SEC on October 29,
1998. Upon effectiveness of the registration statement the Company immediately
commenced an exchange offer whereby the Company will issue $1,000 principal
amount 13% Notes ("New Notes") which are registered with the SEC for each
originally issued $1,000 principal amount 13% Note ("Old Notes") which were
issued in the 13% Notes Offering (the "Exchange Offer").The New Notes are being
offered in exchange for up to $160.0 million principal amount of Old Notes. The
Exchange Offer will expire at 5:00 p.m., New York City time, on November 30,
1998, or such time to which it is extended by the Company.
In November 1998, the Company entered into a non-binding letter of intent to
purchase the assets and certain liabilities of Kansas Communications, Inc. a
telecommunications equipment provider. The purchase price would include a
combination of cash, notes payable (which would be subject to adjustment) and
common stock of the Company, for an aggregate purchase price up to a maximum
of $6.6 million. The acquisition is subject to due diligence, board of
directors' approval, entering into definitive agreements and obtaining
financing for various portions of the transactions.
12
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
THE FOLLOWING DISCUSSION SHOULD BE READ IN CONJUNCTION WITH THE CONSOLIDATED
FINANCIAL STATEMENTS AND NOTES. THE RESULTS HEREIN ARE NOT NECESSARILY
INDICATIVE OF THE RESULTS TO BE EXPECTED IN ANY FUTURE PERIODS. THIS DISCUSSION
CONTAINS FORWARD-LOOKING STATEMENTS BASED ON CURRENT EXPECTATIONS, WHICH INVOLVE
RISKS AND UNCERTAINTIES. ACTUAL RESULTS AND THE TIMING OF CERTAIN EVENTS MAY
DIFFER SIGNIFICANTLY FROM THOSE PROJECTED IN SUCH FORWARD-LOOKING STATEMENTS DUE
TO A NUMBER OF FACTORS.
OVERVIEW. The Company was founded in 1995 by an experienced team of three data
and telephony executives with 61 combined years of experience in the industry.
The Company had 777 employees at September 30, 1998 and operated in thirty-two
markets in the United States. The Company has taken a number of steps since
inception to implement its business plan, including: (i) establishing fully
operational offices, providing direct sales, technical support and customer care
in its markets; (ii) developing and testing its Enterprise Point-of-Presence
("E-POP-TM-") switching architecture; (iii) completing twelve acquisitions,
adding sales and technical personnel, new products and services and increasing
the customer base in the Company's target markets; (iv) assembling a support
services management team of telecommunications experts; (v) developing and
implementing its Computer-Telephony Integrated Support System-TM- ("CTISS")
customer support software platform; and (vi) developing and testing its
Englewood, Colorado customer care center, which provides additional support to
local distributed customer care centers in each of the Company's markets. The
Company is authorized to provide resold international telecommunications
services and interstate long-distance and operator services. The Company is also
authorized to provide intra-state long distance services in 22 states and is
certified to provide local exchange services in California, Colorado, Oregon,
Iowa and Utah.
Prior to the Tie Acquisition, the Company provided one or more of its array
of communications services to more than 4,000 customers. The Company's
primary sources of revenue were sales of data products and services. For the
nine months ended September 30, 1998, the Company had $36.8 million in
revenues and a net loss of $31.6 million for the same period. In December
1997, the Company entered into contracts with its first ENS customers. As of
September 30, 1998, the Company has entered into multi-year contracts with 16
ENS customers with an aggregate of approximately 1,620 desktops and handsets
(voice and/or data communications devices). These contracts will provide the
Company with approximately $2.9 million in annual contract revenue and are
expected to produce an aggregate of approximately $13.8 million in revenue
over their terms. Although these contracts may be cancelled by the customer,
cancellation requires payment of a fee designed to reimburse the Company for
all or substantially all of its costs incurred in entering into the contract.
MARKET EXPANSION. During the first nine months of 1998 the Company made several
strategic business acquisitions. In February 1998, the Company acquired
Telephone Communications Corporation of Vail, Colorado, a long distance
switchless reseller providing 1+, 0+, 800/888, and calling card services. Also
in February 1998, the Company acquired the data network integration assets of
Network Computer Solutions, L.L.C. of Denver, Colorado. In May 1998, the Company
acquired Communications Services of Colorado, a long distance switchless
reseller providing 1+, 0+, 800, and Calling Card services and HH&H Communication
Technologies, Inc. a voice equipment provider. In June 1998, the Company
purchased the assets of CMB Holdings, Inc. d/b/a Independent Equipment Company,
an equipment remarketer and asset manager forming the basis of CCC.
In July 1998, the Company completed the Tie Acquisition, which added
approximately 55,000 customers in 32 markets, 24 of which markets were not yet
served by the Company. Tie was a
13
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
provider of telecommunications equipment and nationwide reseller of long
distance service. With the Tie Acquisition, the Company intends to increase
its market share of telecommunications equipment sales. In addition, the
Company will begin offering all of its existing data services and products
and ENS services to these newly acquired customers and markets over the next
12 to 24 months. This expansion is expected to require additional capital
expenditures and direct operating costs such as salaries, sales commissions,
marketing, management information systems and other general and
administrative expenses. The amounts of these expenditures and costs are
subject to a variety of factors that may vary greatly by geographic market.
The Company expects its net losses to increase as it continues to establish
and expand its services and product offerings to all its existing and newly
acquired markets. As the customer base grows, however, the Company believes
that revenue will increase at a higher rate than operating expenses, which
should result in positive contributions to cash flow.
REVENUE. The Company's revenue is derived from data services (including frame
relay, data network support, monitoring, design, implementation and consulting,
Internet access and web hosting); voice services (including local, long
distance, public telephones, voice network support, monitoring, design,
implementation and consulting); ENS services (including one or more of the
foregoing together with the Company's ownership of network assets); data
products (value added resale of data network equipment) and voice products
(value added resale of voice network equipment). The Company records revenues
from ENS customers only in situations in which the Company owns any of the
related data or telephony equipment at the customer's location and provides
services under long term contracts.
For the nine months ended September 30, 1998, revenue was approximately $36.8
million of which data and voice products contributed approximately $21.9
million, or 60% of revenue; data and voice services which includes ENS revenue
added approximately $14.9 million, or 40% of revenue; ENS revenue was
approximately $1.4 or 4% of revenue.
OPERATING COSTS. The Company's principal component of operating costs for the
period ended September 30, 1998, was the cost of data and voice equipment
purchased by the Company for value-added resale. Data and voice services
operating costs include labor, leased line facilities charges (which include
charges for connecting a customer to a local or long distance network) and
related capacity charges (which are charges local and long distance carriers,
internet providers and others impose to use their switches, ports, servers and
other equipment). ENS operating costs include all of the foregoing costs
associated with data and voice services. As the Company begins to offer local
exchange services, leased line capacity costs and access charges are expected to
increase because the Company plans to obtain access to a greater number of ILEC
facilities through leased lines in order to reach end users who cannot otherwise
be connected to the Company's network on economically attractive terms. As the
Company expands its long distance offerings, additional costs for wholesale
access on third-party networks will continue to grow.
With respect to ENS sales, the Company's strategy is to own all of the
communications assets deployed at a customer's premise. These assets are
expected to be financed through a combination of the use of the proceeds of the
13% Notes Offering and capital leasing facilities.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. These expenses include corporate
expenses and management salaries, sales and marketing expenses, benefits,
occupancy costs, and administrative expenses.
14
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Selling expenses include commissions paid in connection with the Company's sales
programs. The Company plans to add additional sales personnel as it expands the
product and service mix in its existing markets, including those recently
entered through acquisition. Marketing and advertising expenses are expected to
increase as the Company further implements its business plan. Marketing expenses
consist of the costs of marketing the Company's products and services and
include marketing salaries, travel expenses, trade show expenses, consulting
fees and promotional costs. In addition, the Company's marketing expenses
include direct costs related to customer acquisition, such as telemarketing,
direct mailings, brochures, and targeted advertising and promotional campaigns.
General and administrative expenses consist primarily of salaries and related
expenses of management and support services personnel, professional fees and
general corporate and administrative expenses. General and administrative
expenses cover a broad range of the Company's operations, including corporate
functions such as executive administration, finance, legal, human resources and
facilities as well as significant costs associated with the development, support
and expected growth of the Company's CTISS software platform. Selling, general
and administrative expenses will increase significantly as a result of the Tie
acquisition and as the Company continues to recruit experienced personnel to
implement its business strategy and add management personnel to support
expansion of its business operations.
DEPRECIATION AND AMORTIZATION EXPENSES. Depreciation and amortization expenses
include depreciation of property and equipment, including both assets deployed
at customer sites and for the Company's internal use. Generally, depreciation
and amortization is computed using the straight-line method over the estimated
useful lives of the assets, which for property, plant and equipment range from
two to five years, and for other assets, including intangibles, range from three
to ten years. The Company expects depreciation and amortization expenses to
increase substantially as capital expenditures increase in connection with
capital deployment strategies and as a result of increased goodwill amortization
resulting from recent and future acquisitions.
15
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
RESULTS OF OPERATIONS
The table below summarizes the Company's revenues by source:
<TABLE>
<CAPTION>
Three months ended September 30, Nine months ended September 30,
----------------------------------------- --------------------------------------
1997 1998 1997 1998
------------------ ------------------ ----------------- ------------------
(unaudited)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Revenue:
Data products(1) $ 2,147,207 68% $ 5,899,280 26% $ 3,322,770 58% $ 15,749,628 43%
Voice products(2) 172,141 6 5,692,380 26 631,854 11 6,117,117 17
Data services(3) 257,586 8 923,668 4 361,336 6 2,354,020 6
Voice services(4) 565,728 18 9,154,567 41 1,445,094 25 11,203,744 30
ENS(5) - - 646,507 3 - - 1,396,596 4
------------ --- ------------ --- ----------- --- ------------ ---
Total revenue 3,142,662 100% 22,316,402 100% 5,761,054 100% 36,821,105 100%
Cash flows from operating activities (2,900,117) (3,440,969) (4,519,176) (12,277,410)
Cash flows from investing activities (5,631,607) 1,213,657 (6,272,323) (139,446,037)
Cash flows from financing activities 10,775,045 (886,086) 11,740,067 152,246,219
EBITDA(6) (2,117,369) (7,907,617) (4,397,556) (17,744,998)
</TABLE>
- --------------------------------
(1) Data products include the value-added resale of data network equipment.
(2) Voice products include the value-added resale of voice network equipment.
(3) Data services include frame relay, Internet access and hosting, data
network monitoring and support, and data network planning, design and
installation.
(4) Voice services include local telephone service, long distance service,
public telephone service, voice network monitoring and support, and voice
network planning, design and installation.
(5) Enterprise Network Services is the delivery under long-term contracts of
one or more of the Company's data and telephony services utilizing the
Company's owned network inside the customer's premise.
(6) As used herein, EBITDA consists of earnings before interest (net), income
taxes, depreciation, amortization and other income (expense). EBITDA is a
measure commonly used in the telecommunications industry to analyze
companies on the basis of operating performance. It is not a measure of
financial performance under GAAP and should not be considered as an
alternative to net income as a measure of performance or as an alternative
to cash flow as a measure of liquidity. As definitions of EBITDA may vary,
the Company's measure of EBITDA may not be comparable with similarly titled
measures used by other companies.
16
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
THREE MONTHS ENDED SEPTEMBER 30, 1998 COMPARED TO THREE MONTHS ENDED SEPTEMBER
30, 1997
REVENUE. Revenue increased to $22.3 million for the three months ended
September 30, 1998, from $3.1 million for the three months ended September 30,
1997. Revenue for the third quarter of 1998 consisted of $11.6 million in sales
of data systems integration products and voice products and $10.7 million in
service revenue which included $0.6 million in ENS contract revenue. This is in
contrast to revenue generated for the three months ended September 30, 1997
which consisted primarily of $2.3 million in sales of data products and voice
products and $0.8 million in data and voice and service revenue. The increase in
revenue is primarily due to the Tie Acquisition, which was the most significant
factor in the Company's expansion from 5 to 32 markets. Additional explanations
for the increase in revenue include the completion of seven other acquisitions,
continued expansion of existing markets through the rollout of services and the
addition of ENS to the suite of products and services offered.
OPERATING COSTS. Operating costs increased to $14.7 million for the three months
ended September 30, 1998 from $2.2 million for the three months ended September
30, 1997. Operating costs as a percentage of revenue were 66% for the three
months ended September 30, 1998, compared to 71% for the three months ended
September 30, 1997. The decrease in operating costs as a percentage of revenue
is due to an increase in service revenue as a percentage of total revenue, which
has a lower related operating cost as a percentage of revenue, partially offset
by certain significant and strategic transactions in which the Company offered
more competitive prices on voice and data products. The overall increase in
operating costs is attributable to costs associated with increased sales, the
majority of which is due to revenue generated from the assets and customers
acquired in the Tie Acquisition.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general, and
administrative expenses increased to $15.5 million for the three months ended
September 30, 1998 from $3.1 million for the three months ended September 30,
1997. This increase was primarily attributable to the Tie Acquisition, which
added 436 employees and 24 markets. Overall, the Company expanded its operations
from 5 to 32 markets as a result of completing the Tie Acquisition and seven
other acquisitions. The increase in selling, general, and administrative
expenses was also due to the Company building a support services organization
required to support field operations during the last 12 months, which accounted
for approximately $6.8 million, or 44% of the selling, general and
administrative expenses for the third quarter of 1998. Included in the support
services expenses is approximately $0.4 million of costs associated with the
transition of the Tie Acquisition. The number of employees at September 30, 1998
was 777 compared to 106 at September 30, 1997.
DEPRECIATION AND AMORTIZATION EXPENSE. Depreciation and amortization expense
increased to $2.6 million for the three months ended September 30, 1998 from
$0.3 million for the three months ended September 30, 1997. This increase was
attributable to the acquisition of additional assets in connection with the
Company expanding its operations from 5 to 32 markets, increased amortization of
goodwill and customer lists as a result of eight additional acquisitions
completed over the last 12 months and the expansion of the Company's network to
support ENS customers.
INTEREST EXPENSE. Interest expense increased to approximately $5.9 million for
the three months ended September 30, 1998 from approximately $66,476 for the
three months ended September 30, 1997. Approximately $5.8 million of the
increase is attributable to interest expense related to the sale of the
17
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
$160.0 million of 13% Notes which closed on April 2, 1998. In addition, the
Company has incurred additional indebtedness under various equipment leasing
facilities and acquisition related notes payable.
INTEREST INCOME. Interest income increased from approximately $18,000 for the
three months ended September 30, 1997 to approximately $1.1 million for the
three months ended September 30, 1998. This increase is attributable to the
temporary investment of the proceeds of the 13% Notes Offering which closed on
April 2, 1998.
OTHER, NET. Other net income or expense decreased from an other net expense of
approximately $356,000 for the three months ended September 30, 1997 to other
net expense of approximately $78,000 for the three months ended September 30,
1998. Other net expense for the three months ended September 30, 1997 primarily
consisted of non-capitalized acquisition related expenses and for the three
months ended September 30, 1998 primarily consisted of loss on disposal of
assets.
NINE MONTHS ENDED SEPTEMBER 30, 1998 COMPARED TO NINE MONTHS ENDED SEPTEMBER 30,
1997
REVENUE. Revenue increased to $36.8 million for the six months ended September
30, 1998, from $5.8 million for the nine months ended September 30, 1997.
Revenue for the first nine months of 1998 consisted of $21.9 million in sales of
data systems integration products and voice products and $14.9 million in
service revenue which included $1.4 million in ENS contract revenue. Revenue
for the first nine months of 1997 consisted of $4.0 million in sales of data
systems integration products and voice products and $1.8 million in data and
voice services revenue. The increase in revenue is primarily due to the
expansion from 5 to 32 markets, the completion of eight acquisitions, the most
significant of which was the Tie Acquisition, continued expansion of existing
markets through the rollout of services and the addition of ENS to the suite of
products and services offered.
OPERATING COSTS. Operating costs increased to $25.3 million for the nine months
ended September 30, 1998 from $3.9 million for the nine months ended September
30, 1997. Operating costs as a percentage of revenue were 69% for the nine
months ended September 30, 1998, compared to 67% for the nine months ended June
30, 1997. The increase in operating costs as a percentage of revenue is due to
the Company offering more competitive prices on voice and data products in
certain significant and strategic transactions partially offset by an increase
in service revenue as a percentage of total revenue, which has a lower related
operating cost as a percentage of revenue. The overall increase in operating
costs is attributable to costs associated with increased sales.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general, and
administrative expenses increased to $29.3 million for the nine months ended
September 30, 1998 from $6.2 million for the nine months ended September 30,
1997. This increase was largely attributable to the Tie Acquisition, which added
436 employees and 24 markets. Overall, the Company expanded its operations from
5 to 32 markets as a result of completing the Tie Acquisition and seven other
acquisitions. The increase in selling, general, and administrative expenses was
also due to the Company building a support services organization required to
support field operations during the last 12 months, which accounted for
approximately $13.9 million, or 47% of the current year-to-date expenses. The
number of employees at September 30, 1998 was 777 compared to 106 at September
30, 1997.
DEPRECIATION AND AMORTIZATION EXPENSE. Depreciation and amortization expense
increased to $4.6 million for the nine months ended September 30, 1998 from $0.8
million for the nine months ended
18
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
September 30, 1997. This increase was attributable to the acquisition of
additional assets in connection with the Company expanding its operations
from 5 to 32 markets, increased amortization of goodwill and customer lists
as a result of eight additional acquisitions completed over the last 12
months and the expansion of the Company's network to support ENS customers.
INTEREST EXPENSE. Interest expense increased to approximately $11.8 million for
the nine months ended September 30, 1998 from approximately $75,000 for the nine
months ended September 30, 1997. Approximately $11.5 million of the increase is
attributable to interest expense related to the sale of $160.0 million of 13%
Notes which closed on April 2, 1998 including amortization of offering costs and
accretion of the original issue discount. In addition, the Company has incurred
additional indebtedness under various equipment leasing facilities and
acquisition related notes payable.
INTEREST INCOME. Interest income increased from approximately $62,000 for the
nine months ended September 30, 1997 to approximately $2.5 million for the nine
months ended September 30, 1998. This increase is attributable to the temporary
investment of the proceeds of the 13% Notes Offering, which closed on April 2,
1998, pending their deployment in the Company's business.
OTHER, NET. Other net income or expense decreased from an other net expense of
approximately $325,000 for the nine months ended September 30, 1997 to other net
expense of approximately $65,000 for the nine months ended September 30, 1998.
Other net expense for the nine months ended September 30, 1997 primarily
consisted of an amount to pay an acquisition related dispute, loss on disposal
of assets and non-capitalized acquisition related expenses and for the nine
months ended September 30, 1998 primarily consisted of loss on disposal of
assets.
INCOME TAXES. The Company incurred net losses of $31.6 million and $5.5 million
for the nine months ended September 30, 1998 and 1997, respectively.
Accordingly, no provision for current federal or state income taxes has been
made to the financial statements. At December 31,1997, the Company and its
subsidiaries had net operating loss carry-forwards for federal income tax
purposes of approximately $9.1 million. These losses begin to expire in 2011 for
federal income tax purposes. A full valuation allowance has been recorded
against the deferred tax assets at December 31, 1997 and September 30, 1998 as
the recoverability of such deferred tax assets is not considered to be more
likely than not due to the Company's continuing losses.
LIQUIDITY AND CAPITAL RESOURCES
Since inception, the Company has funded its operations primarily through cash
from the private placement of units consisting of common stock and warrants to
purchase common stock and debt, most recently the 13% Notes Offering. The
Company's private placements generated net proceeds of $152.9.million, $17.3
million and $4.4 million for the nine months ended September 30, 1998 and years
ended December 31, 1997 and 1996, respectively. The Company's principal uses of
cash are to fund working capital requirements, capital expenditures, business
acquisitions, and the operating losses incurred during the start up phase in
each new market established by the Company.
As of September 30, 1998, the Company had current assets of $86.3 million,
including cash, cash equivalents and short-term investments of $36.5 million,
and working capital of $42.7 million. In addition to cash, cash equivalents and
short-term investments, the Company had $61.2 million in restricted cash which,
along with the earnings thereon, will be used to make the first six interest
19
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
payments on the 13% Notes through April 2001, the first of which was made on
October 1, 1998. The Company invests excess funds in short-term investments
until such funds are needed for capital investments, acquisitions and operations
of the Company's business.
CASH FLOWS FROM OPERATING ACTIVITIES:
The Company's operating activities utilized cash of approximately $12.3 million
for the nine months ended September 30, 1998, compared to $4.5 million for the
nine months ended September 30, 1997. The majority of the increase was due to a
$26.0 million increase in the operating loss which was partially offset by
$10.5 million of accrued interest and other non-cash expenses such as
depreciation and amortization, provision for uncollectible accounts and stock
compensation.
CASH FLOWS FROM INVESTING ACTIVITIES:
During the nine months ended September 30, 1998 and 1997 cash used by investing
activities was $139.4 million and $6.3 million, respectively. Cash used by
investing activities during the nine months ended September 30, 1998 primarily
consisted of cash invested in short-term investments and restricted cash of
$87.7 million, cash used in business combinations of $42.4 million and cash used
for capital expenditures of $9.1 million.
CASH FLOWS FROM FINANCING ACTIVITIES:
Cash flows from financing activities provided $152.2 million and 11.7 million,
for the nine months ended September 30, 1998 and 1997, respectively. Cash
provided during the nine months ended September 30, 1998 was primarily
attributable to net cash flows of approximately $152.9 million in net proceeds
from the 13% Notes Offering and outflows of approximately $2.2 million in
payments on long-term obligations.
On April 2, 1998 the Company completed a private offering of $160.0 million in
13% Notes and 640,000 warrants to purchase 1,728,000 shares of Common Stock of
the Company. The 13% Notes mature on April 1, 2008 and interest is payable
semiannually in arrears on April 1 and October 1 of each year. Concurrent with
the closing of the 13% Notes Offering the Company deposited in a collateral
account U.S. Government Securities, which, together with the interest received
thereon, will be sufficient to pay, the first six interest payments, the first
of which was paid on October 1, 1998. Each Warrant entitles the holder to
purchase 2.7 shares of Common Stock of the Company at an exercise price of $.01
per share. Proceeds available to the Company, net of offering costs of
approximately $7.1 million and the deposit into the collateral account of $56.8
million, were approximately $96.1 million
In November 1997, the Company entered into a three year Program Agreement with
Comdisco, Inc. ("Comdisco") which provides for up to $50 million of equipment
lease financing. At September 30, 1998, $10 million was available to the Company
under this facility of which approximately $1.7 million was being utilized. The
availability of additional amounts depends on whether the Company meets certain
financial criteria. The Program Agreement expires on June 30, 2000.
20
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
The Company has an agreement with Sun Financial Group, Inc. under which the
Company has borrowed $2.8 million to finance the Company's development of the
CTISS system and other internal capital needs. The Company also has a $0.8
million inventory credit facility with NationsCredit Commercial Corporation.
RECENTLY ADOPTED ACCOUNTING STANDARDS:
See Note 1 to the Consolidated Financial Statements.
GENERAL:
The Company's business plans will continue to require a substantial amount of
capital to fund its expansion of existing and recently acquired markets,
including funding the development of its ENS networks (which includes providing
its customers with all necessary hardware, software, transmission facilities and
management services), deploying E-POPs-TM-, creating local customer care and
sales organizations, continuing to develop its CTISS system and funding
operating losses and debt service requirements. The Company also continues to
evaluate acquisitions and investments in light of the Company's long range
plans. Such acquisitions and investments, if realized, could require expenditure
of a material portion of the Company's financial resources and would accelerate
the need for raising additional capital in the future.
The Company's cash and short-term investments are expected to provide
sufficient liquidity to meet the Company's capital requirements for
approximately the next 12, or 18 months assuming the exercise of the
Company's warrants expiring in July 1999. Sources of funding for the
Company's financing requirements may include vendor financing, bank loans and
public offerings or private placements of equity and/or debt securities.
There can be no assurance that additional financing will be available to the
Company or, if available, that financing can be obtained on a timely basis
and on acceptable terms. The failure to obtain such financing on acceptable
terms could have a material adverse effect on the Company.
IMPACT OF THE YEAR 2000
The "year 2000 issue" generally describes the various problems that may result
from the improper processing of dates and date-sensitive calculations by
computers and other equipment as a result of computer hardware and software
using two digits to identify the year in a date. If a computer program or other
piece of equipment fails to properly process dates including and after the year
2000, date-sensitive calculations may be inaccurate as a result of those
computers and software failing to distinguish dates in the 2000's from dates in
the 1900's. The failure to process dates could result in system failures or
miscalculations causing disruptions in operations including, among other things,
a temporary inability to process transactions, send invoices or engage in
similar normal business activities.
STATE OF READINESS. The Company has created a Year 2000 Task Force to evaluate
its year 2000 readiness as it may affect the Company's operations. The Task
Force has identified two areas for review: (i) internal issues (including the
Company's information technology ("IT") assets and non-IT systems); and
(ii) external issues (including third-party manufactured products sold by the
Company, and issues with customers, vendors and suppliers). The Company is in
the process of contacting
21
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
manufacturers and suppliers of IT and non-IT assets used internally by the
Company for services such as customer billing, customer service and financial
reporting, including manufacturers and suppliers of computer equipment,
software programs, telephone systems, data systems, systems comprising the
Company's enterprise networks and equipment used to provide services to
customers. These contacts will help the Company determine the extent to which
these systems could cause a material adverse effect on the Company's
operations in the event that the systems fail to properly process
date-sensitive calculations following the year 2000. The Company is also
actively identifying potential external issues which could have an impact on
the operations of the Company. These include issues with (i) the functioning
of third-party manufactured products sold by the Company to its customers;
(ii) significant customer systems, including customer-owned and operated
systems and systems that are connected to the Company's networks; (iii)
vendors and suppliers such as credit facility providers, third-party service
providers (e.g., local and long distance wholesale providers and
interconnection providers) and employee benefit plan providers (e.g., 401(k)
plan administrators).
The Company's evaluation of its state of year 2000 readiness is not
complete. As a result, the Company may in the future identify a significant
internal or external year 2000 issue which, if not remediated in a timely
manner, could have a material adverse effect on the Company's business,
financial condition and results of operations.
The Task Force has developed four phases for the implementation of its
review and response to year 2000 issues. The phases will, to a great extent, be
completed simultaneously as issues are identified in Phase I. While the Company
anticipates it will complete all Phases described below by mid-1999, this may
not be possible if the Company discovers a significant, previously unrecognized
year 2000 issue in the course of completing its assessment of its year 2000
readiness.
PHASE I - Phase I involves identifying all potential internal and external
IT and non-IT systems that may have a material adverse effect on the
operations of the Company in the event that they fail to process
date-sensitive information correctly. The Company believes that it has
identified substantially all significant internal IT systems the failure of
which could have a material adverse effect. The Company has only begun to
identify external IT systems and internal and external non-IT systems the
failure of which could have a material adverse effect on operations.
PHASE II - Phase II involves determining the extent of readiness of each IT
and non-IT system identified in Phase I. The Company is currently
contacting manufacturers, suppliers and vendors to determine the extent of
readiness of systems it has identified to date. With respect to the vendors
and suppliers of the systems identified to date in Phase I, the Company has
received a number of statements regarding year 2000 readiness. The Company
is in the process of evaluating these statements. To date, the Company has
not positively identified any year 2000 issues with its own systems. The
Company does not yet have enough information to determine whether there are
any year 2000 issues with third-parties which could have a material adverse
effect on operations.
PHASE III - Phase III involves the implementation of any corrective action
necessary for any problems in the systems identified in Phase II. The
Company anticipates that any corrective action will require use of the
Company's internal resources, third-party manufacturers, suppliers and
vendors and potentially additional third-party consultants, as necessary.
22
<PAGE>
CONVERGENT COMMUNICATIONS, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
PHASE IV - Phase IV involves determining alternatives and contingency plans
for any system the failure of which could have a material adverse effect on
the Company's business, financial condition or results of operations if the
corrective action implemented in Phase III is partially or wholly
ineffective. The Company has begun identifying alternatives to systems in
the event that existing systems are determined to not be year 2000 ready.
Because the Company has not identified any year 2000 issues in Phase II
which have not already been remediated, the Company has no finalized
contingency plans. The Company will continue to develop such plans as
additional information is received from manufacturers, suppliers and
vendors.
COSTS. Other than time spent by the Company's internal IT and legal personnel
which could be spent on other matters, the Company has not incurred any
significant costs in identifying year 2000 issues. The Company does not
anticipate any significant further costs in Phase I or Phase II. Because no
material year 2000 issues have yet been identified in Phase II, and therefore no
contingency plans have been finalized, the Company cannot reasonably estimate
further costs relating to Phase III remediation of any year 2000 issues at this
time, or costs of contingency plans which might be implemented under Phase IV.
As the Company continues to gather information regarding its year 2000 issues,
the Company will re-evaluate its ability to estimate costs associated with the
year 2000 issue. There can be no assurance that as additional year 2000 issues
are addressed, the Company's costs to correct such issues will be consistent
with historical costs.
RISKS OF YEAR 2000 ISSUES. Because no material year 2000 issues have yet been
identified in Phase II, the Company cannot reasonably ascertain the extent of
the risks involved in the event that any one system fails to process
date-sensitive calculations accurately. Potential risks include the inability to
process customer billing accurately or in a timely manner, the inability to
provide accurate financial reporting to management, auditors, investors and
others, litigation costs associated with potential suits from customers and
investors, delays in implementing other IT projects as a result of work by
internal personnel on year 2000 issues, and delays in receiving payment or
equipment from customers or suppliers as a result of their systems' failure. Any
one of these risks, if they materialize, could individually have a material
adverse effect on the Company's business, financial condition or results of
operations.
As almost all of the Company's IT and non-IT systems and products relating
to the Company's internal and external issues are manufactured or supplied by
third parties which are outside of the Company's control, there can be no
assurance that all of those third parties' systems will be year 2000 ready. If
some or all of the Company's internal and external systems fail, or if any
critical IT or non-IT systems are overlooked or are not year 2000 ready in a
timely manner, there could be a material adverse effect on the Company's
business, financial condition or results of operations.
CONTINGENCY PLANS. Because no material year 2000 issues have yet been
identified in Phase II, no contingency plans have yet been finalized under Phase
IV.
EFFECTS OF INFLATION
Management does not believe that its business is impacted by inflation to a
significantly different extent than is the general economy. However, there can
be no assurances that inflation will not have a material effect on the
Company's operations in the future.
23
<PAGE>
PART II
Item 1. Legal Proceedings
The Company is involved in legal proceedings from time to time, none of
which management believes, if decided adversely to the Company, would have
a material adverse effect on the business, financial condition or results
of operations of the Company.
Item 2. Changes in Securities
None
Item 3. Defaults Upon Senior Securities
None
Item 4. Submission of Matters to a Vote of Security Holders
None
Item 5. Other Information
None
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
10 Material Contracts
Asset Purchase Agreement, dated June 16, 1998 by and between
Convergent Communications Services, Inc. and Tie
Communications, Inc., Debtor in Possession (Incorporated by
reference to exhibit 10.6 of the Company's Registration
Statement on Form S-4, file number 333-53953 dated
October 29, 1998).
11 Computation of Earnings Per Share
27 Financial Data Schedule
(a) Reports on Form 8-K
None
24
<PAGE>
SIGNATURE
PURSUANT TO THE REQUIREMENTS OF THE SECURITIES AND EXCHANGE ACT OF 1934, THE
REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE
UNDERSIGNED THEREUNTO DULY AUTHORIZED.
CONVERGENT COMMUNICATIONS, INC.
Date: November 10, 1998 By: /s/ John R. Evans
------------------------ ------------------------------------
John R. Evans
Chairman and Chief Executive Officer
Date: November 10, 1998 By: /s/ Keith V. Burge
------------------------ ------------------------------------
Keith V. Burge
President and Chief Operating Officer
Date: November 10, 1998 By: /s/ John J. Phibbs Jr.
------------------------ ------------------------------------
John J. Phibbs Jr.
Chief Financial Officer and Treasurer
25
<PAGE>
EXHIBIT 11
CONVERGENT COMMUNICATIONS, INC.
COMPUTATION OF EARNINGS PER SHARE
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
1997 1998 1997 1998
----------- ------------ ---------- -----------
<S> <C> <C> <C> <C>
EARNINGS PER SHARE - PRIMARY
Net loss $(2,817,568) $(15,355,480) $(5,487,744) $(31,634,867)
----------- ------------ ----------- ------------
----------- ------------ ----------- ------------
Weighted average common shares
used for basic earnings per share 19,408,022 27,738,811 18,656,265 27,335,217
Warrants - - - -
Stock Options - - - -
----------- ------------ ----------- ------------
Weighted average number of shares outstanding 19,408,022 27,738,811 18,656,265 27,335,217
----------- ------------ ----------- ------------
----------- ------------ ----------- ------------
Weighted average earnings per share - primary $ (0.15) $ (0.55) $ (0.29) $ (1.16)
----------- ------------ ----------- ------------
----------- ------------ ----------- ------------
EARNINGS PER SHARE - FULL DILUTION
Net loss $(2,817,568) $(15,355,480) $(5,487,744) $(31,634,867)
----------- ------------ ----------- ------------
----------- ------------ ----------- ------------
Weighted average common shares
used for basic earnings per share 19,408,022 27,738,811 18,656,265 27,335,217
Warrants - - - -
Stock Options - - - -
----------- ------------ ----------- ------------
Weighted average number of shares outstanding 19,408,022 27,738,811 18,656,265 27,335,217
----------- ------------ ----------- ------------
----------- ------------ ----------- ------------
Weighted average earnings per share - full dilution $ (0.15) $ (0.55) $ (0.29) $ (1.16)
----------- ------------ ----------- ------------
----------- ------------ ----------- ------------
</TABLE>
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<S> <C> <C> <C> <C>
<PERIOD-TYPE> 3-MOS 3-MOS 9-MOS 9-MOS
<FISCAL-YEAR-END> DEC-31-1997 DEC-31-1998 DEC-31-1997 DEC-31-1998
<PERIOD-START> JUL-01-1997 JUL-01-1998 JAN-01-1997 JAN-01-1998
<PERIOD-END> SEP-30-1997 SEP-30-1998 SEP-30-1997 SEP-30-1998
<CASH> 0 0 0 1,190,116
<SECURITIES> 0 0 0 35,279,361
<RECEIVABLES> 0 0 0 21,567,452
<ALLOWANCES> 0 0 0 (3,298,204)
<INVENTORY> 0 0 0 8,468,529
<CURRENT-ASSETS> 0 0 0 2,298,451
<PP&E> 0 0 0 21,468,434
<DEPRECIATION> 0 0 0 (3,569,956)
<TOTAL-ASSETS> 0 0 0 199,268,853
<CURRENT-LIABILITIES> 0 0 0 43,599,003
<BONDS> 0 0 0 154,595,296
0 0 0 0
0 0 0 0
<COMMON> 0 0 0 27,327,104
<OTHER-SE> 0 0 0 (29,030,369)
<TOTAL-LIABILITY-AND-EQUITY> 0 0 0 0
<SALES> 2,319,348 11,591,660 3,954,625 21,866,745
<TOTAL-REVENUES> 3,142,662 22,316,402 5,761,054 36,821,105
<CGS> 1,857,814 9,117,972 17,397,145 3,019,728
<TOTAL-COSTS> 2,208,277 14,717,364 3,945,154 25,287,038
<OTHER-EXPENSES> 3,703,125 18,230,879 7,290,274 33,943,101
<LOSS-PROVISION> 0 0 0 755,862
<INTEREST-EXPENSE> 66,476 5,868,531 74,951 11,751,121
<INCOME-PRETAX> (2,817,568) (15,355,480) (5,487,744) (31,634,867)
<INCOME-TAX> 0 0 0 0
<INCOME-CONTINUING> (2,817,568) (15,355,480) (5,487,744) (31,634,867)
<DISCONTINUED> 0 0 0 0
<EXTRAORDINARY> 0 0 0 0
<CHANGES> 0 0 0 0
<NET-INCOME> (2,817,568) (15,355,480) (5,487,744) (31,634,867)
<EPS-PRIMARY> (0) (1) (0.29) (1.16)
<EPS-DILUTED> (0) (1) (0.29) (1.16)
</TABLE>
