UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE YEAR ENDED DECEMBER 31, 1998
Commission File Number: 0-24061
US LEC CORP.
(Exact name of registrant as specified in its charter)
DELAWARE 56-2065535
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
401 NORTH TRYON STREET, SUITE 1000
CHARLOTTE, NORTH CAROLINA 28202
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (704) 319-1000
Securities registered pursuant to Section 12(b) of Act: None.
Securities registered pursuant to Section 12(g) of Act: Class A Common Stock,
par value $.01 per share.
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 the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [X]
The aggregate market value of voting stock of the registrant held
by non-affiliates of the registrant was $152,153,585 as of March 23, 1999 based
on the closing sales price on The Nasdaq National Market as of that date. For
purposes of this calculation only, affiliates are deemed to be directors and
executive officers of the registrant.
As of March 23, 1999, there were 10,351,500 shares of Class A Common
Stock and 17,075,270 shares of Class B Common Stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant's Annual Report to Stockholders for the year
ended December 31, 1998 are incorporated by reference into Part I, Part II and
Part IV of this report. Portions of the registrant's Proxy Statement for its
Annual Meeting of Stockholders to be held on April 20, 1999 are incorporated by
reference into Part III of this report.
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US LEC CORP.
1998 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS
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PART I
Item 1: Business 3
Item 2: Properties 17
Item 3: Legal Proceedings 18
Item 4. Submission of Matters to a Vote of Security Holders 18
PART II
Item 5: Market for the Registrant's Common Stock and Related Stockholder Matters 18
Item 6: Selected Consolidated Financial Data 18
Item 7: Management's Discussion and Analysis of Financial Condition and Results
of Operations 18
Item 8: Financial Statements and Supplementary Data 18
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial
Disclosure 18
PART III
Item 10: Directors and Executive Officers of the Registrant 19
Item 11: Executive Compensation 19
Item 12: Security Ownership of Certain Beneficial Owners and Management 19
Item 13: Certain Relationships and Related Transactions 19
PART IV
Item 14: Exhibits, Financial Statement Schedules and Reports on Form 8-K 20
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PART I
ITEM 1. BUSINESS
THE COMPANY
US LEC Corp. ("US LEC" or the "Company") is a rapidly growing
competitive local exchange carrier ("CLEC") that provides switched local, long
distance and enhanced telecommunications services to its customers. The Company
primarily serves telecommunication-intensive customers including businesses,
universities, financial institutions, hospitals, hotels, Internet Service
Providers ("ISPs") and government agencies. The predecessor to US LEC was
incorporated in June 1996 after passage of the Telecommunications Act of 1996
("Telecom Act"), which enhanced the competitive environment for local exchange
services. On December 31, 1996, the original corporation was merged into US LEC
L.L.C., a limited liability company. On December 31, 1997, in anticipation of an
initial public offering, US LEC L.L.C. was merged into US LEC. US LEC initiated
service in North Carolina in March 1997, becoming one of the first CLECs in
North Carolina to provide switched local exchange services, and now has switches
in Charlotte, Raleigh, Greensboro, Atlanta, Memphis, Nashville, Knoxville,
Orlando, Miami, Tampa, Jacksonville, and Norfolk/Virginia Beach. US LEC
currently plans to establish switch sites in additional markets during 1999,
including Richmond, Birmingham, Philadelphia and the Washington D.C.
metropolitan area. As of December 31, 1998 the Company had 199,578 Equivalent
Access Lines in service. See "Item 7: Management's Discussion and Analysis of
Financial Condition and Results of Operations" for a detailed explanation of how
the Company calculates Equivalent Access Lines.
BUSINESS STRATEGY
US LEC's objective is to become a leading telecommunications service
provider and the primary provider of telecommunications services to its existing
and target customers. The principal elements of US LEC's business strategy
include:
DEPLOY A CAPITAL-EFFICIENT NETWORK. US LEC utilizes a "smart-build"
strategy of purchasing and deploying switching equipment and leasing the
required fiber optic transmission capacity from competitive access providers
("CAPs"), other CLECs and incumbent local exchange carriers ("ILECs").
Management believes the Company's switch-based, leased-transport strategy
enables it to enter markets and generate revenue and positive cash flow more
rapidly than if the Company first constructed its own transmission facilities.
By leasing fiber transport, this smart-build strategy also reduces the up-front
capital expenditures required to build a network and enter new markets and
avoid the risk of "stranded" investment in under-utilized fiber networks.
Management also believes that the Company's ability to align its leased
transmission costs with customer orders permits a higher return on invested
capital.
FOCUS ON A REGIONAL CLUSTER OF OPERATIONS. The Company focuses its
network build out and marketing presence in target markets composed of Tier I
cities (major metropolitan areas such as Atlanta, Miami and Washington D.C.) and
Tier II cities (mid-size metropolitan areas such as Greensboro, Tampa and
Nashville) throughout the southeastern and mid-Atlantic United States -- two of
the fastest growing regional markets for business telecommunications services in
the country. The Company has selected its target markets based on a number of
considerations, including the number of potential customers and other
competitors in such markets and the presence of multiple transmission facility
suppliers. Management believes that the Company's clustered network will enable
it to take advantage of regional calling patterns and capture an increasing
portion of customer traffic on its network.
TARGET TELECOMMUNICATIONS-INTENSIVE CUSTOMERS. The Company focuses its
primary sales efforts on telecommunications-intensive customers including
businesses, universities, financial institutions, hospitals, hotels, ISPs and
government agencies. The volume of usage generated by the Company's target
customers allows the Company to efficiently concentrate the telecommunications
traffic of its customers. In addition, the Company frequently is able to sell
enhanced and long distance services to complement its core local services. This
further
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enhances network utilization and thereby improves margins, as fixed network
costs are spread over a larger base of minutes of use. Unlike many other
CLECs, the Company does not resell ILEC services.
INSTALL A ROBUST TECHNOLOGY PLATFORM. The Company has chosen the 5ESS(R)
Any Media(TM) digital switch manufactured by Lucent Technologies, Inc.
("Lucent") to provide a consistent technology platform throughout its network.
US LEC currently has twelve Lucent switches active throughout its network. To
enhance its service offerings, the Company is in the process of deploying
Alcatel MegaHub(R) 600ES ("Alcatel") tandem switches. The Alcatel switches will
complement the Lucent switches and improve US LEC's ability to provide enhanced
services, including calling cards, toll-free services, operator services and
Virtual Private Networks ("VPN"). The Company has also reached the final stages
of selection for an Advanced Intelligent Network ("AIN") platform. This AIN
platform will position US LEC for many enhanced services as well as allow the
Company more reliability for Signaling System No. 7 connectivity. This advanced
switching platform allows the Company to (i) deploy features and functions
quickly throughout its entire network, (ii) expand switch capacity in a cost
effective manner, (iii) achieve direct connectivity to cellular and personal
communication system applications in the future and (iv) provide a broader range
of product offerings.
EMPLOY AN EXPERIENCED SALES FORCE. Management believes that the
Company's success in a particular market is enhanced by employing a direct
sales force with extensive local market and telecommunications sales
experience. The Company employed this strategy in building its existing sales
forces in North Carolina, Georgia, Tennessee, Florida and Virginia and intends
to continue implementing this strategy in other markets. Salespeople with
experience in a particular market provide the Company with extensive knowledge
of the Company's target customer base and in many cases have existing
relationships with target customers.
IMPLEMENT EFFICIENT PROVISIONING PROCESSES WITH STATE-OF-THE-ART BACK
OFFICE Support. Management believes that a critical aspect of the success of a
CLEC is timely and effective provisioning systems, which includes the process of
transitioning ILEC customers to the Company's network. The Company focuses on
implementing effective and timely provisioning practices in each of its markets
to rapidly and efficiently transition customers from the ILEC or other CLECs to
the Company with minimal disruption of the customer's operations. US LEC
continues to work with ILECs to streamline its process for migration of
customers to US LEC's network. Among other things, US LEC is approved by
Lockheed Martin as a provider of Local Number Portability("LNP") for its
customers. In addition, the US LEC Network Operations Center ("NOC") houses the
tools to monitor and maintain customers' networks at all times. The NOC provides
network surveillance, real-time alarm notification, dispatch services, and 24
hour x 7 day a week availability and notification. Management believes that
these practices provide the Company with a long-term competitive advantage and
enable it to implement services in its markets rapidly and to shorten the time
between receipt of the customer order and the generation of revenue.
OFFER A BROAD RANGE OF PRODUCTS AND SERVICES. US LEC offers
customers a broad range of bundled telecommunication services. Management
believes rapid deployment of new technologies, customized services for diverse
applications and highly competitive pricing give US LEC customers an exceptional
value. Local network access is available in many forms including Integrated
Services Digital Network ("ISDN"), Primary Rate Interface ("PRI"), T1 Access and
Channel Access ("DSO"). Multiple local access services are also available,
including business lines, Private Branch Exchange ("PBX") trunks and Foreign
Exchange trunks. US LEC also offers its customers competitively priced long
distance service including intrastate, interstate, international and toll-free
calls. US LEC's efforts to expand its technology platform will allow the Company
to further increase its product offerings.
US LEC'S NETWORK
During 1998, the Company installed new Lucent 5ESS(R) Any Media(TM)
digital switches in eight new cities, bringing the total to eleven switches
serving twenty-four markets. During the first quarter of 1999, the Company
activated its twelfth Lucent switch in Norfolk/Virginia Beach. The Company has
announced plans to activate additional Lucent switches during 1999 in Richmond,
Birmingham, Philadelphia and the Washington D.C. metropolitan area. Also during
the first quarter of 1999, US LEC installed its first Alcatel switch in
Charlotte.
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US LEC utilizes a "smart build" strategy of purchasing and deploying
switching equipment and leasing fiber optic transmission capacity from CAPs,
other CLECs and ILECs.
Calls originating with a US LEC customer are transported over leased
lines to the US LEC switch and can either be terminated directly on the
Company's network or routed to a long distance carrier, an ILEC or another CLEC,
depending on the location of the call recipient. Similarly, calls originating
from the public switched telephone network and destined for a US LEC customer
are routed through the US LEC switch and delivered to call recipients via leased
transmission facilities. Management believes that this smart-build strategy
results in the following competitive advantages:
o an increased number of buildings that can be directly connected to the
Company's switching network, which should maximize the number of
customers to which the Company can offer its services;
o a higher volume of telecommunications traffic both originating and
terminating on the Company's network, which should result in improved
operating margins; and
o the ability to leverage its investment in high capacity switching equipment
and related electronics.
The Company has signed interconnection agreements with various ILECs,
including BellSouth, GTE, Sprint, Bell Atlantic and other carriers. These
agreements provide the framework for the Company to serve its customers when
other local carriers are involved. The agreement with BellSouth covers all
states in BellSouth's operating area in which US LEC operates. The Company's
interconnection agreement with BellSouth is scheduled to expire in June 1999,
but management does not anticipate any interruption of interconnect services. No
other interconnection agreements are scheduled to expire in 1999.
PRODUCTS AND SERVICES
The Company provides local dial-tone services to customers. Local
access is available in many different forms including ISDN, PRI, TI Access and
Channel Access. Local services and long distance services can be bundled
together using the same transport facility. The Company's network is designed to
allow a customer to easily increase or decrease capacity and utilize enhanced
services as the telecommunications requirements of the customer change. The
Company also provides access to third party directory assistance and operator
services.
US LEC provides domestic and international long distance services for
completing intrastate, interstate and international calls. The Company also
provides toll-free services. Long distance calls which do not terminate on the
Company's network are passed to long distance carriers which route the remaining
portion of the call. The Company's ability to bundle local and long distance
services allows it to offer its customers more efficient use of transport
facilities and allows it to aggregate customers' monthly recurring, local usage
and long distance charges on a single, consolidated invoice.
In addition to providing typical enhanced services such as voice mail,
call transfer and conference calling, US LEC offers additional value-added
enhanced services to complement its core local and long distance services. These
enhanced service offerings include:
o Access to Internet Services -- Enables customers to use their available
capacity for access to ISPs.
o Data Networking Services -- The Company can provide high-speed,
broadband services to use for data and Internet access such as ISDN and
PRI.
o Specialized Application Services -- The Company can create products and
services that are tailored for target industries with special
telecommunications needs such as the hospitality industry. These
services typically include non-measured rate local calling, expanded
local calling area, discounted long distance rates and tailored trunking
configurations.
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SALES AND MARKETING
SALES. US LEC is building a highly motivated and experienced direct
sales force. The Company recruits salespeople with strong sales backgrounds in
its existing and target markets, including salespeople from long distance
companies, telecommunications equipment manufacturers, network systems
integrators, CLECs and ILECs. The Company expanded its sales force from 23
salespeople at December 31, 1997 to 98 salespeople at December 31, 1998, and
management expects to further increase the Company's sales force to over 150
salespeople by the end of 1999. The Company plans to continue to attract and
retain highly qualified salespeople by offering them an opportunity to work with
an experienced management team in an entrepreneurial environment and to
participate in the potential economic rewards made available through a
results-oriented compensation program. The Company also utilizes independent
sales agents to identify and maintain customers.
MARKETING. In its existing markets, US LEC seeks to position itself as a
high quality alternative to ILECs for local telecommunication services by
offering network reliability and superior customer support at competitive
prices. The Company is building its reputation and brand identity by working
closely with its customers to develop services tailored to their particular
needs and by implementing targeted product offerings, advertising and
promotional efforts.
The Company primarily uses three service marks: US LEC, a logo that
includes US LEC, and THE COMPETITIVE TELEPHONE COMPANY. These service marks have
been registered either on the principal or the supplemental register of the U.S.
Patent and Trademark Office for uses related to telecommunications services. The
Company also has pending trademark applications for these marks.
CUSTOMER SERVICE. Management believes that the Company's ability to
provide superior customer service is a key factor in acquiring new customers and
reducing churn of existing customers. The Company has developed a customer
service strategy that is designed to effectively meet the service requirements
of its target customers. The principal salesperson for each customer provides
the first line of customer service by identifying and resolving any customer
needs. An account development representative is assigned to each customer to
supervise all aspects of customer relations, including account collections and
complaint resolution, and to provide a single point of contact for all customer
service issues. To support this locally-based team, the Company also has a
centrally based customer service and NOC team.
BILLING. US LEC outsources the preparation of customer bills, which are
available in a variety of formats that can be tailored to a customer's specific
needs. US LEC offers customers simplicity and convenience by sending one bill
for all services, and the bill is sent out within a few days after the billing
cycle.
SIGNIFICANT CUSTOMER
In fiscal 1997 and 1998, BellSouth, the predominant ILEC operating in
the Company's existing markets, accounted for 65% and 80%, respectively, of the
Company's net revenue (before reduction for the $12 million allowance described
in Note 6 to Company's consolidated financial statements). The majority of this
revenue for 1998 was generated from reciprocal compensation. Although reciprocal
compensation owed to the Company by BellSouth is not a customer relationship in
the traditional sense, BellSouth is shown here due to the significant
contribution to revenue. At December 31, 1997 and 1998, BellSouth accounted for
67% and 94% of the Company's total accounts receivables before allowance,
respectively. The majority of such receivables and revenues have resulted from
traffic associated with Metacomm, LLC ("Metacomm"), a customer of the Company
and BellSouth, and which became a related party to the Company during 1998 (see
Notes 6 and 8 to Company's consolidated financial statements).
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EMPLOYEES
As of December 31, 1998, the Company employed 253 people. The Company
expects to employ over 400 people by the end of 1999. The Company considers its
employee relations to be very good.
EXECUTIVE OFFICERS OF THE REGISTRANT
The following table sets forth certain information regarding the
executive officers of US LEC Corp:
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Name Age Position*
Richard T. Aab 49 Chairman of the Board, Chief Executive Officer
and Director
Tansukh V. Ganatra 55 President, Chief Operating Officer and Director
Aaron D. Cowell, Jr. 36 Executive Vice President, General Counsel and
Secretary (since June 1998)
Michael K. Robinson 42 Executive Vice President and Chief Financial
Officer (since July 1998)
David C. Conner 41 Executive Vice President -- Engineering
and Operations and Chief Technology Officer
Gary D. Grefrath 57 Executive Vice President -- Administration
Michael K. Simmons 40 Executive Vice President -- Corporate Development
Craig K. Simpson 36 Executive Vice President -- Sales
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* Except as otherwise indicated, all offices were assumed on January 1,
1998.
REGULATION
The following summary of regulatory developments and legislation does
not purport to describe all present and proposed federal, state and local
regulations and legislation affecting the telecommunications industry. Other
existing federal and state legislation and regulations are currently the subject
of judicial proceedings, legislative hearings and administrative proposals which
could change, in varying degrees, the manner in which this industry operates.
Neither the outcome of these proceedings, nor their impact upon the
telecommunications industry or the Company, can be predicted at this time. This
section also includes a brief description of regulatory and tariff issues
pertaining to the operation of the Company.
OVERVIEW. The Company's services are subject to varying degrees of
federal, state and local regulation. The Federal Communications Commission (the
"FCC") generally exercises jurisdiction over the facilities of, and services
offered by, telecommunications common carriers that provide interstate or
international communications. The state regulatory commissions (herein "PUC's)
retain jurisdiction over the same facilities and services to the extent they are
used to provide intrastate communications.
FEDERAL LEGISLATION. The Company must comply with the requirements of
common carriage under the Communications Act of 1934, as amended (the
"Communications Act"). The Telecom Act, enacted on February 8, 1996,
substantially revised the Communications Act. The Telecom Act establishes a
regulatory framework for the introduction of local competition throughout the
United States and is intended to reduce unnecessary regulation to the greatest
extent possible. Among other things, the Telecom Act preempts, after notice and
an opportunity for comment, any state or local government from prohibiting any
entity from providing telecommunications service.
The Telecom Act also establishes a dual federal-state regulatory scheme
for eliminating other barriers to competition faced by competitors to the ILECs
and other new entrants into the local telephone market. Specifically, the
Telecom Act imposes on ILECs certain interconnection obligations, some of which
are to be implemented by FCC regulations. The Telecom Act contemplates that
states will apply the federal regulations and oversee the
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implementation of all aspects of interconnection not subject to FCC jurisdiction
as they oversee interconnection negotiations between ILECs and their new
competitors.
The FCC has significant responsibility in the manner in which the
Telecom Act will be implemented especially in the areas of pricing universal
service, access charges and price caps. The details of the rules adopted by the
FCC will have a significant effect in determining the extent to which barriers
to competition in local services are removed, as well as the time frame within
which such barriers are eliminated.
The PUCs also have significant responsibility in implementing the
Telecom Act. Specifically, the states have authority to establish
interconnection pricing, including unbundled loop charges, reciprocal
compensation and wholesale pricing consistent with the FCC regulations. The
states are also charged under the Telecom Act with overseeing the arbitration
process for resolving interconnection negotiation disputes between CLECs and the
ILECs and must approve interconnection agreements. See "Business -- Forward
Looking Statements and Risk Factors -- Uncertainties Related to Reciprocal
Compensation" for a discussion of the actions before the North Carolina PUC
related to its interconnection agreement with BellSouth.
The Telecom Act imposes on ILECs certain interconnection obligations
that, taken together, grant competitive entrants such as the Company what is
commonly referred to as "co-carrier status." It is anticipated that co-carrier
status and the preemption of state and local prohibitions on entry could permit
the Company to become a full service provider of switched telecommunications
services anywhere in the United States.
The Company has historically received a significant portion of its
initial revenue in a given market from the ILEC in the form of reciprocal
compensation payments due to the Company. Several ILECs have challenged the
applicability of the reciprocal compensation related to enhanced service
providers ("ESP") and ISP customers receiving more calls than they make. See
"Business -- Forward Looking Statements and Risk Factors -- Uncertainties
Related to Reciprocal Compensation".
The obligations imposed on ILECs by the Telecom Act to promote
competition, such as local number portability, dialing parity, reciprocal
compensation arrangements and non-discriminatory access to telephone poles,
ducts, conduits and rights-of-way also apply to CLECs, including the Company. As
a result of the Telecom Act's applicability to other telecommunications
carriers, it may provide the Company with the ability to reduce its own
interconnection costs by interconnecting directly with non-ILECs, but may also
cause the Company to incur additional administrative and regulatory expenses in
responding to interconnection requests. At the same time, the Telecom Act also
makes competitive entry into other service or geographic markets more attractive
to Regional Bell Operating Companies ("RBOCs"), other ILECs, long distance
carriers and other companies and likely will increase the level of competition
the Company faces. See "Business - Competition".
In addition, the Telecom Act, as passed, provided that ILECs that are
subsidiaries of RBOCs could not offer in-region, long distance services across
LATAs until they had demonstrated that (i) they have entered into an approved
interconnection agreement with a facilities-based CLEC or that no such CLEC has
requested interconnection as of a statutorily determined deadline, (ii) they
have satisfied a 14-element checklist designed to ensure that the ILEC is
offering access and interconnection to all local exchange carriers on
competitive terms and (iii) the FCC has determined that in-region, inter-LATA
approval is consistent with the public interest, convenience and necessity.
These limitations have been challenged by the RBOC's. See "Business -- Forward
Looking Statements and Risk Factors--Regulation".
FEDERAL REGULATION AND RELATED PROCEEDINGS. The Telecom Act and the
FCC's efforts to initiate reform have resulted in numerous legal challenges. As
a result, the regulatory framework in which the Company operates is subject to a
great deal of uncertainty. Any changes that result from this uncertainty could
have a material adverse effect on the Company. The FCC has adopted orders
eliminating tariff filing requirements for non-dominant carriers providing
interstate access and domestic interstate long distance services. However, on
February 13, 1997, the United States Court of Appeals for the District of
Columbia granted motions for stay of the FCC order detariffing domestic
interstate long distance service pending judicial review of that order. The
result of this stay is that carriers
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must continue to file tariffs for interstate long distance services. Tariff
filing requirements remain in place for international traffic. US LEC has filed
federal interstate long distance, interstate access and international tariffs.
The FCC also has proposed reducing the level of regulation that applies
to the ILECs, and increasing their ability to respond quickly to competition
from the Company and others. For example, in accordance with the Telecom Act,
the FCC has applied "streamlined" tariff regulation to the ILECs, which greatly
accelerates the time prior to which changes to tariffed service rates may take
effect, and has eliminated the requirement that ILECs obtain FCC authorization
before constructing new domestic facilities. These actions will allow ILECs to
change service rates more quickly in response to competition. Similarly, the FCC
has proposed affording significant new pricing flexibility to ILECs subject to
price cap regulation. To the extent such increased pricing flexibility is
provided, the Company's ability to compete with ILECs for certain service may be
adversely affected.
The FCC has taken several actions related to the assignment of telephone
numbers, first in July 1995 mandating the responsibility for administering and
assigning local telephone numbers be transferred from the RBOCs and a few other
ILECs to a neutral entity, and second in July 1996 adopting a regulatory
structure under which a wide range of number portability issues would be
resolved. In March 1997, the FCC affirmed its number portability rules, but it
extended slightly certain deadlines for the implementation of true number
portability. The FCC has established cost recovery rules for long-term number
portability.
On August 8, 1996, the FCC issued an order containing rules providing
guidance to the ILECs, CLECs, long distance companies and state PUCs regarding
several provisions of the Telecom Act. The rules include, among other things,
FCC guidance on: (i) discounts for end-to-end resale of ILEC retail local
exchange services (which the FCC has suggested should be in the range of
17%-25%); (ii) availability of unbundled local loops and other unbundled ILEC
network elements; (iii) the use of Total Element Long Run Incremental Costs in
the pricing of these unbundled network elements; (iv) average default proxy
prices for unbundled local loops in each state; (v) mutual compensation proxy
rates for termination of ILEC/CLEC local calls; and (vi) the ability of CLECs
and other service providers to opt into portions of previously-approved
interconnection agreements negotiated by the ILECs with other parties on a most
favored nation (or a "pick and choose") basis. See " Regulation -- Eighth
Circuit Court of Appeals Decision and Supreme Court Reversal" for a discussion
of the Eighth Circuit Court of Appeals decision related to this order.
On May 8, 1997, the FCC released an order establishing a significantly
expanded federal universal service program which subsidized certain eligible
services. For example, the FCC established new subsidies for services provided
to qualifying schools and libraries with an annual cap of $2.25 billion and for
services provided to rural health care providers with an annual cap of $400
million. The FCC also expanded the federal subsidies to low-income consumers and
consumers in high-cost areas. Providers of interstate telecommunications
service, such as the Company, as well as certain other entities, must pay for
these programs. The Company's share of the schools, libraries and rural health
care funds will be based on its share of the total industry telecommunications
service and certain defined telecommunications end user revenues. The Company's
share of all other federal subsidy funds will be based on its share of the total
interstate telecommunications service and certain defined telecommunications end
user revenues. Although the Company has already begun contributing to the fund,
the amount of the Company's required contribution changes each quarter. As a
result, the Company cannot predict the revenue effect these regulations will
have on the Company in the future. In the May 8 order, the FCC also announced
that it will revise its rules for subsidizing service provided to consumers in
high cost areas. Several parties have appealed the May 8 order. Such appeals
have been consolidated and transferred to the United States Court of Appeals for
the Fifth Circuit where they are currently pending. In addition, on July 3,
1997, several ILECs filed a petition for stay of the May 8 order with the FCC.
That petition is also pending.
In a combined Report and Order and Notice of Proposed Rulemaking
released on December 24, 1996, the FCC made changes and proposed further changes
in the interstate access charge structure. In the Report and Order, the FCC
removed restrictions on an ILEC's ability to lower access prices and relaxed the
regulation of new switched access services in those markets where there are
other providers of access services. If this increased pricing flexibility is not
effectively monitored by federal regulators, it could have a material adverse
effect on the Company's ability to compete in providing interstate access
services. On May 16, 1997, the FCC released an order revising its access charge
rate structure. The new rules substantially increase the costs that ILECs
subject to the FCC's price cap
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rules ("price cap LECs") recover through monthly, non-traffic sensitive access
charges and substantially decrease the costs that price cap LECs recover through
traffic sensitive access charges. In the May 16 order, the FCC also announced
its plan to bring interstate access rate levels more in line with cost. The plan
will include rules to be established that grant price cap LECs increased pricing
flexibility upon demonstrations of increased competition (or potential
competition) in relevant markets. The manner in which the FCC implements this
approach to lowering access charge levels will have a material effect on the
Company's ability to compete in providing interstate access services. Several
parties have appealed the May 16 order. Those appeals were consolidated and
transferred to the United States Court of Appeals for the Eighth Circuit which
upheld the Commission's rules.
As part of its overall plan to lower interstate access rates, the FCC
also released an order on May 21, 1997, in which the FCC revised its price cap
rules. In the May 21 order, the FCC increased the so-called X-Factor (the
percentage by which price cap LECs must lower their interstate access charges
every year, net of inflation and exogenous cost increases) and made it uniform
for all price cap LECs. The results of these rule changes will be both a
one-time overall reduction in price cap LEC interstate access charges and an
increase in the rate at which those charges will be reduced in the future.
Several parties have appealed the May 21 order. Those appeals were consolidated
and transferred to the United States Court of Appeals for the Tenth Circuit.
They have been subsequently transferred to the United States Court of Appeals
for the District of Columbia where they are currently pending.
On February 26, 1999, the FCC issued a declaratory ruling and notice of
proposed rulemaking concerning ISP traffic. The FCC concluded in its ruling that
ISP traffic is jurisdictionally interstate in nature. The FCC has requested
comment as to what reciprocal compensation rules should govern this traffic upon
expiration of existing interconnection agreements. The FCC also determined that
no federal rule existed that governed reciprocal compensation for ISP traffic at
the time existing interconnection agreements were negotiated and concluded that
it should permit states to determine whether reciprocal compensation should be
paid for calls to ISPs under existing interconnection agreements. In light of
the FCC order, state commissions which previously addressed this issue and
required reciprocal compensation to be paid for ISP traffic may reconsider and
may modify their prior rulings. The FCC order has been appealed by several
parties. No procedural calendar has been established yet. To date, no PUC in any
state where the Company has earned reciprocal compensation has either affirmed
or altered its prior position on this issue.
The Company anticipates that the FCC will initiate a number of
additional proceedings, of its own volition and as a result of requests from
CLECs and others, as a result of the Telecom Act.
The FCC also requires carriers to file periodic reports concerning
carriers interstate circuits and deployment of network facilities. The FCC
generally does not exercise direct oversight over cost justification and the
level of charges for services of non-dominant carriers, although it has the
power to do so. The FCC also imposes prior approval requirements on transfers of
control and assignments of operating authorizations. The FCC has the authority
to generally condition, modify, cancel, terminate, or revoke operating authority
for failure to comply with federal laws or rules, regulations and policies of
the FCC. Fines or other penalties also may be imposed for such violations. There
can be no assurance that the FCC or third parties will not raise issues with
regard to the Company's compliance with applicable laws and regulations.
EIGHTH CIRCUIT COURT OF APPEALS DECISIONS AND THE SUPREME COURT
REVERSAL. Various parties, including ILECs and state PUCs, requested that the
FCC reconsider its own rules and/or filed appeals of the FCC's August 8, 1996
order.
The U.S Court of Appeals for the Eighth Circuit ("8th Circuit") held
that, in general, the FCC does not have jurisdiction over prices for
interconnection, resale, leased unbundled network elements and traffic
termination. The 8th Circuit also overturned the FCC's "pick and choose" rules
as well as certain other FCC rules implementing the Telecom Act's local
competition provisions. In addition, the 8th Circuit decisions substantially
limited the FCC's authority to enforce the local competition provisions of the
Telecom Act. On January 25, 1999, U.S. Supreme Court reversed the 8th Circuit
and upheld the FCC's authority to issue regulations governing pricing of
unbundled network elements provided by the ILECs in interconnection agreements
(including regulations governing reciprocal compensation, which is discussed in
more detail below). In addition, the Supreme Court affirmed the "pick and
choose" rules which allows carriers to choose individual portions of existing
interconnection agreements with other
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carriers and to opt-in only to those portions of the interconnection agreement
that they find most attractive. The Supreme Court did not, however, address
other challenges raised about the FCC's rules at the 8th Circuit because the 8th
Circuit did not decide those challenges. These challenges will now have to be
addressed by the 8th Circuit in light of the Supreme Court's decision. In
addition, the Supreme Court disagreed with the standard applied by the FCC for
determining whether an ILEC should be required to provide a competitor with
particular unbundled network elements. This issue will have to be addressed by
the FCC in a new rule-making proceeding that the FCC intends to initiate in the
spring of 1999.
The 8th Circuit decisions and the reversal by the Supreme Court continue
to create uncertainty about the rules governing pricing terms and conditions of
interconnection agreements. This uncertainty makes it difficult to predict
whether the Company will be able to rely on existing interconnection agreements
or have the ability to negotiate acceptable interconnection agreements in the
future.
STATE REGULATION. The Company is certified by the appropriate state PUCs
as follows:
<TABLE>
<CAPTION>
STATE TELECOMMUNICATION SERVICES
<S> <C>
North Carolina local exchange, exchange access, and intrastate
interexchange long distance
Georgia local exchange, long distance and intrastate interexchange
alternate operator services
Virginia intrastate local exchange and exchange access, not
required for long distance
Tennessee local exchange, exchange access and interexchange
South Carolina resale and facilities-based local exchange, exchange access and
intrastate interexchange
Florida local exchange, long distance
Alabama facilities-based and resold local exchange, exchange access and
interexchange
The Company has applications pending with the following PUC's:
Washington D.C. resale and facilities-based local exchange
Pennsylvania resale and facilities-based local exchange, exchange access and
interexchange (provisional certification granted)
Maryland resale and facilities-based local exchange and interexchange
Delaware resale and facilities-based local exchange and interexchange
New Jersey resale and facilities-based local exchange and interexchange
</TABLE>
To the extent that an area within a state in which the Company operates
is served by a small (in line counts) or rural ILEC not currently subject to
competition, the Company generally does not have authority to service those
areas at this time. Most states regulate entry into local exchange and other
intrastate service markets, and states' regulation of CLECs vary in their
regulatory intensity. The majority of states mandate that companies seeking to
provide local exchange and other intrastate services apply for and obtain the
requisite authorization from the PUC. This authorization process generally
requires the carrier to demonstrate that it has sufficient financial, technical,
and managerial capabilities and that granting the authorization will serve the
public interest.
As a CLEC, the Company is subject to the regulatory directives of each
state in which the Company is certified. In addition to tariff filing
requirements, most states require that CLECs charge just and reasonable rates
and not discriminate among similarly situated customers. Some states also
require the filing of periodic reports, the payment of various regulatory fees
and surcharges, and compliance with service standards and consumer protection
rules. States also often require prior approvals or notifications for certain
transfers of assets, customers or ownership of a CLEC. States generally retain
the right to sanction a carrier or to revoke certifications if a carrier
violates relevant laws and/or regulations.
In all of the states where US LEC is certified, the Company is required
to file tariffs or price lists setting forth the terms, conditions and/or prices
for services which are classified as intrastate. In some states, the Company's
tariff may list a range of prices or a ceiling price for particular services,
and in others, such prices can be set on an individual customer basis, although
the Company may be required to file tariff addenda of the contract terms. The
Company is not subject to price cap or to rate of return regulation in any state
in which it currently provides services.
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<PAGE>
As noted above, the states have the primary regulatory role over
intrastate services under the Telecom Act. The Telecom Act allows state
regulatory authorities to continue to impose competitively neutral and
nondiscriminatory requirements designed to promote universal service, protect
the public safety and welfare, maintain the quality of service and safeguard the
rights of consumers. State PUCs will implement and enforce most of the Telecom
Act's local competition provisions, including those governing the specific
charges for local network interconnection. In some states, those charges are
being determined by generic cost proceedings and in other states they are being
established through arbitration proceedings. Depending on how such charges are
ultimately determined, such charges could become a material expense to the
Company.
COMPETITION
As noted above, the regulatory environment in which the Company operates
is changing rapidly. The passage of the Telecom Act combined with other actions
by the FCC and state regulatory authorities continues to promote competition in
the provision of telecommunications services.
ILECS. In each market served by its networks, the Company faces, and
expects to continue to face, significant competition from the ILECs, which
currently dominate their local telecommunications markets as a result of their
historic monopoly position.
The Company competes with the ILECs in its markets for local exchange
services on the basis of product offerings, reliability, state-of-the-art
technology, price, route diversity, ease of ordering and customer service.
However, the ILECs have long-standing relationships with their customers and
provide those customers with various transmission and switching services, a
number of which the Company does not currently offer. In addition, ILECs enjoy a
competitive advantage due to their vast financial resources. The Company has
sought, and will continue to seek, to achieve parity with the ILECs in order to
become able to provide a full range of local telecommunications services. See
"Business -- Regulation" for additional information concerning the regulatory
environment in which the Company operates. Because US LEC leases fiber optic
transmission capacity to link its customers with its networks, and uses
state-of-the-art technology in its switch platforms, the Company may have cost
and service quality advantages over some currently available ILEC networks.
OTHER COMPETITORS. The Company also faces, and expects to continue to
face, competition from other potential competitors in certain of the markets in
which the Company offers its services. In addition to the ILECs and CAPs,
potential competitors capable of offering switched local and long distance
services include long distance carriers, cable television companies, electric
utilities, microwave carriers, wireless telephone system operators and private
networks built by large end-users. Many of these potential competitors enjoy
competitive advantages based upon existing relationships with subscribers, brand
name recognition and vast financial resources. A continuing trend toward
business combinations and alliances in the telecommunications industry may
create significant new competitors to the Company.
The Company believes that the Telecom Act, as well as a recent series of
completed and proposed transactions between ILECs and long distance companies
and cable companies, increase the likelihood that barriers to local exchange
competition will be removed. The Telecom Act, as passed, conditioned the
provision of in-region interLATA services by RBOCs upon a demonstration that the
market in which an RBOC seeks to provide such services has been opened to
competition. When ILECs that are RBOC subsidiaries are permitted to provide such
services they will be in a position to offer single source service. ILECs that
are not RBOC subsidiaries may offer single source service presently. The Telecom
Act's limitations on provision of in-region interLATA services have been
challenged by the RBOCs. See "Business - Regulation".
The Company also competes with long distance carriers in the provision
of long distance services. Although the long distance market is dominated by a
few major competitors, hundreds of other companies also compete in the long
distance marketplace.
12
<PAGE>
FORWARD LOOKING STATEMENTS AND RISK FACTORS
Except for historical statements and discussions, statements contained
in this report constitute "forward looking statements" within the meaning of
Section 27A of the Securities Act of 1933, as amended, and Section 21E of the
Securities Exchange Act of 1934, as amended. In addition, the Company's Annual
Report to Stockholders for the year ended December 31, 1998, Quarterly Reports
on Form 10-Q, Current Reports on Form 8-K and subsequently filed Annual Reports
on Form 10-K may include forward looking statements. Other written or oral
statements which constitute forward looking statements have been made and may in
the future be made by or on behalf of US LEC, including statements regarding
future operating performance, share of new and existing markets, short-term and
long-term revenue, earnings and cash flow amounts, judicial, statutory and
regulatory developments and general industry growth rates and US LEC's
performance in relation thereto. These statements are identified by the use of
forward-looking terminology such as "believes," "expects," "may," "will,"
"should," "estimates" or "anticipates" or the negative thereof or other
variations thereon or comparable terminology, or by discussions of strategy that
involve risks and uncertainties. These forward looking statements are based on a
number of assumptions concerning future events, including the outcome of
judicial and regulatory proceedings, the adoption of balanced and effective
rules and regulations by the FCC and PUCs, and US LEC's ability to successfully
execute its strategy. These forward looking statements are also subject to a
number of uncertainties and risks, many of which are outside of US LEC's
control, that could cause actual results to differ materially from such
statements. These risks include, but are not limited to, the following:
UNCERTAINTIES RELATED TO RECIPROCAL COMPENSATION The Telecom Act
requires ILECs to provide reciprocal compensation to a CLEC for local traffic
terminated on such CLEC's network. Notwithstanding this requirement, a number of
ILECs have taken the position that traffic terminated to ESPs, including
information service providers such as ISPs, is not local traffic. A majority of
the Company's revenue is derived from reciprocal compensation amounts due from
ILECs, principally BellSouth, a majority of which relates to ISP revenue
(approximately $54 million in 1998 before an allowance of $12 million) that is
being disputed. Management believes that such revenue has been earned by the
Company and payments are due from BellSouth pursuant to the interconnection
agreements that BellSouth has with the Company. However, in August 1997,
BellSouth notified the Company and other CLECs that it considered ISP traffic
interstate (and therefore not subject to reciprocal compensation) and that
BellSouth would not pay (or bill) reciprocal compensation under interconnection
agreements for traffic terminated to ESPs, including information service
providers and ISPs. On February 26, 1998, following a petition by the Company,
the NCUC ordered BellSouth to bill and pay for all such traffic. Following
motions filed by BellSouth, the NCUC stayed enforcement of its order until June
1, 1998. On April 27, 1998, BellSouth filed a petition for judicial review of
the NCUC's order and an action for declaratory judgment and other relief
(including a request for an additional stay) with the United States District
Court for the Western District of North Carolina (U.S. District Court). This
matter was filed against the Company and the NCUC and is currently pending
before the U.S. District Court.
On February 26, 1999, the FCC issued a declaratory ruling and notice of
proposed rulemaking concerning ISP traffic. The FCC concluded in its ruling that
ISP traffic is jurisdictionally interstate in nature. The FCC has requested
comment as to what reciprocal compensation rules should govern this traffic upon
expiration of existing interconnection agreements. The FCC also determined that
no federal rule existed that governed reciprocal compensation for ISP traffic at
the time existing interconnection agreements were negotiated and concluded that
it should permit states to determine whether reciprocal compensation should be
paid for calls to ISPs under existing interconnection agreements. In light of
the FCC order, state commissions which previously addressed this issue and
required reciprocal compensation to be paid for ISP traffic may reconsider and
may modify their prior rulings. The FCC order has been appealed by several
parties. No procedural calendar has been established yet. To date, no PUC in any
state where the Company has earned reciprocal compensation has either affirmed
or altered its prior position on this issue.
On September 14, 1998, BellSouth filed a complaint with the NCUC
seeking to be relieved from an unspecified portion of obligations under its
interconnection agreement with the Company to pay reciprocal compensation for
traffic related to Metacomm, a customer of BellSouth and the Company, and
currently a related party of the Company (see Note 8 to Company's consolidated
financial statements). In addition to disputing the traffic due to its ISP
nature, BellSouth has also alleged that the traffic related to Metacomm would
not qualify for reciprocal compensation, alleging that such traffic does not
constitute "telecommunications" subject to reciprocal compensation under the
Telecom Act and the existing interconnection agreement. Also, on September 14,
1998, the Company filed a complaint with the NCUC seeking payment of facilities
charges, non-ISP based reciprocal compensation and intraLATA toll termination
charges. These matters are currently pending before the NCUC.
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<PAGE>
Management believes that the Company will ultimately obtain favorable
results in these proceedings; however, BellSouth may elect to initiate
additional proceedings (by way of appeal or otherwise) challenging amounts owed
to the Company. If a decision adverse to the Company is issued in any of these
proceedings by the U.S. District Court, the NCUC or the FCC, or in any appeal
or review of a favorable decision by the U.S. District Court, the NCUC, or the
FCC, or in any other proceeding affecting these issues in another forum, or if
the FCC were to alter its position regarding reciprocal compensation
obligations under existing interconnection agreements or if the NCUC were to
alter its position on this issue, such an event could have a material adverse
effect on the Company's operating results and financial condition. The
Company's revenues for the year ended December 31, 1998 and trade accounts
receivable as of December 31, 1998 included approximately $54 million (before
the $12 million allowance) of earned but unpaid ISP reciprocal compensation,
the majority of which was related to Metacomm.
The Company's interconnection agreements with BellSouth are
scheduled to expire in June 1999 and the Company does not anticipate that
BellSouth will willingly agree to renew the agreements in a manner consistent
with the Company's existing agreements as they relate to reciprocal
compensation. However, the Company intends to pursue consistent agreements
vigorously and does not anticipate any interruption in interconnection service.
The Company's ultimate ability to obtain such terms will depend on a number of
factors, including decisions of the FCC and the PUCs.
LIMITED OPERATING HISTORY. US LEC was formed in June 1996 and
began generating revenue in March 1997. Accordingly, investors have limited
historical operating and financial information upon which to base an evaluation
of the Company's performance. Given the Company's limited operating history,
there can be no assurance that it will continue to compete successfully in the
telecommunications business, sustain profitability or generate sufficient
positive cash flow in the future to meet debt service, working capital or other
cash requirements. See "Item 7: Management's Discussion and Analysis of
Financial Condition and Results of Operations - Liquidity and Capital
Resources".
RISKS ASSOCIATED WITH IMPLEMENTATION OF GROWTH STRATEGY. The expansion
and development of US LEC's operations depend on, among other things, the
Company's ability to continue to (i) accurately assess potential new markets,
(ii) identify, hire and retain qualified personnel, (iii) lease access to
suitable fiber optic transmission facilities, (iv) purchase, install and operate
switches and related equipment and (v) obtain any required government
authorizations, all in a timely manner, at reasonable costs and on satisfactory
terms and conditions. In addition, US LEC has experienced rapid growth since its
inception, and management believes that sustained growth will place a strain on
operational, human and financial resources. The Company's ability to manage its
expansion effectively depends on the continued development of plans, systems and
controls for its operational, financial and management needs. Given the
Company's limited operating history, there can be no assurance that the Company
will be able to satisfy these requirements or otherwise manage its growth
effectively. The failure of US LEC to satisfy these requirements could have a
material adverse effect on the Company's financial condition and its ability to
fully implement its expansion plans.
The Company's growth strategy also involves the following risks:
QUALIFIED PERSONNEL. A critical component for US LEC's success is hiring
and retaining additional qualified managerial, sales and technical personnel.
Since its inception, the Company has experienced significant competition in
hiring and retaining personnel possessing necessary skills and
telecommunications experience. Although management believes the Company has been
successful in hiring and retaining qualified personnel, there can be no
assurance that US LEC will be able to do so in the future.
SWITCHES AND RELATED EQUIPMENT. An essential element of the Company's
current strategy is the provision of switched local service. There can be no
assurance that installation of the switches and associated equipment necessary
to implement the Company's business plan will be completed on a timely basis or
that the Company will not experience technological problems that cannot be
resolved in a satisfactory or timely matter. The failure of the Company to
install and operate successfully switches and other network equipment could have
a material adverse effect on the Company's financial condition and its ability
to enter additional markets.
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<PAGE>
INTERCONNECTION AGREEMENTS. The Company has agreements for the
interconnection of its networks with the networks of the ILECs covering each
market in which US LEC either has or is currently installing a switching
platform. US LEC may be required to negotiate new interconnection agreements as
it enters new markets in the future. In addition, as its existing
interconnection agreements expire, it will be required to negotiate extension or
replacement agreements. There can be no assurance that the Company will
successfully negotiate such additional agreements for interconnection with the
ILECs or renewals of existing interconnection agreements on terms and conditions
acceptable to the Company. The Company's interconnection agreement with
BellSouth is scheduled to expire in June 1999 but management does not anticipate
any interruption of interconnect services. The regulatory environment related to
interconnection agreements is not static, and recent decisions may change the
rules related to this process. See "Business -- Regulation". The regulatory
uncertainty makes negotiating and enforcing such agreements more difficult and
possibly more protracted, and could result in the need to renegotiate existing
agreements. The failure to negotiate and obtain required interconnection
agreements on terms and conditions acceptable to the Company could have a
material adverse effect on the Company's ability to rapidly enter a particular
market and on its operations in its existing markets.
ORDERING, PROVISIONING AND BILLING. The Company has developed processes
and procedures and is working with external vendors, including the ILECs, in the
implementation of customer orders for services, the provisioning, installation
and delivery of such services and monthly billing for those services. The
failure to manage effectively processes and systems for these service elements
or the failure of the Company's current vendors or the ILECs to deliver
ordering, provisioning and billing services on a timely and accurate basis could
have a material adverse effect upon the Company's ability to fully execute its
strategy.
PRODUCTS AND SERVICES. The Company currently focuses its efforts on
providing local and long distance telecommunications services. In order to
address the needs of its target customers, the Company will be required to
emphasize and develop additional products and services. No assurance can be
given that the Company will be able to provide the range of telecommunication
services that its target customers need or desire.
ACQUISITIONS. US LEC may acquire other businesses as a means of
expanding into new markets or developing new services. The Company is unable to
predict whether or when any prospective acquisitions will occur or the
likelihood of a material transaction being completed on favorable terms and
conditions. Such transactions would involve certain risks including, but not
limited to, (i) difficulties assimilating acquired operations and personnel;
(ii) potential disruptions of the Company's ongoing business; (iii) the
diversion of resources and management time; (iv) the possibility that uniform
standards, controls, procedures and policies may not be maintained; (v) risks
associated with entering new markets in which the Company has little or no
experience; and (vi) the potential impairment of relationships with employees or
customers as a result of changes in management. If an acquisition were to be
made, there can be no assurance that the Company would be able to obtain the
financing to consummate any such acquisition on terms satisfactory to it or that
the acquired business would perform as expected.
DEPENDENCE ON KEY PERSONNEL. The Company's business is managed by a
small number of key executive officers, most notably Richard T. Aab, Chairman
and Chief Executive Officer, and Tansukh V. Ganatra, President and Chief
Operating Officer. The loss of the services of one or more of these key people,
particularly Mr. Aab or Mr. Ganatra, could materially and adversely affect US
LEC's business and its prospects. None of the Company's executive officers have
employment agreements and the Company does not maintain key man life insurance
on any of its officers. The competition for qualified managers in the
telecommunications industry is intense. Accordingly, there can be no assurance
that US LEC will be able to hire and retain necessary personnel in the future to
replace any of its key executive officers, if any of them were to leave US LEC
or be otherwise unable to provide services to US LEC.
RELIANCE ON LEASED CAPACITY. A key element of US LEC's business and
growth strategy is leasing fiber optic transmission capacity instead of
constructing its own transport facilities. In implementing this strategy, the
Company relies upon its ability to lease capacity from CAPs, other CLECs and
ILECs operating in its markets. In order for this strategy to be successful, the
Company must be able to negotiate and renew satisfactory agreements with its
fiber optic network providers, and the providers must process provisioning
requests on a timely basis, maintain their networks in good working order and
provide adequate capacity. Although US LEC enters into agreements with its
network providers that are intended to ensure access to adequate capacity and
timely processing
15
<PAGE>
of provisioning requests and although US LEC's interconnection agreements with
ILECs generally provide that the Company's connection and maintenance orders
will receive attention at parity with the ILECs and other CLECs and that
adequate capacity will be provided, there can be no assurance that the ILECs and
other network providers will comply with their contractual (and, in the case of
the ILECs, legally required) network provisioning obligations, or that the
provisioning process will be completed for the Company's customers on a timely
and otherwise satisfactory basis. Furthermore, there can be no assurance that
the rates to be charged to US LEC under future interconnection agreements or
lease agreements with other providers will allow the Company to offer usage
rates low enough to attract a sufficient number of customers and operate its
networks at satisfactory margins.
COMPETITION. The telecommunications industry is highly competitive. In
each of the Company's existing and target markets, the Company competes and will
continue to compete principally with the ILECs serving that area. ILECs are
established providers of local telephone and exchange access services to all or
virtually all telephone subscribers within their respective service areas. ILECs
also have greater financial and personnel resources, brand name recognition and
long-standing relationships with customers and with regulatory authorities at
the federal and state levels and with most long distance carriers.
The Company also faces, and expects to continue to face, competition
from other current and potential market entrants, including long distance
carriers seeking to enter, reenter or expand entry into the local exchange
marketplace, and from other CLECs, CAPs, cable television companies, electric
utilities, microwave carriers, wireless telephone system operators and private
networks built by large end-users. In addition, a continuing trend toward
combinations and strategic alliances in the telecommunications industry could
give rise to significant new competitors. Many of these current and potential
competitors have financial, personnel and other resources, including brand name
recognition, substantially greater than those of the Company, as well as other
competitive advantages over the Company.
The Company also competes with long distance carriers in the
provisioning of long distance services. Although the long distance market is
dominated by few major competitors, hundreds of other companies also compete in
the long distance marketplace.
In addition, the regulatory environment in which the Company operates is
undergoing significant change. As this regulatory environment evolves, changes
may occur which could create greater or unique competitive advantages for all or
some of the Company's current or potential competitors, or could make it easier
for additional parties to provide services.
See "Business -- Competition".
REGULATION. Although passage of the Telecom Act has resulted in
increased opportunities for companies that are competing with the ILECs, no
assurance can be given that changes in current or future regulations adopted by
the FCC or state regulators or other legislative or judicial initiatives
relating to the telecommunications industry would not have a material adverse
effect on the Company. In addition, although the Telecom Act, as passed,
conditions RBOCs' provisioning of in-region long distance service on a showing
that the local market has been opened to competition, in the event a RBOC has
satisfied these conditions, it could (i) remove the incentive RBOCs presently
have to cooperate with companies like US LEC to foster competition within their
service areas so that they can qualify to offer in-region long distance by
allowing RBOCs to offer such services immediately and (ii) give the RBOCs the
ability to offer "one-stop shopping" for both long distance and local service.
In addition to the specific concern regarding the RBOC's ability to
provide in-region long distance, the regulatory environment facing the Company
is subject to numerous uncertainties. The FCC and PUC orders that were designed
to implement the Telecom Act have been challenged in numerous proceedings. As a
result, the Company must attempt to execute its business strategy without
knowing the rules that will govern its operations and its dealings with other
telecommunications companies. As the regulatory environment changes, it is
possible that
16
<PAGE>
the Company's strategy and its execution of the strategy may not be the optimal
choice. Any such changes could also result in additional, unanticipated
expenses. There can be no assurances that regulatory change will not have a
material and adverse effect on the Company. See "Business - Regulation".
FUTURE CAPITAL AND OPERATING REQUIREMENTS. Implementation of the
Company's business strategy will require significant capital and operating
expenditures during 1999 and future years. In December 1998, the Company entered
into a $50 million loan agreement with two lenders (the "Credit Facility"). See
"Item 7: Management's Discussion and Analysis of Financial Condition and Results
of Operations - Liquidity and Capital Resources". The Company's principal
capital expenditures relate to the purchase and installation of its switching
platform, related infrastructure and facilities. Management expects to satisfy
its capital and operating requirements primarily with current cash balances,
borrowings under the Credit Facility and cash flow from operations, although
there can be no assurance that the actual expenditures required to implement the
Company's business strategy will not exceed amounts available from these
sources. In addition, the actual amount and timing of the Company's future
expenditures may differ materially from the Company's estimates as a result of,
among other things, the ability of the Company to meet its planned expansion
schedule, the number of its customers and the services for which they subscribe
and regulatory, technological and competitive developments in the Company's
industry. Due to the uncertainty of these factors, actual revenues and costs may
vary from expected amounts, possibly to a material degree, and such variations
are likely to affect the implementation of the Company's business strategy.
The Company also will continue to evaluate revenue opportunities in
planned and other markets as well as potential acquisitions. The Company expects
to obtain the capital required to pursue additional opportunities from the
Credit Facility and other borrowings, the sale of additional equity or debt
securities or cash generated from operations. There can be no assurance,
however, that the Company would be successful in raising sufficient additional
capital on acceptable terms or that the Company's operations would produce
sufficient positive cash flow to pursue such opportunities should they arise.
Failure to raise and generate sufficient funds, or unanticipated increases in
capital requirements may require the Company to delay or curtail its expansion
plans, which could have a material adverse effect on the Company's growth and
its ability to compete in the telecommunications services industry.
VARIABILITY OF QUARTERLY OPERATING RESULTS. As a result of the
significant expenses associated with the Company's expansion into new markets,
the Company's operating results may vary significantly from period to period.
CONTROL BY SINGLE STOCKHOLDER. As of March 23, 1999, Richard T. Aab
beneficially owns or otherwise controlled 100% of the outstanding shares of
Class B Common Stock representing approximately 94% of the Company's total
voting power. In addition, holders of Class B Common Stock are entitled to vote
as a separate class to elect two members of the Board of Directors and to vote
with the holders of Class A Common Stock for the election of other members of
the Board of Directors. As a result, Mr. Aab will be able to control the board
and all stockholder decisions and, in general, to determine (without the consent
of the Company's other stockholders) the outcome of any corporate transaction or
other matter submitted to the stockholders for approval, including mergers,
consolidations and the sale of all or substantially all of the Company's assets.
Mr. Aab also has the power to prevent or cause a change in control of the
Company. See "Item 12: Security Ownership of Certain Beneficial Owners and
Management".
ITEM 2. PROPERTIES
The Company's corporate headquarters are located at its principal office
at 401 North Tryon Street, Suite 1000, Charlotte, North Carolina 28202. The
Company leases all of its administrative and sales offices and its switch sites.
The various leases expire in years ranging from 2000 to 2005. Most of these
leases have renewal options. Additional office space and switch sites will be
leased or otherwise acquired as the Company's operations and networks are
expanded and as new networks are constructed.
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ITEM 3. LEGAL PROCEEDINGS
US LEC is not currently a party to any material legal proceedings, other
than the NCUC and U.S. District Court proceedings related to reciprocal
compensation and other amounts due from BellSouth. See "Business--Regulation"
and "Forward Looking Statements and Risk Factors" above and Note 6 to the
Company's consolidated financial statements for a detailed description of these
proceedings.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS
No matters were submitted to a vote of security holders during the
quarter ending December 31, 1998.
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
The information required to be furnished in response to Item 5 is
incorporated by reference to the inside back cover of the Company's 1998 Annual
Report to Stockholders (the "Annual Report"). This section of the Annual Report
has been included in Exhibit 13 to this report.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The information required to be furnished in response to Item 6 is
incorporated by reference to the section of the Annual Report that appears under
the heading "Selected Financial Data". This section of the Annual Report has
been included in Exhibit 13 to this report.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The information required to be furnished in response to Item 7 is
incorporated by reference to the section of the Annual Report that appears under
the heading "Management's Discussion and Analysis of Financial Condition and
Results of Operations". This section of the Annual Report has been included in
Exhibit 13 to this report.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The information required to be furnished in response to Item 8 is
incorporated by reference to the sections of the Annual Report that appear under
the headings "Consolidated Balance Sheets," "Consolidated Statements of
Operations," "Consolidated Statements of Stockholders' Equity (Deficiency),"
"Consolidated Statements of Cash Flows," "Notes to Consolidated Financial
Statements" and "Independent Auditors' Report." These sections of the Annual
Report have been included in Exhibit 13 to this report.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
18
<PAGE>
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required to be furnished in response to Item 10 with
respect to directors is incorporated by reference from the section of the proxy
statement for the Company's annual meeting of stockholders to be held April 20,
1999 (the "Proxy Statement") that appears under the heading "Election of
Directors". Information relating to the Company's executive officers is
contained in Part I of this report under the heading "Executive Officers of the
Registrant".
ITEM 11. EXECUTIVE COMPENSATION
The information required to be furnished in response to Item 11 is
incorporated by reference from the sections of the Proxy Statement that appear
under the headings "Compensation of Directors" and "Compensation of Executive
Officers".
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required to be furnished in response to Item 12 is
incorporated by reference from the section of the Proxy Statement that appear
under the heading "Security Ownership of Certain Beneficial Owners and
Management".
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required to be furnished in response to Item 13 is
incorporated by reference from the section of the Proxy Statement that appear
under the heading "Certain Relationships and Related Transactions".
19
<PAGE>
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) Financial Statements, Financial Statement Schedules and Exhibits - The
following documents are filed as part of this Form 10-K.
(1) Financial statements:
A. Consolidated Balance Sheets as of December 31, 1997 and 1998
B. Consolidated Statements of Operations for the Period from
June 6, 1996 (Inception) to December 31, 1996 and years ended
December 31, 1997 and 1998
C. Consolidated Statements of Stockholders' Equity (Deficiency)
for the Period from June 6, 1996 (Inception) to December 31,
1996 and years ended December 31, 1997 and 1998
D. Consolidated Statements of Cash Flows for the Period from
June 6, 1996 (Inception) to December 31, 1996 and years
ended December 31, 1997 and 1998
E. Notes to Consolidated Financial Statements for the Period
from June 6, 1996 (Inception) to December 31, 1996 and years
ended December 31, 1997 and 1998
F. Independent Auditors' Report
(2) Financial Statement Schedules:
A. Schedule I - Independent Auditors' Report
B. Schedule II -Valuation and Qualifying Accounts
(3) List of Exhibits:
<TABLE>
<CAPTION>
No. Exhibit
--- -------
<S> <C>
3.1 Form of Restated Certificate of Incorporation of the Company (1)
3.2 Bylaws of the Company (1)
3.3 Amendment No. 1 to Bylaws of the Company (1)
4 Form of Class A Common Stock Certificate (1)
10.1 US LEC Corp. 1998 Omnibus Stock Plan (1) (2)
10.2 Promissory Note, dated January 16, 1998, made by the Company to
Melrich Associates, LP (1)
10.3 Security Agreement dated January 16, 1998, by and between the
Company and Melrich Associates, L.P. (1)
10.4 Promissory Note, dated January 16, 1998, made by the Company to
Tansukh V. Ganatra (1)
10.5 Security Agreement, dated January 16, 1998, by and between the
Company and Tansukh V. Ganatra (1)
10.6 Guaranty and Suretyship Agreement, dated January 16, 1998, by and
among the Company and Richard T. Aab, Melrich Associates, L.P. and
Tansukh V. Ganatra (1)
10.7 Contribution Agreement, dated February 14, 1998, by and between
US LEC Corp. and Richard T. Aab (1)
10.8 Form of Non-transferable Warrant, dated August 4, 1997, issued
Craig K. Simpson (1) (2)
</TABLE>
20
<PAGE>
<TABLE>
<CAPTION>
No. Exhibit
--- -------
<S> <C>
10.9 Amended and Restated Class B Stockholders Agreement, dated as of
January 1, 1998 (1)
10.10 Consulting Agreement, dated December 18, 1997, by and between the
Company and RTA Associates, LLC and related termination letter,
dated January 1, 1998 (1)
10.11 Consulting Agreement, dated December 18, 1997 by and between the
Company and Super STAR Associates Limited Partnership and related
termination letter, dated January 1, 1998 (1) 10.12 Loan and Security
Agreement, dated as of December 30, 1998, among US LEC Corp.,
certain operating subsidiaries of US LEC Corp., General Electric
Capital Corporation and First Union National Bank (3)
13 Specified portions (pages 13 to 36 and inside back cover) of the
Company's Annual Report to Stockholders for the year ended
December 31, 1998
21 Subsidiaries of the Registrant
23 Consent of Deloitte & Touche LLP
27 Financial Data Schedule
- ----------------------------
</TABLE>
(1) Incorporated by reference to Registration Statement from Form S-1
(File No. 333-46341) filed February 13, 1998.
(2) Indicates a management contract or compensatory plan or
arrangement.
(3) Incorporated by reference from the Company's Current Report on
Form 8-K filed on January 7, 1999.
(b) Reports on Form 8-K.
No Current Reports on Form 8-K were filed during the quarter ending
December 31, 1998.
21
<PAGE>
SCHEDULE I
INDEPENDENT AUDITORS' REPORT
Board of Directors US LEC Corp.
Charlotte, North Carolina
We have audited the consolidated financial statements of US LEC Corp.
and subsidiaries as of December 31, 1997 and 1998, and for the period from June
6, 1996 (inception) to December 31, 1996 and each of the two years in the period
ended December 31, 1998, and have issued our report thereon dated February 6,
1999 (February 26, 1999 as to Note 6), which report includes an emphasis of a
matter paragraph as to a significant portion of the Company's accounts
receivables and revenues relating to reciprocal compensation currently in
dispute; such financial statements and report are included in your 1998 Annual
Report to Stockholders and are incorporated herein by reference. Our audits also
included the consolidated financial statement schedule of US LEC Corp. and
subsidiaries, listed in Item 14. This financial statement schedule is the
responsibility of the Corporation's management. Our responsibility is to express
an opinion based on our audits. In our opinion, such consolidated financial
statement schedule, when considered in relation to the basic consolidated
financial statements taken as a whole, presents fairly in all material respects
the information as set forth therein.
DELOITTE & TOUCHE LLP
Charlotte, North Carolina
February 26, 1999
22
<PAGE>
SCHEDULE II
VALUATION AND QUALIFYING ACCOUNTS
US LEC CORP. (IN THOUSANDS)
<TABLE>
<CAPTION>
ADDITIONS
--------------------------
BALANCE AT
BEGINNING OF CHARGED TO CHARGED TO BALANCE AT END
PERIOD COSTS AND OTHER OF PERIOD
DESCRIPTION (DEC. 31, 1997) EXPENSES ACCOUNTS DEDUCTIONS (DEC. 31, 1998)
- --------------------- ----------------- ------------ ------------- --------------- ---------------
<S> <C> <C> <C> <C> <C>
Allowance against
accounts receivables $0 $12,024 $0 $0 $12,024
-- ------- -- -- -------
</TABLE>
23
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, as amended, Registrant has duly caused this report to be
signed on its behalf by the undersigned, thereunto duly authorized.
US LEC CORP.
Date: March 30, 1999 By: /s/ Richard T. Aab
-----------------------------
Richard T. Aab
Chairman of the Board and
Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, as
amended, this report has been signed below by the following persons on behalf of
Registrant and in the capacities and on the dates indicated.
<TABLE>
<CAPTION>
Signature Title Date
--------- ----- ----
<S> <C> <C>
/s/ Richard T. Aab Chairman of the Board and March 30, 1999
------------------ Chief Executive Officer
Richard T. Aab (Principal Executive Officer)
/s/ Tansukh V. Ganatra President, Chief Operating Officer and March 30, 1999
---------------------- Director
Tansukh V. Ganatra
/s/ Michael K. Robinson Executive Vice President and March 30, 1999
----------------------- Chief Financial Officer
Michael K. Robinson (Principal Financial and Accounting
Officer)
/s/ David M. Flaum Director March 30, 1999
------------------
David M. Flaum
/s/Steven L. Schoonover Director March 30, 1999
-----------------------
Steven L. Schoonover
</TABLE>
24
US LEC o The Competitive Telephone Company
Management's Discussion and Analysis of Financial Condition and Results of
Operations
13
Except for historical information, this report contains forward-looking
statements subject to uncertainties and risks, and as a result, US LEC's actual
results may differ materially from those discussed here. These uncertainties and
risks include among others, the demand for US LEC's services, the ability of the
Company to successfully attract and retain personnel, competition, uncertainties
regarding its dealings with incumbent local exchange carriers ("ILECs"), other
telecommunications carriers and facility providers, regulatory uncertainties,
reliance on leased transmission capacity and the cost of that capacity, the need
to finance operations and future capital expenditures, the possibility of an
adverse decision related to reciprocal compensation owed to the Company by
BellSouth Telecommunications, Inc. ("BellSouth"), as well as the Company's
ability to successfully initiate operations in additional markets. These and
other applicable risks are described in the Company's Annual Report on Form 10-K
for the year ended December 31, 1998 and other filings with the Securities and
Exchange Commission.
The following discussion and analysis should be read in conjunction with the
"Selected Financial Data" on page 12 of this report and the Company's
consolidated financial statements and related notes thereto appearing elsewhere
in this report.
Company Overview
US LEC is a rapidly growing switch-based competitive local exchange carrier
("CLEC") that provides local, long distance and enhanced telecommunications
services to its customers. The Company primarily serves telecommunication-
intensive customers including businesses, universities, financial institutions,
hospitals, hotels and government agencies. US LEC was founded in June 1996 after
passage of the Telecommunications Act of 1996 (the "Telecom Act"), which
enhanced the competitive environment for local exchange services. US LEC
initiated service in North Carolina in March 1997, becoming one of the first
CLECs in North Carolina to provide switched local exchange services, and now
operates from offices in Charlotte, Raleigh, Greensboro, Atlanta, Memphis,
Nashville, Knoxville, Orlando, Miami, Tampa and Jacksonville. US LEC currently
plans to establish offices in additional markets during 1999, including
Richmond, Norfolk/Virginia Beach, Chattanooga, Birmingham, Philadelphia, and the
Washington D.C. metropolitan area.
Revenue and Cost of Services
US LEC's revenue is comprised of two primary components: (1) fees paid by
customers for local, long distance and enhanced services and (2) access charges.
Local, long distance and enhanced service revenue is comprised of monthly
recurring charges, usage charges, and initial non-recurring charges. Monthly
recurring charges include the fees paid by customers for lines in service and
additional features on those lines. Usage charges consist of usage-sensitive
fees paid for calls made. Initial non-recurring charges consist primarily of
installation charges. Access charges are comprised of charges paid by
interexchange carriers ("IXCs") for the origination and termination of
interexchange toll and toll-free calls and reciprocal compensation, which is
discussed below. US LEC's "core business" revenue is comprised of local, long
distance, enhanced service fees and toll and toll-free access charges as
described above. The Company does not resell any ILEC services.
Reciprocal compensation arises when a local exchange carrier completes a call
that originated on another local exchange carrier's network. Reciprocal
compensation rates are fixed by an interconnection agreement negotiated between
those carriers. The majority of the Company's 1998 revenue was earned from
reciprocal compensation and is currently being disputed by BellSouth. This
dispute relates to reciprocal compensation charges related to traffic that is
terminated to enhanced service providers, including internet service providers.
As part of this dispute BellSouth has disputed reciprocal compensation charges
related to Metacomm, LLC, a company that is indirectly controlled by Richard T.
Aab, the majority stockholder and chief executive officer of the Company. The
BellSouth dispute contends that such traffic does not constitute
"telecommunications" subject to reciprocal compensation under the Telecom Act
and the existing interconnection agreement between BellSouth and the Company.
See Note 6 to the consolidated financial statements for a detailed description
of these proceedings and uncertainties associated with their outcome.
Although the Company has generated a majority of its revenue from reciprocal
compensation, US LEC was founded to establish a company that would provide a
wide array of telecommunications services to its customers. US LEC has deployed
a significant regional network, and as of December 1998 has active switches in
11 sites, serving over 550 customers. Management believes this level of growth,
achieved in less than two years, is indicative of the markets' acceptance of US
LEC's strategy and service offerings in its core business. Management expects
the Company's core business revenue to increase and reciprocal compensation to
decrease as percentages of total revenue in future periods as US LEC continues
to deploy its network and expand its customer base.
<PAGE>
US LEC o The Competitive Telephone Company
Management's Discussion and Analysis of Financial Condition and Results of
Operations
14
In order to provide local exchange services, the Company has signed
interconnection agreements with various ILECs, including BellSouth, GTE and
Sprint. These agreements provide the framework for the Company to serve its
customers when other local carriers are involved. The Company's interconnection
agreement with BellSouth is scheduled to terminate in June 1999 but management
does not anticipate any interruption of interconnect services. While the Company
does not anticipate that BellSouth will agree to renew the agreements in a
manner consistent with the Company's existing agreements as they relate to
reciprocal compensation, it intends to pursue such consistent terms vigorously.
The Company's ultimate ability to obtain such terms will depend on a number of
factors, including decisions by the Federal Communications Commission and state
regulatory authorities.
Cost of services is comprised primarily of leased transport charges and
commissions payable with respect to reciprocal compensation revenue. The
Company's leased transport charges are the lease payments incurred by US LEC for
the fiber optic transmission facilities used to connect the Company's customers
to its switch and to the ILEC and other carrier networks. US LEC, as part of its
"smart-build" strategy, does not currently own any fiber or copper transport
facilities. These facilities are leased from various providers including, in
some cases, the ILEC. The Company's strategy of leasing rather than building its
own fiber transport facilities results in the Company's cost of services being a
significant component of total costs. Management believes that this strategy has
several benefits, including faster time-to-market, more efficient asset
utilization, and diverse interconnection opportunities. The Company has to date
been successful in negotiating lease agreements which generally match the
duration of its customer contracts, thereby allowing the Company to mitigate the
risk of incurring charges associated with transmission facilities that are not
being utilized by customers. The Company shares revenue in the case of toll-free
access and reciprocal compensation revenue. While the majority of the Company's
cost of services is comprised of leased transport charges and reciprocal
compensation commissions, management expects that over time outbound traffic and
other usage sensitive charges will become a major component of cost of services
as the Company begins to carry more of its customers' outbound calls.
Selling, General and Administrative Expenses; Depreciation and Amortization
In addition to the costs of services described above, the Company incurs
certain other expenses. The largest component of selling, general and
administrative expense ("SG&A") relates to employee salaries, related taxes and
benefits, and other incentive-based compensation. Other major categories of SG&A
include expenses associated with leasing real estate for the Company's offices
and network, travel, supplies, legal and accounting.
Depreciation and amortization expense is primarily due to capital expenditures
made by the Company. Gross property, plant, and equipment increased from $13.3
million in 1997 to $61.3 million in 1998. Depreciation and amortization expense
increased from $0.4 million in 1997 to $4.9 million in 1998.
As the Company continues to build its network, SG&A, depreciation and
amortization expense will continue to grow. Although the Company is currently
profitable, there can be no assurance that the Company can continue to maintain
its profitability.
Results of Operations
Comparison of Year Ended December 31, 1998 to Year Ended December 31, 1997
Net revenue increased to $84.7 million for the year ended December 31, 1998
from $6.5 million in 1997. The increase in revenue of $78.2 million resulted
from the Company's expansion into new markets, an increase in the total number
of customers in existing markets and an increase in telecommunications traffic
on its network. As mentioned above, a majority of the Company's revenue was
comprised of reciprocal compensation originated by customers of ILECs. Given
that no near term resolution of the reciprocal compensation dispute is expected,
the Company recorded a $12.0 million allowance against reciprocal compensation
revenue and related receivables during 1998. The results discussed in this
report are net of this adjustment. This allowance was made for the uncertainty
associated with the current judicial and regulatory proceedings related to this
revenue, and does not reflect a change in the Company's commitment to pursue the
matter to a successful conclusion. See Note 6 to the consolidated financial
statements for a detailed description of these proceedings and uncertainties
associated with their outcome.
<PAGE>
15
Billable minutes of use were approximately 10.9 billion in 1998 compared to
approximately 472 million in 1997. Billable trunks increased to 39,304 at
December 31, 1998 from 8,039 at the December 31, 1997. Equivalent Access Lines
("EALs") increased to 199,578 at December 31, 1998, from 49,229 at December 31,
1997. Equivalent Access Lines is a term used by US LEC to quantify the size of
its network. During 1998, the Company modified the ratio of lines per trunk used
in calculating EALs, which are based on the number of customer lines and trunks
and the utilization of those lines and trunks during the "busy hour". The "busy
hour" refers to the hour of the day when line usage is at its highest level. The
Company calculates its EALs by multiplying the number of its trunks in service
by five and adding to the result the number of its separate access lines in
service. The decision to use five as the multiplier is based on management's
experience, which now indicates that the typical business access line is in use
for approximately 400 seconds during the busy hour (or approximately 11.1% of
capacity during the busy hour) and a typical business trunk is in use for
approximately 2,000 seconds during the busy hour (or approximately 55.6% of
capacity during the busy hour) or approximately five times use during the busy
hour of a typical business line. Beginning in the third quarter of 1998, as part
of its periodic review of this issue, management changed the multiplier that it
uses in the calculation of EALs from six to five in order to reflect changes in
the usage of its network.
Cost of services is comprised primarily of leased transport, facility
installation, commissions and usage charges. Cost of services increased from
$4.2 million, or 65.1% of revenue, for 1997, to $33.6 million, or 39.7% of
revenue, for 1998. This increase was primarily a result of the increase in the
size of US LEC's network, increased usage by its customers, and increased
commissions due to reciprocal compensation.
Selling, general and administrative expenses for 1998 increased to $25.0
million, or 29.5% of revenue, compared to $6.1 million, or 94.7% of revenue, for
1997. This increase was primarily a result of costs associated with developing
and expanding the infrastructure of the Company as it expands into new markets,
such as expenses associated with personnel, sales and marketing, occupancy,
administration and billing as well as legal expenses associated with the
BellSouth litigation.
Depreciation and amortization for 1998 increased to $4.9 million from $0.4
million in 1997 primarily due to the increase in depreciable assets in service
related to US LEC's network expansion.
Interest income for 1998 increased by $1.8 million over 1997 to $1.9 million
as a result of investing the proceeds from the Company's initial public
offering.
Interest expense for 1998 decreased from 1997 by $184 thousand to $237
thousand. This decrease was primarily due to the full repayment of $3.3 million
in notes payable in June 1998.
Provision for income taxes for 1998 was $9.3 million, based on an effective
tax rate of 40.9%. As a result of timing differences between book and tax income
at December 31, 1998, the Company had a tax net operating loss carryforward of
$2.8 million. US LEC was organized as a limited liability company during 1997
and effectively converted to C Corporation status as of January 1, 1998.
Accordingly, no provision (benefit) for income taxes was necessary for 1997
since income taxes were the responsibility of the individual limited liability
company members.
Net earnings after tax for 1998 amounted to $13.4 million, or $.52 per share
(diluted), compared to a net loss of $4.7 million, or ($.25) per share (diluted)
for 1997. The increase in net earnings and net earnings per share is attributed
to the factors discussed above.
Earnings before interest, taxes, depreciation and amortization ("EBITDA") for
1998 increased to $26.0 million from a loss of $3.9 million in 1997. EBITDA is a
measure commonly used by analysts, investors, and other interested parties in
the telecommunications industry and is presented to assist in understanding the
Company's operating results. EBITDA is not a measurement of financial
performance under generally accepted accounting principles and should not be
considered an alternative to net income or loss as a measure of performance or
to cash flow as a measure of liquidity. EBITDA is not necessarily comparable
with the similarly titled measures for other companies.
<PAGE>
US LEC o The Competitive Telephone Company
Management's Discussion and Analysis of Financial Condition and Results of
Operations
16
Comparison of Year Ended December 31, 1997 to the Period from Inception (June 6,
1996) to December 31, 1996
Although the Company began operations on June 6, 1996, it did not generate
revenue until March 1997 and, accordingly, any comparison of operating results
between 1996 and 1997 would not be meaningful. Selling, general and
administrative expenses for 1996 were $942 thousand resulting primarily from
payroll costs. The Company's net loss for fiscal 1996 was $963 thousand
resulting from operating expenses incurred for the initial development of the
Company's business. During fiscal 1996, the Company was organized as an S
corporation.
Liquidity and Capital Resources
US LEC's business is capital intensive and its operations require substantial
capital expenditures for the purchase and installation of network switches,
related electronic equipment and facilities. The Company's cash capital
expenditures were $47.7 million and $5.8 million for the years ended December
31, 1998 and 1997, respectively. The Company anticipates that it will have
substantial capital requirements in connection with its planned expansion into
additional markets during 1999 and beyond.
In February 1998, US LEC registered 6,325,000 shares of its Class A Common
Stock for sale to the public. In April and May 1998, the Company completed the
public offering of these 6,325,000 shares (the "Equity Offering"). The net
proceeds to the Company from the Equity Offering were approximately $87.1
million, after deducting underwriting discounts and commissions of $6.6 million
and offering expenses of $1.1 million.
At December 31, 1997, US LEC was indebted to Richard T. Aab, the Company's
principal stockholder, Chairman and Chief Executive Officer, in the amount of
$5.0 million. In February 1998, Mr. Aab exchanged this loan for 480,770 shares
of Class B Common Stock. During the first quarter of 1998, Tansukh V. Ganatra,
US LEC's President and Chief Operating Officer, and Melrich Associates, L.P. (an
entity of which Mr. Aab is a general partner) loaned the Company a total of $3.3
million. The Company repaid these loans in June 1998.
In December 1998, the Company entered into a $50.0 million loan agreement with
General Electric Capital Corporation and First Union National Bank. The loan
agreement was comprised of a $42.5 million one year revolving credit facility
which converts to a seven year term loan and a $7.5 million reducing revolving
credit facility with a six year term. The amount outstanding at December 31,
1998 was $20.0 million, all of which was borrowed under the $42.5 million one
year revolving credit facility. The interest rate for the loan agreement is a
floating rate based, at the Company's option, on a base rate or the London
Interbank Offered Rate, plus, in each case, a specified margin. Initial advances
under the agreement bear an interest rate of approximately 8.6%. This loan is
subject to certain financial covenants the most significant of which relate to
the levels of maintenance of revenue, earnings and debt ratios. Substantially
all of the Company's and its subsidiaries' assets are pledged as collateral to
serve amounts borrowed under the loan agreement.
Cash used in operating activities was approximately $19.1 million for 1998
compared to $5.6 million in 1997. The increase in cash used in operating
activities was primarily due to a $56 million increase related to accounts
receivable (net of a $12 million receivable allowance) offset by an increase in
net income of $18.1 million, an increase in depreciation of $4.5 million, an
increase in deferred taxes of $8.4 million and an increase related to accrued
expenses of $10.6 million. The majority of the Company's accounts receivable at
December 31, 1998 represented amounts due from BellSouth for reciprocal
compensation, facility charges, toll and other charges. Management expects
receivables due from BellSouth to continue to increase until the judicial and
regulatory proceedings with BellSouth are resolved. The increase in depreciation
was due to the increase in depreciable assets in service related to US LEC's
network expansion. The increase in deferred taxes was due to timing differences
between book and tax income at December 31, 1998. The increase in accrued
expenses was primarily the result of an increase in accrued network costs,
accrued compensation and other accrued expenses related to the Company's
expansion.
Cash used in investing activities increased to $48.5 million in 1998 from $6.0
million during 1997. The increase was primarily related to purchases of
switching and related telecommunications equipment, office equipment and
leasehold improvements associated with the Company's expansion into additional
locations and markets during 1998 and, to a lesser extent, an increase in
restricted cash which serves as collateral for letters of credit related to
certain office leases.
<PAGE>
17
Cash provided by financing activities increased to $106.5 million for 1998
from $14.0 million for 1997. The increase was primarily due to the $87.1 million
of net proceeds from the Equity Offering and $20.0 million of borrowings under
the Company's credit facility, both of which are discussed above.
Effect of Recently Issued Accounting Pronouncements
In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133, "Accounting for Derivative Instruments
and Hedging Activities". This statement addresses the accounting for derivative
instruments, including certain derivative instruments embedded in other
contracts and hedging activities. This statement will be effective for the
Company's 2000 fiscal year. The Company has not yet completed its analysis of
any potential impact of this statement on its financial statements.
Year 2000 Compliance
Many computer systems will experience difficulty processing dates beyond the
year 1999 and will need to be modified prior to the Year 2000. Failure to make
such modifications could result in system failures or miscalculations causing a
disruption of operations. Most of the Company's information technology purchases
were made after March 1997 and, because the Company's systems are relatively new
and there were no legacy systems to integrate, management believes the Company's
internal software and hardware systems will function properly with respect to
dates in the Year 2000 and thereafter. In addition, Year 2000 issues are also
addressed as the Company's network and internal systems are upgraded in the
normal course of business. As of December 31, 1998, the Company's costs expended
towards Year 2000 compliance has been minimal and it does not expect its
additional expenditures directly related to Year 2000 compliance cost to exceed
$100 thousand. Management continually reassesses the estimated costs and status
of the Company's Year 2000 compliance efforts.
The Company began conducting verification testing of all its internal
information technology and information systems in 1998. The testing is a
multi-phased process which includes, but is not limited to, setting the system
clocks to simulate several key dates and times in the Year 2000, then performing
daily activities. The infrastructure, servers and workstations, as well as
software systems are being tested and validated using this process. The final
phase of testing is scheduled to be completed in October 1999.
While management believes that its hardware and software applications are Year
2000 compliant, there can be no assurance until the Year 2000 occurs that all
systems will then function adequately. The Company is monitoring all key vendors
and suppliers for Year 2000 compliance by various methods including, but not
limited to, gathering information from a detailed survey sent by the Company,
public domain websites, public service commission filings, and Securities and
Exchange Commission filings. While most of the Company's significant suppliers
and vendors have advised the Company that they are or anticipate being Year 2000
compliant, if the software applications of other local exchange carriers, long
distance carriers, service providers, competitive access providers, or others on
whose services the Company depends are not Year 2000 compliant, a material
adverse effect on the Company's financial condition and results of operations
could result. The Company is not aware of any significant vendor who may be
unable to provide services to the Company as a result of Year 2000
non-compliance. The Company currently has a disaster recovery plan in place
which will serve as a foundation for its contingency plan in the event its
suppliers and vendors are not Year 2000 compliant. The full contingency plan is
currently being developed and will be completed by mid-1999.
Market Risk
US LEC is exposed to various types of market risk in the normal course of
business, including the impact of interest rate changes on its investments and
debt. As of December 31, 1998, investments consisted primarily of institutional
money market funds. All of the Company's long-term debt consist of variable rate
instruments with interest rates that are based on a floating rate which, at the
Company's option, is determined by either a base rate or the London Interbank
Offered Rate, plus, in each case, a specified margin.
Although US LEC does not currently utilize any interest rate management tools,
it will evaluate the use of derivatives such as, but not limited to, interest
rate swap agreements to manage its interest rate risk. As the Company's
investments are all short-term in nature and its long-term debt is at variable
short-term rates, management believes the carrying values of the Company's
financial instruments approximate fair values.
<PAGE>
US LEC o The Competitive Telephone Company
US LEC Corp. and Subsidiaries
Consolidated Balance Sheets
December 31, 1997 and 1998 (In Thousands)
18
<TABLE>
<CAPTION>
1997 1998
- ------------------------------------------------------------------------------------------
Assets (Note 5)
<S> <C> <C> <C>
Current Assets:
Cash and cash equivalents (Note 2) $ 3,189 $ 41,965
Certificates of deposit and restricted cash (Note 2 and 6) 350 1,167
Accounts receivable, net of allowance of $12,024 for 1998
(Notes 2 and 6) 6,006 66,214
Prepaid expenses and other assets 111 2,838
- ------------------------------------------------------------------------------------------
Total current assets 9,656 112,184
Property and Equipment, Net (Notes 2, 3 and 5) 12,889 56,219
Other Assets 136 1,800
- ------------------------------------------------------------------------------------------
Total Assets $22,681 $ 170,203
==========================================================================================
Liabilities and Stockholders' Equity
Current Liabilities:
Accounts payable $ 8,201 $ 13,509
Deferred revenue (Note 2) 1,141 829
Accrued network costs (Notes 2 and 8) 1,865 9,866
Accrued interest payable - related party (Note 4) 282 -
Deferred income taxes (Notes 2 and 7) - 7,108
Accrued expenses - other 435 4,657
- ------------------------------------------------------------------------------------------
Total current liabilities 11,924 35,969
Notes Payable-Stockholders (Note 4) 5,000 -
Deferred Income Taxes (Notes 2 and 7) - 1,259
Long-Term Debt (Note 5) - 20,000
Commitments and Contingencies (Note 6)
Stockholders' Equity (Note 10):
Common stock - Class A, $.01 par (72,925 authorized shares,
3,855 and 10,345 outstanding at December 31, 1997 and 1998,
respectively) 39 103
Common stock - Class B, $.01 par (17,076 authorized
shares, 16,595 and 17,076 outstanding at December 31, 1997 and 1998,
respectively) 166 171
Additional paid-in capital 11,173 106,800
Retained earnings (deficit) (5,621) 6,556
Unearned compensation - stock options - (655)
- ------------------------------------------------------------------------------------------
Total stockholders' equity 5,757 112,975
- ------------------------------------------------------------------------------------------
Total Liabilities and Stockholders' Equity $22,681 $ 170,203
==========================================================================================
</TABLE>
See notes to consolidated financial statements.
<PAGE>
US LEC o The Competitive Telephone Company
US LEC Corp. and Subsidiaries
Consolidated Statements of Operations
Period from June 6, 1996 (inception) to December 31, 1996
and years ended December 31, 1997 and 1998 (In Thousands, Except
Per Share Data)
19
<TABLE>
<CAPTION>
1996 1997 1998
- ----------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Revenue, Net (Notes 2, 6 and 8) $ - $6,458 $ 84,716
Cost of Services (Note 8) - 4,201 33,646
-------------------------------------
Gross Margin - 2,257 51,070
Selling, General and Administrative (Note 8) 942 6,117 25,020
Depreciation and Amortization 4 443 4,941
-------------------------------------
Earnings (Loss) from Operations (946) (4,303) 21,109
Other (Income) Expense:
Interest income - (66) (1,860)
Interest expense (Note 4) 17 421 237
--------------------------------------
Earnings (Loss) Before Income Taxes (963) (4,658) 22,732
Provision For Income Taxes (Note 7) - - 9,305
--------------------------------------
Net Earnings (Loss) $ (963) $(4,658) $13,427
======================================
Net Earnings (Loss) Per Share (Note 11):
Basic $ (.06) $ (.25) $ .53
======================================
Diluted $ (.06) $ (.25) $ .52
======================================
Weighted Average Shares Outstanding (Note 11):
Basic 17,310 18,653 25,295
======================================
Diluted 17,310 18,653 25,804
======================================
</TABLE>
See notes to consolidated financial statements.
<PAGE>
US LEC o The Competitive Telephone Company
US LEC Corp. and Subsidiaries
Consolidated Statements of Stockholders' Equity (Deficiency)
Period from June 6, 1996 (inception) to December 31, 1996
and years ended December 31, 1997 and 1998 (Notes 1 and
10) (In Thousands)
20
<TABLE>
<CAPTION>
Common Stock Common Stock
Class A Class B
Shares Amount Shares Amount
- ----------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Balance, June 6, 1996 (Inception) -- $ -- -- $ --
Issuance of voting shares/units -- -- -- --
Shares/units granted to employees -- -- -- --
Net loss -- -- -- --
-----------------------------------------
Balance (Deficiency), December 31, 1996 -- -- -- --
Issuance of nonvoting units -- -- -- --
Issuance of voting units -- -- -- --
Issuance of warrants -- -- -- --
Contribution to capital -- -- -- --
Exchange of limited liability company units
for C Corporation shares 3,855 39 16,595 166
Net loss -- -- -- --
----------------------------------------
Balance, December 31, 1997 3,855 39 16,595 166
Public stock offering 6,325 63 -- --
Conversion of $5,000 stockholder loans
for 481 shares of Class B common stock -- -- 481 5
Dividend (Note 4) -- -- -- --
Issuance of stock warrants -- -- -- --
Unearned compensation-stock options -- -- -- --
Exercise of warrants 165 1 -- --
Tax effect of non-qualified options/warrants
exercised -- -- -- --
Net earnings -- -- -- --
----------------------------------------
Balance, December 31, 1998 10,345 $ 103 17,076 $ 171
========================================
</TABLE>
(1) On December 31, 1996, all S Corporation common shares were converted
into limited liability company units based on a one-for-one conversion
ratio of units for each share. On December 31, 1997, all limited
liability units were converted into C Corporation common shares based
upon a conversion ratio of 1,500 shares for each unit.
See notes to consolidated financial statements.
<PAGE>
21
<TABLE>
<CAPTION>
Common Stock/ Common Stock/ Unearned
Voting Units (1) Nonvoting Units (1) Additional Retained Compensation
----------------- ------------------- Paid-in Earnings Stock
Shares Amount Shares Amount Capital (Deficit) Options Total
- ----------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
-- $ -- -- $ -- $ -- $ -- $ -- $ --
10 600 -- -- -- -- -- 600
-- -- 2 28 -- -- -- 28
-- -- -- -- -- (963) -- (963)
- ----------------------------------------------------------------------------------------
10 600 2 28 -- (963) -- (335)
-- -- 1 4,413 -- -- -- 4,413
1 4,555 -- -- -- -- -- 4,555
-- -- -- -- 70 -- -- 70
-- -- -- -- 1,711 -- -- 1,711
(11) (5,155) (3) (4,441) 9,392 -- -- 1
-- -- -- -- -- (4,658) -- (4,658)
- ----------------------------------------------------------------------------------------
-- -- -- -- 11,173 (5,621) -- 5,757
-- -- -- -- 87,079 -- -- 87,142
-- -- -- -- 4,995 -- -- 5,000
-- -- -- -- 1,250 (1,250) -- --
-- -- -- -- 75 -- -- 75
-- -- -- -- 819 -- (655) 164
-- -- -- -- 471 -- -- 472
-- -- -- -- 938 -- -- 938
-- -- -- -- -- 13,427 -- 13,427
- ----------------------------------------------------------------------------------------
-- $ -- -- $ -- $ 106,800 $6,556 $(655) $ 112,975
========================================================================================
</TABLE>
<PAGE>
US LEC o The Competitive Telephone Company
US LEC Corp. and Subsidiaries
Consolidated Statements of Cash Flows
Period from June 6, 1996 (inception) to
December 31, 1996 and years ended December
31, 1997 and 1998 (In Thousands)
22
<TABLE>
<CAPTION>
1996 1997 1998
- ---------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Operating Activities:
Net earnings (loss) $ (963) $(4,658) $13,427
Adjustments to reconcile net earnings (loss)
to net cash used in operating activities:
Depreciation and amortization 4 443 4,941
Accounts receivable allowance - - 12,024
Stock compensation 28 71 240
Deferred compensation - - (655)
Deferred taxes - - 8,367
Changes in assets and liabilities which provided (used) cash:
Accounts receivable - (6,006) (74,177)
Prepaid expenses and other assets (141) 31 (579)
Other assets (124) (14) (1,271)
Accounts payable 34 899 5,769
Deferred revenue - 1,141 (312)
Accrued expenses - other 83 634 5,082
Accrued network costs - 1,865 8,001
----------------------------
Total adjustments (116) (936) (32,570)
----------------------------
Net cash used in operating activities (1,079) (5,594) (19,143)
----------------------------
Investing Activities:
Purchase of property and equipment (266) (5,802) (47,721)
Purchases of certificates of deposit and restricted cash - (349) (817)
(Advances to) repayments from stockholder (200) 200 -
----------------------------
Net cash used in investing activities (466) (5,951) (48,538)
----------------------------
Financing Activities:
Issuance of common shares and limited liability company units 600 8,968 471
Proceeds from public stock offering - - 87,142
Contribution of capital - 1,711 -
Proceeds from long-term debt - - 20,000
Payment of loan fees - - (1,156)
Proceeds from notes payable - stockholders 1,671 4,289 3,289
Repayment of notes payable - stockholders - (960) (3,289)
----------------------------
Net cash provided by financing activities 2,271 14,008 106,457
----------------------------
Net Increase in Cash and Cash Equivalents 726 2,463 38,776
Cash and Cash Equivalents, Beginning of Period - 726 3,189
----------------------------
Cash and Cash Equivalents, End of Period $ 726 $ 3,189 $ 41,965
============================
Supplemental Cash Flows Disclosures
Cash paid for:
Interest $ - $ 672 $ 505
----------------------------
Taxes $ - $ - $ 1,860
----------------------------
</TABLE>
Supplemental Noncash Investing and Financing Activities:
During 1997, accrued interest of $55 due to stockholders was converted into
voting equity.
At December 31, 1996, 1997 and 1998, $14, $7,267 and $6,838 respectively, of
property and equipment additions are included in outstanding accounts payable.
During 1998, the majority stockholder converted $5,000 of loans to the Company
for 481 shares of Class B Stock. The dividend resulting from the conversion of
the loan was $1,250.
See notes to consolidated financial statements.
<PAGE>
US LEC o The Competitive Telephone Company
US LEC Corp. and Subsidiaries
Notes to Consolidated Financial Statements
Period from June 6, 1996 (inception) to December 31, 1996
and years ended December 31, 1997 and 1998 (In Thousands, Except
Per Share Data)
23
1. ORGANIZATION AND NATURE OF BUSINESS
The consolidated financial statements include the accounts of US LEC Corp.
(the "Company") and its nine wholly owned subsidiaries. All significant
intercompany transactions and balances have been eliminated in consolidation.
The Company was incorporated in 1996 as an S Corporation. Effective December 31,
1996, US LEC Corp. was converted to a limited liability company ("US LEC
L.L.C.") through an exchange of the S Corporation common stock for voting and
nonvoting units of US LEC L.L.C. On December 31, 1997, in anticipation of an
initial public offering of common stock, the Company became a C Corporation
through a merger of US LEC L.L.C. into the Company and the exchange of all of
the limited liability company units into shares of Class A or Class B Common
Stock. On April 29, 1998, the Company completed the sale of 5,500 shares of
Class A Common Stock through an initial public offering. Additionally, on May
12, 1998, the Company issued 825 shares of Class A Common Stock in connection
with the underwriters' exercise of their option to cover over-allotments. The
total offering resulted in net proceeds of approximately $87,142, after
deducting underwriting discounts, commissions and offering expenses. The Company
has used and intends to use substantially all of the net proceeds of the initial
public offering to further expand and develop its telecommunications network and
services.
The Company, through its subsidiaries, provides switched local, long distance
and enhanced telecommunications services primarily to businesses and other
organizations in selected markets in the southeastern United States. The Company
was a development stage enterprise from inception until March 1997, when it
began generating telecommunications revenues.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Revenue Recognition - The Company normally recognizes revenue on
telecommunications and enhanced communications services in the period that the
service is provided. Revenue is recorded net of amounts which are rebated to a
customer or outside sales agent pursuant to each respective telecommunications
service contract. Revenue related to billings in advance of providing services
is deferred and recognized when earned. At December 31, 1997, deferred revenue
primarily represented billings to incumbent local exchange carriers ("ILECs")
relating to internet service provider ("ISP") reciprocal compensation.
Reciprocal compensation represents the compensation paid to and by a competitive
local exchange carrier ("CLEC") and the ILEC for termination of a local call on
the other's network. The Company deferred the recognition of such amounts in
1997 pending a ruling from the North Carolina Utilities Commission ("NCUC").
During 1998, such amounts were subsequently recorded as revenue as a result of
the decision by the NCUC on February 26, 1998 in favor of the Company. As a
result of this ruling, the Company began recognizing all such ISP reciprocal
compensation revenue in the period in which the service was provided. However,
due to current regulatory and judicial proceedings related to this type of
revenue, the Company established an allowance of $12,000 at December 31, 1998,
which has been recorded as a reduction of revenue during the year ended December
31, 1998 (see Note 6).
Cash and Cash Equivalents - Cash equivalents consist of highly liquid
investments with original maturities of three months or less at the time of
purchase.
Certificates of Deposit and Restricted Cash - Certificates of deposit were
carried at cost. All of these certificates matured during 1998, and served as
collateral for letters of credit related to certain office leases. The
restricted cash balance as of December 31, 1998 serves as collateral for letters
of credit related to certain office leases.
Accounts Receivable - The majority of the accounts receivable at December 31,
1998 arose from reciprocal compensation revenue earned in accordance with terms
of an interconnection agreement with BellSouth Telecommunications, Inc.
("BellSouth"). The Company established an allowance of $12,000 as of December
31, 1998 to allow for the uncertainty associated with the current judicial and
regulatory proceedings related to this revenue (see Note 6).
<PAGE>
US LEC o The Competitive Telephone Company
US LEC Corp. and Subsidiaries
Notes to Consolidated Financial Statements
Period from June 6, 1996 (inception) to December 31, 1996
and years ended December 31, 1997 and 1998 (In Thousands, Except Per
Share Data)
24
Property and Equipment - Property and equipment is stated at cost less
accumulated depreciation. Depreciation is computed using the straight-line
method over the estimated useful lives of the assets, except for leasehold
improvements as noted below.
The estimated useful lives of the Company's principal classes of property and
equipment are as follows:
Telecommunications switching and other equipment 5 - 9 years
Office equipment, furniture and other 5 years
Leasehold improvements The lesser of the estimated useful
lives or the lease term
Long-Lived Assets - The Company reviews the carrying value of its long-lived
assets for impairment whenever events or changes in circumstances indicate that
the carrying value of these assets may not be recoverable. Measurement of any
impairment would include a comparison of estimated undiscounted future operating
cash flows anticipated to be generated during the remaining life of the assets
with their net carrying value. An impairment loss would be recognized as the
amount by which the carrying value of the assets exceeds their fair value.
Accrued Network Costs - Accrued network costs include management's estimate of
charges for direct access lines, facility charges, outgoing and incoming
minutes, reciprocal compensation and other costs of revenue for a given period
for which bills have not been received by the Company. Management's estimate is
developed from the minutes of use and rates charged by each respective service
provider. Subsequent adjustments to this estimate may result when actual costs
are billed by the service provider to the Company. However, management does not
believe such adjustments will be material to the Company's financial statements.
Fair Value of Financial Instruments - Management believes the fair values of
the Company's financial instruments, including cash equivalents, certificates of
deposit, accounts receivables, accounts payable and notes payable to
stockholders approximate their carrying value. In addition, because the
long-term debt consists of variable rate instruments, their carrying values
approximate fair values.
Income Taxes - The Company was organized as an S Corporation for the period
from inception to December 31, 1996, and as a limited liability company for the
period from January 1, 1997 to December 31, 1997, on which date it was converted
to a C Corporation. Accordingly, no provision (benefit) for income taxes was
necessary for 1996 and 1997 since income taxes were the responsibility of the
individual S Corporation stockholders or limited liability company members. On a
pro forma basis, had the Company been structured as a C Corporation since
inception, there would have been no change in the net loss or net loss per share
for 1996 and 1997. At December 31, 1997, deferred tax assets and liabilities
related to the conversion to a C Corporation were not significant.
For 1998, income taxes are provided for temporary differences between the tax
and financial accounting basis of assets and liabilities using the liability
method. The tax effects of such differences, as reflected in the balance sheet,
are at the enacted tax rates expected to be in effect when the differences
reverse.
Concentration of Risk - The Company is exposed to concentration of credit risk
principally from trade accounts receivable. The Company's trade customers are
located in the southeastern United States. The Company performs ongoing credit
evaluations of its customers but does not require collateral to support customer
receivables. Credit risk may be reduced by the fact that the Company's most
significant trade receivables are from large, well-established
telecommunications entities. However, at December 31, 1997 and 1998, the
majority of the accounts receivable balance is due from BellSouth and is
currently in dispute (see Note 6).
<PAGE>
25
The Company is dependent upon certain suppliers for the provision of
telecommunications services to its customers. The Company has executed
interconnection agreements for all of its current operating networks, and a
number of these agreements expire at various dates in 1999. Management believes
that suitable interconnection agreements can be negotiated in the future and,
accordingly, does not expect any disruption of services.
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
the disclosure of contingent assets and liabilities at the date of the financial
statements. Actual results could differ from those estimates. Significant
estimates relate to the accrual of network costs payable to other
telecommunications entities and the estimate for the allowance for receivables
due from BellSouth (see Note 6). Any difference between the amounts recorded and
amounts ultimately realized or paid will be adjusted prospectively as new facts
become known.
Advertising- The Company expenses advertising costs in the period incurred.
Advertising expense amounted to $22, $137 and $276 for 1996, 1997 and 1998,
respectively.
Significant Customer - In fiscal 1997 and 1998, BellSouth, operating in the
majority of the Company's markets, accounted for 65% and 80%, respectively, of
the Company's net revenue (before reduction for the $12,000 allowance described
in Note 6). The majority of this revenue for 1998 was generated from reciprocal
compensation. Although reciprocal compensation owed to the Company by BellSouth
is not a customer relationship in the traditional sense, BellSouth is shown here
due to the significant contribution to revenue. At December 31, 1997 and 1998,
BellSouth accounted for 67% and 94% of the Company's total accounts receivables
before allowance, respectively. The majority of such receivables and revenues
have resulted from traffic associated with Metacomm, LLC ("Metacomm"), a
customer of the Company and BellSouth, and which became a related party to the
Company during 1998 (see Notes 6 and 8).
Recent Accounting Pronouncements - In June 1997, the Financial Accounting
Standards Board ("FASB") issued Statement of Financial Accounting Standards
("SFAS") No. 131, "Disclosures about Segments of an Enterprise and Related
Information." This Standard redefines how operating segments are determined and
requires disclosure of certain financial and descriptive information about a
company's operating segments. This Statement is effective for the Company's
current fiscal year end. Management has determined that the adoption of SFAS 131
has no material impact on the Company's current disclosures of its one operating
segment, providing telecommunications services.
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities." This standard addresses the accounting for
derivative instruments, including certain derivative instruments embedded in
other contracts and hedging activities. This statement will be effective for the
Company's 2000 fiscal year. The Company has not yet completed its analysis of
any potential impact of this standard on its financial statements.
In March 1998, the American Institute of Certified Public Accountants
("AICPA") issued Statement of Position ("SOP") 98-1, "Accounting for the Costs
of Computer Software Developed or Obtained for Internal Use." Adoption of the
SOP is effective for the current fiscal year. Management has concluded that
adoption of such guidance had no material effect on the financial statements.
Reclassifications - Certain reclassifications have been made to 1996 and 1997
amounts to conform to the 1998 presentation.
<PAGE>
US LEC o The Competitive Telephone Company
US LEC Corp. and Subsidiaries
Notes to Consolidated Financial Statements
Period from June 6, 1996 (inception) to December 31, 1996
and years ended December 31, 1997 and 1998 (In Thousands, Except Per
Share Data)
26
3. PROPERTY AND EQUIPMENT Property and equipment at December 31, 1997 and 1998
is summarized by major class as follows:
1997 1998
- ------------------------------------------------------------------------------
Telecommunications switching and other equipment $11,790 $ 45,334
Office equipment, furniture and other 775 9,158
Leasehold improvements 770 6,785
---------------------
13,335 61,277
Less accumulated depreciation and amortization (446) (5,058)
---------------------
Total $12,889 $ 56,219
=====================
4. NOTES PAYABLE-STOCKHOLDERS
During 1997, the Company's majority stockholder loaned an aggregate of $5,000
to the Company. Interest charged on loaned amounts was at prime plus 2% (10.5%
per annum at December 31, 1997). On February 14, 1998, the Company's majority
stockholder exchanged the $5,000 loan for 481 shares of Class B Common Stock
with a fair value of $10.40 per share. The fair value of the Class B Common
Stock issued in the exchange was $1,250 in excess of the carrying value of the
debt. Accordingly, the difference between the carrying value of the debt and the
fair value of the Class B Common Stock issued in the exchange was recorded as a
dividend to the majority stockholder in the first quarter of 1998. In January
1998, an entity controlled by this stockholder loaned an additional $2,289 to
the Company with an interest rate of 12%. The Company repaid all the outstanding
amounts due under the loan in June 1998.
Another stockholder loaned the Company an aggregate of $960 in 1996, with an
interest rate of prime plus 2%. These loans were repaid in 1997. In January
1998, this stockholder loaned $1,000 to the Company, with an interest rate of
12%. The Company repaid all the outstanding amounts due under the loan in June
1998.
Interest expense to related parties totaled $17, $420 and $223 in 1996, 1997
and 1998, respectively.
5. LONG-TERM DEBT
Effective December 30, 1998, the Company entered into a $50,000 loan agreement
with General Electric Capital Corporation and First Union National Bank. The
loan agreement was comprised of a $42,500 one year revolving credit facility
which converts to a seven year term loan and a $7,500 reducing revolving credit
facility with a six year term. The amount outstanding at December 31, 1998 was
$20,000, all of which was borrowed under the $42,500 one year revolving credit
facility. On December 31, 1998, the interest rate on the borrowings was 10.25%
(prime plus 2.5%) and the Company had an additional $30,000 available under the
loan agreement. On January 5, 1999, the Company converted the $20,000 borrowings
under the line to a LIBOR-based loan with an interest rate of 8.56%, based on
one month LIBOR plus 3.50%. This loan is subject to certain financial covenants,
the most
<PAGE>
27
significant of which relate to the maintenance of levels of revenue, earnings
and debt ratios. Substantially all of the Company's and its subsidiaries' assets
are pledged as collateral to secure amounts borrowed under the loan agreement.
Scheduled maturities of long-term debt, assuming conversion to a term loan are
as follows:
Year ending December 31:
1999 $ -
2000 -
2001 -
2002 3,000
2003 3,000
Thereafter 14,000
--------
Total $ 20,000
========
6. COMMITMENTS AND CONTINGENCIES
Disputed ISP Revenues - A majority of the Company's revenue is derived from
reciprocal compensation amounts due from ILECs, principally BellSouth, a
majority of which relates to ISP revenue (approximately $54,000 in 1998 before
the $12,000 allowance) that is being disputed. Management believes that such
revenue has been earned by the Company and payments are due from BellSouth
pursuant to the interconnection agreements that BellSouth has with the Company.
However, in August 1997, BellSouth notified the Company and other CLECs that it
considered ISP traffic interstate (and therefore not subject to reciprocal
compensation) and that BellSouth would not pay (or bill) reciprocal compensation
under interconnection agreements for traffic terminated to enhanced service
providers ("ESPs"), including information service providers and ISPs. On
February 26, 1998, following a petition by the Company, the NCUC ordered
BellSouth to bill and pay for all such traffic. Following motions filed by
BellSouth, the NCUC stayed enforcement of its order until June 1, 1998. On April
27, 1998, BellSouth filed a petition for judicial review of the NCUC's order and
an action for declaratory judgment and other relief (including a request for an
additional stay) with the United States District Court for the Western District
of North Carolina ("U.S. District Court") pending determination of certain ISP
issues by the Federal Communications Commission ("FCC"). This action was filed
against the Company and the NCUC. This matter is currently pending before the
U.S. District Court.
On February 26, 1999, the FCC ruled that Internet traffic represents
interstate traffic. However, they further ruled that carriers are bound by their
existing interconnection agreements, as interpreted by state utility
commissions, and thus are subject to reciprocal compensation obligations to the
extent provided by such agreements or as determined by state utility
commissions. As noted, the NCUC had ruled on February 26, 1998 in favor of the
Company with respect to the Company's existing interconnection agreement with
BellSouth.
On September 14, 1998, BellSouth filed a complaint with the NCUC seeking to be
relieved from an unspecified portion of obligations under its interconnection
agreement with the Company to pay reciprocal compensation for traffic related to
Metacomm, a customer of BellSouth and the Company, and currently a related party
of the Company (see Note 8). In addition to disputing the traffic due to its ISP
nature, BellSouth has also alleged that traffic related to Metacomm would not
qualify for reciprocal compensation, alleging that such traffic does not
constitute "telecommunications" subject to reciprocal compensation under the
Telecommunications Act of 1996 and the existing interconnection agreement. On
September 14, 1998, the Company filed a complaint with the NCUC seeking payment
of facilities charges, non-ISP based reciprocal compensation and intraLATA toll
termination charges. These matters are currently pending before the NCUC.
<PAGE>
US LEC o The Competitive Telephone Company
US LEC Corp. and Subsidiaries
Notes to Consolidated Financial Statements
Period from June 6, 1996 (inception) to December 31, 1996
and years ended December 31, 1997 and 1998 (In Thousands, Except
Per Share Data)
28
Management believes that the Company will ultimately obtain favorable results
in these proceedings; however, BellSouth may elect to initiate additional
proceedings (by way of appeal or otherwise) challenging amounts owed to the
Company. If a decision adverse to the Company is issued in any of these
proceedings by the U.S. District Court, the NCUC or the FCC, or in any appeal or
review of a favorable decision by the U.S. District Court, the NCUC, or the FCC,
or in any other proceeding affecting these issues in another forum, or if either
the FCC or the NCUC were to alter its view of reciprocal compensation, such an
event could have a material adverse effect on the Company's operating results
and financial condition. The Company's revenues for the year ended December 31,
1998 and trade accounts receivable as of December 31, 1998 included
approximately $54,000 (before the $12,000 allowance) of earned but unpaid ISP
reciprocal compensation, the majority of which was generated as a result of
traffic related to Metacomm (see Note 8).
The Company's interconnection agreements with BellSouth are scheduled to
terminate in June 1999 and the Company does not anticipate that BellSouth will
agree to renew the agreements in a manner consistent with the Company's existing
agreements as they relate to reciprocal compensation. However, the Company
intends to pursue such agreements vigorously and does not anticipate any
interruption in interconnection service. The Company's ultimate ability to
obtain such terms will depend on a number of factors, including the decision of
the FCC and state regulatory authorities.
Leases - The Company leases office premises in various locations under
operating lease arrangements. Total rent expense on these leases amounted to
$12, $180 and $1,853 in 1996, 1997 and 1998, respectively. The Company's
restricted cash balance as of December 31, 1998 serves as collateral for letters
of credit for some of these office leases.
Future minimum rental payments under operating leases having initial or
remaining noncancelable lease terms in excess of one year are as follows:
1999 $ 2,903
2000 2,886
2001 2,801
2002 2,794
2003 2,003
----------------
Total $ 13,387
================
Purchase Commitments - At December 31, 1998, the Company has outstanding
commitments to purchase switching equipment with an aggregate cost of $6,154.
7. INCOME TAXES
The provision for income taxes in 1998 consists of the following components:
Current - Charge equivalent to net tax benefit
of stock warrant exercise and
issuance of stock options $ 938
Deferred ----------------
Federal 6,702
State 1,665
----------------
8,367
----------------
Total provision for income taxes $ 9,305
================
<PAGE>
29
The reconciliation of the statutory federal income tax rate to the Company's
federal and state overall effective income tax rate is as follows:
Statutory federal rate 35.00%
State income taxes 5.30
Miscellaneous .63
------
Effective tax rate 40.93%
======
Deferred income taxes reflect the net tax effects of the temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for tax purposes. Significant components of the
Company's deferred tax assets and liabilities as of December 31, 1998 are as
follows:
Deferred tax assets:
Net operating loss carryforward $ 1,192
Deferred state taxes and other 584
Accrued expenses 328
---------
Total deferred tax assets 2,104
---------
Deferred tax liabilities:
Net deferred revenues 7,834
Depreciation and amortization 2,591
Other 46
---------
Total deferred tax liabilities 10,471
---------
Net deferred tax liability $ 8,367
=========
At December 31, 1998 the Company has federal and state net operating loss
carryforwards of approximately $2,771 expiring at the end of 2018 and 2003,
respectively.
8. RELATED PARTIES
In 1996, the Company advanced $200 to its majority stockholder. The amount was
repaid in January 1997. During 1997, the Company received services under
consulting agreements with two entities controlled by Company stockholders.
Under these agreements in fiscal 1997, the Company expensed $175 which is
included in selling, general and administrative expenses in the accompanying
financial statements. No such consulting agreements existed during the year
ended December 31, 1998.
During 1998, the Company's majority stockholder acquired an indirect
controlling interest in Metacomm. Metacomm is engaged in the business of
developing and operating a high-speed data network in North Carolina, and is a
customer of the Company and BellSouth. During 1998, the Company recorded $6,239
in revenue earned from services provided to Metacomm (which did not include
revenue from reciprocal compensation due from BellSouth, see Note 6). Metacomm
also earns commissions from the Company for reciprocal compensation revenue
relating to Metacomm's network. The Company recorded $19,759 in reciprocal
compensation commission expense earned by Metacomm, which is included in cost of
services in the accompanying financial statements. As of December 31, 1998, the
Company had a liability to Metacomm in the amount of $5,345, which is recorded
in accrued network costs in the accompanying financial statements. The Company
and Metacomm are parties to agreements by
<PAGE>
US LEC o The Competitive Telephone Company
US LEC Corp. and Subsidiaries
Notes to Consolidated Financial Statements
Period from June 6, 1996 (inception) to December 31, 1996
and years ended December 31, 1997 and 1998 (In Thousands, Except
Per Share Data)
30
which commissions earned by Metacomm related to reciprocal compensation would
not be paid to Metacomm until the related reciprocal compensation is collected
from the ILEC. However, in 1998, the Company paid Metacomm $8,256 prior to
collecting the earned reciprocal compensation from BellSouth. These payments are
subject to a repayment agreement if the related reciprocal compensation is
ultimately determined not to be collectible from BellSouth.
During 1998, the Company incurred $35 in expenses for chartered aircraft
services provided by the majority stockholder.
During 1998, the Company acquired $471 in software from Global Vista
Communications, LLC ("Global Vista"), a company controlled by the Company's
majority stockholder. In addition, the Company incurred $89 in expenses for
consulting services provided by Global Vista. As of December 31, 1998, a
liability totaling $6 was recorded in the Company's financial statements,
relating to software and consulting services purchased from Global Vista.
Company management believes that all of the above transactions were under
terms no less favorable to the Company than could be arranged with unrelated
parties.
9. EMPLOYEE BENEFIT PLAN
The Company has a 401(k) profit-sharing plan under which employees can
contribute up to 15% of their annual salary. For 1998, the Company made matching
contributions to the plan totaling $41 based on 50% of the first 6% of an
employee's contribution to the plan. There were no matching contributions made
in 1997.
10. STOCKHOLDERS' EQUITY
Common Stock - The Company has authorized two classes of common stock, Class A
and Class B. The rights of holders of the Class A Common Stock and the Class B
Common Stock are substantially identical, except that (i) holders of the Class A
Common Stock are entitled to one vote per share and holders of the Class B
Common Stock are entitled to ten votes per share; (ii) holders of the Class B
Common Stock vote as a separate class to elect two members of the Company's
Board of Directors in addition to voting with the holders of Class A Common
Stock in the election of the other members of the Board of Directors; and (iii)
the Class B Common Stock is fully convertible at any time into Class A Common
Stock, at the option of the holder, or automatically upon transfer to certain
third persons, on a one-for-one basis. Pursuant to an agreement among the Class
B stockholders, if a Class B stockholder proposes to sell or transfer Class B
Common Stock to anyone other than a permitted transferee (as defined in the
agreement), the other Class B stockholders who are parties to the agreement
would have a right to acquire the Class B Common Stock that is proposed to be
sold or transferred.
Preferred Stock - The Company is authorized to issue 10,000 shares of
preferred stock ($.01 par value) in one or more series without stockholder
approval, subject to any limitations prescribed by law. Each series of preferred
stock shall have such rights and preferences as shall be determined by the
Company's Board of Directors. No shares of preferred stock have been issued.
Capital Contribution - During 1997, the Company's majority stockholder
contributed an aggregate of $1,711 to additional paid-in capital. In addition,
during 1998, this stockholder exchanged a $5,000 loan for 481 shares of Class B
Common Stock (see Note 4).
Employee Stock Grants - In 1996, as part of the Company's organizational
activities, an aggregate of one thousand, five hundred and forty non-voting
limited liability company units were issued to encourage certain employees to
<PAGE>
31
join the Company. The Company recorded compensation expense of $28 in 1996 for
these units, based on the estimated fair value at the time the units were
issued.
Warrants - During 1997, the Company issued warrants to three employees to
purchase an aggregate of 345 shares of Class A Common Stock and a warrant to an
outside sales agent to purchase 99 shares of Class A Common Stock. All of these
warrants are fully vested and are exercisable at $2.86 per share for a
three-year period from the date of issuance. Management believes that these
employee warrants issued through October 1997 are noncompensatory based upon an
internal valuation of their fair value.
For the warrant issued in 1997 to the outside sales agent, the fair value
charged to expense was $24. The exercise price of those warrants is the same as
the issuance price in 1997 of shares to numerous outside investors. In November
1997, the Company granted to an employee a warrant to purchase 15 shares of
Class A Common Stock at an exercise price of $2.86 per share. This warrant was
fully vested at date of grant and exercisable over three years. Management
estimated the fair value of the warrant granted in November to be $6.00 per
share. As a result, compensation of $47 was charged to expense relating to the
difference between the fair value and the exercise price of the warrant on the
date of grant. In January 1998, the Company issued a warrant to a consultant to
purchase 25 shares of Class A Common Stock at $10 per share, exercisable at any
time through January 1, 2001. These warrants are fully vested and exercisable
over three years. The Company recorded compensation expense of $75 in 1998
associated with the warrant issued in January 1998. In June 1998, a former
executive officer of the Company exercised a warrant to purchase 165 shares of
Class A Common Stock for $2.86 per share.
Stock Option Plan - In January 1998, the Company adopted the US LEC Corp. 1998
Omnibus Stock Plan (the "Stock Plan"). In August 1998, the Company filed a
registration statement to register (i) 1,300 shares of Class A Common Stock
reserved for issuance under the Stock Plan and (ii) 180 shares of Class A Common
Stock reserved for issuance upon the exercise of nontransferable warrants
granted by the Company to employees. Under the Stock Plan, 1,300 shares of Class
A Common Stock have been reserved for issuance for stock options, stock
appreciation rights, restricted stock, performance awards or other stock-based
awards. Options granted under the Stock Plan are at exercise prices determined
by the Board of Directors or its Compensation Committee. For incentive stock
options, the option price may not be less than the market value of the Class A
Common Stock on the date of grant (110% of market value for greater than 10%
stockholders).
In January 1998, the Company granted incentive stock options to substantially
all employees to purchase an aggregate of 183 shares of Class A Common Stock at
$10 per share (fair market value on date of grant was $13 per share). These
options began vesting annually in four equal installments beginning in January
1999. The Company recorded deferred compensation of $548 in 1998 associated with
these options which will be amortized to compensation expense over the four-year
vesting period. During 1998, the Company amortized $105 to compensation expense
relating to these options, after consideration of forfeitures.
Also, during 1998, the Company granted to an employee, an option to purchase
360 shares of Class A Common Stock at $13 per share (fair market value on the
date of grant was $14 per share). The Company recorded deferred compensation of
$360 associated with these options and will amortize this amount to compensation
expense over the four year vesting period. During 1998, the Company amortized
$60 to compensation expense relating to these options. Also, during 1998, the
Company granted options to purchase 5 shares of Class A Common Stock at the fair
market value on the date of grant to each of the Company's two outside
directors. These options vested immediately upon grant.
<PAGE>
US LEC o The Competitive Telephone Company
US LEC Corp. and Subsidiaries
Notes to Consolidated Financial Statements
Period from June 6, 1996 (inception) to December 31, 1996
and years ended December 31, 1997 and 1998 (In Thousands, Except
Per Share Data)
32
Effective September 18, 1998, the Company repriced 744 options outstanding to
the fair value on such date of $7.31 per share. As a condition to the repricing,
these options (other than the directors' options) will now vest over four years
beginning at the repricing date.
A summary of the option and warrant activity is as follows:
<TABLE>
<CAPTION>
Options Warrants
------------------------------------------------------------------
Weighted Weighted Weighted Weighted
Average Average Average Average
Number Exercise Fair Value Number Exercise Fair Value
of Price at Date of of Price at Date of
Shares Per Share Grant Warrants Per Warrant Grant
- -------------------------------------------------------------------------------------------------------------
Balance, December 31, 1996
<S> <C> <C> <C> <C> <C> <C>
Granted at fair market value 429 $ 2.86 $ 2.86
Granted at less than fair market value 15 2.86 6.00
-----
Balance, December 31, 1997 (all exercisable) 444 2.86
Granted at fair market value* 1,324 $ 10.27 $ 3.95
Granted at less than fair
market value 575 11.88 6.89 25 10.00 $ 13.00
Exercised - (165) 2.86
Forfeited or cancelled* (817) 14.41 - -
---- -----
Balance, December 31, 1998 1,082 $ 8.00 304 $ 3.45
===== ====== === ========
</TABLE>
* Includes 744 options repriced
The Company measures the compensation cost of its stock option plan under the
provisions of Accounting Principles Board (APB) Opinion No. 25, "Accounting for
Stock Issued to Employees", as permitted under Statement of Financial Accounting
Standards (SFAS) No. 123, "Accounting for Stock-Based Compensation". Under the
provisions of APB No. 25, compensation cost is measured based on the intrinsic
value of the equity instrument awarded. Under the provisions of SFAS No. 123,
compensation cost is measured based on the fair value of the equity instrument
awarded.
Had compensation cost for the employee warrants and stock options been
determined consistent with SFAS No. 123, the Company's net earnings (loss) and
net earnings (loss) per share would approximate the following proforma amounts:
1997 1998
----------------------- ---------------------
As Reported Proforma As Reported Proforma
- ----------------------------------------------------------------------------
Net earnings (loss) $ (4,658) $(4,737) $13,427 $12,832
Earnings (loss) per share:
Basic (.25) (.25) .53 .51
Diluted (.25) (.25) .52 .50
<PAGE>
33
The Company estimated the fair value for both the stock options and the
warrants using the Black-Scholes model assuming no dividend yield in 1997 and
1998; volatility of 0% and 40% for 1997 and 1998, respectively, a risk-free
interest rate of 6.0% and 5.0% for 1997 and 1998, respectively, an expected life
of 18 months for the warrants and 5.8 years for the stock options. The weighted
average remaining contractual life of warrants and stock options outstanding at
December 31, 1998 was 20 months and 9.7 years, respectively.
A summary of the range of exercise prices and weighted average remaining lives
for options and warrants outstanding at December 31, 1998 is as follows:
<TABLE>
<CAPTION>
Options Outstanding
-----------------------------------------------
Weighted
Average Weighted
Range of Number of Remaining Average
Exercise Options Contractual Exercise
Price Outstanding Life Price
- ----------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Options granted at fair market value $7.31 917 9.7 years $ 7.31
9.50 11 9.8 years 9.50
11.25 25 9.9 years 11.25
12.38 115 10.0 years 12.38
---------
7.31 - 12.38 1,068 9.7 years 7.97
Options granted at less than fair market ---------
value 10.00 14 9.1 years 10.00
--------
Total options outstanding at
December 31, 1998 $7.31 - $12.38 1,082 9.7 years $ 8.00
========
<CAPTION>
Warrants Outstanding
------------------------------------------
Weighted
Average Weighted
Range of Number of Remaining Average
Exercise Warrants Contractual Exercise
Price Outstanding Life Price
- ---------------------------------------------------------------------------------------------------
Warrants granted at fair market value $2.86 264 19.1 months $ 2.86
Warrants granted at less than fair market value 2.86 15 22.4 months 2.86
10.00 25 24.1 months 10.00
---------
2.86 - 10.00 40 23.4 months 7.32
Total warrants outstanding at ---------
December 31, 1998 $2.86 - $10.00 304 19.7 months $ 3.45
</TABLE>
A summary of the number of options and warrants exercisable and the weighted
average exercise price at December 31, 1998 is as follows:
Weighted
Average
Options Exercise
Exercisable Price
- -------------------------------------------------------------------------------
Options granted at fair market value 10 $7.31
Options granted at less than fair market value - -
-------------------
Total options exercisable at December 31, 1998 10 $7.31
===================
<PAGE>
US LEC o The Competitive Telephone Company
US LEC Corp. and Subsidiaries
Notes to Consolidated Financial Statements
Period from June 6, 1996 (inception) to December 31, 1996
and years ended December 31, 1997 and 1998
(In Thousands, Except Per Share Data)
34
Weighted
Average
Warrants Exercise
Exercisable Price
- ------------------------------------------------------------------------------
Warrants granted at fair market value 264 $ 2.86
Warrants granted at less than fair market value 40 7.32
---------------------
Total warrants exercisable at December 31, 1998 304 $ 3.45
=====================
11. EARNINGS (LOSS) PER SHARE
Earnings (loss) per common and common equivalent share have been calculated in
accordance with SFAS 128, "Earnings Per Share," and are based on net income
(loss) divided by the weighted average shares outstanding during the period. The
weighted average shares outstanding used in the calculation has been determined
by giving retroactive effect to the merger of the predecessor limited liability
company into the Company, which occurred on December 31, 1997 (based on the
share conversion ratios utilized in the merger). Outstanding options and
warrants are included in the calculation of diluted earnings per common share to
the extent they are dilutive. Securities and Exchange Commission Staff
Accounting Bulletin No. 98 requires that equity instruments granted at nominal
amounts for periods prior to the filing of the registration statement be
included in the calculation of per share data as if outstanding for all periods
presented. Accordingly, the weighted average shares used in the calculation of
basic and diluted earnings (loss) per share includes two thousand, three hundred
and ten shares (two limited liability company units) granted in 1996 to
employees, as if such shares were outstanding for the entire period.
Following is the reconciliation of earnings (loss) per share for 1996,
1997 and 1998:
1996 1997 1998
- ------------------------------------------------------------------------------
Basic earnings (loss) per share:
Net earnings (loss) $ (963) $(4,658) $13,427
Weighted average shares outstanding 17,310 18,653 25,295
------------------------------
Basic earnings (loss) per share $ (.06) $ (.25) $ .53
==============================
Diluted earnings (loss) per share:
Net earnings (loss) $ (963) $(4,658) $13,427
==============================
Weighted average shares outstanding 17,310 18,653 25,295
Dilutive effect of stock options - - 214
Dilutive effect of warrants - - 295
------------------------------
Weighted average shares, adjusted 17,310 18,653 25,804
==============================
Diluted earnings (loss) per share $ (.06) $ (.25) $ .52
===============================
<PAGE>
35
12.QUARTERLY FINANCIAL DATA (UNAUDITED)
The following table summarizes the Company's results of operations as
presented in the consolidated statements of operations by quarter for 1997 and
1998. Amounts below exclude per share data for periods prior to the completion
of the Company's initial public offering:
Quarter Ended
------------------------------------------
March 31, June 30, Sept. 30, Dec. 31,
1998 1998 1998 1998
- --------------------------------------------------------------------------------
Year ended December 31, 1998:
Revenue, Net $ 13,630 $18,348 $22,291 $30,447
Cost of Services 6,473 7,537 7,296 12,340
-------------------------------------------
Gross Margin 7,157 10,811 14,995 18,107
Selling, General and Administrative 4,426 5,747 6,690 8,157
Depreciation and Amortization 442 925 1,547 2,027
-------------------------------------------
Earnings from Operations 2,289 4,139 6,758 7,923
Interest Income (Expense), Net (90) 596 704 413
-------------------------------------------
Earnings Before Income Taxes 2,199 4,735 7,462 8,336
Provision for Income Taxes 880 1,905 2,999 3,521
-------------------------------------------
Net Earnings $ 1,319 $2,830 $4,463 $ 4,815
==========================================-
Net Earnings per Share:
Basic $ .11 $ .16 $ .18
==============================
Diluted $ .11 $ .16 $ .17
==============================
Weighted Average Shares Outstanding:
Basic 25,548 27,420 27,420
==============================
Diluted 26,082 27,905 28,016
==============================
Quarter Ended
-----------------------------------------
March 31, June 30, Sept. 30, Dec. 31,
1997 1997 1997 1997
- --------------------------------------------------------------------------------
Year ended December 31, 1997:
Revenue $ 1 $ 229 $ 1,530 $ 4,698
Cost of Services 423 315 1,075 2,388
------------------------------------------
Gross Margin (loss) (422) (86) 455 2,310
Selling, General and Administrative 1,049 1,048 1,294 2,726
Depreciation and Amortization 14 88 125 216
------------------------------------------
Loss from Operations (1,485) (1,222) (964) (632)
Interest Expense, Net 67 108 102 78
------------------------------------------
Net Loss $(1,552) $(1,330) $(1,066) $ (710)
===========================================
<PAGE>
US LEC o The Competitive Telephone Company
Independent Auditors' Report
36
Board of Directors
US LEC Corp.
Charlotte, North Carolina
We have audited the accompanying consolidated balance sheets of US LEC Corp.
(the "Company") and subsidiaries as of December 31, 1997 and 1998, and the
related consolidated statements of operations, stockholders' equity
(deficiency), and cash flows for the period from June 6, 1996 (inception) to
December 31, 1996 and the years ended December 31, 1997 and 1998. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such financial statements present fairly, in all material
respects, the financial position of US LEC Corp. and subsidiaries as of December
31, 1997 and 1998, and the results of their operations and their cash flows for
the period from June 6, 1996 (inception) to December 31, 1996 and the years
ended December 31, 1997 and 1998 in conformity with generally accepted
accounting principles.
As discussed in Note 6 to the financial statements, a significant portion of
the Company's accounts receivable and revenues relate to reciprocal compensation
which is currently in dispute.
/s/ DELOITTE & TOUCHE, LLP
-----------------------
February 6, 1999 (February 26, 1999 as to Note 6)
Charlotte, North Carolina
<PAGE>
Board of Directors
- --------------------------------------------------------------------------------
Richard T. Aab David M. Flaum (1)(2)
Chairman of the Board and President
Chief Executive Officer Flaum Management
US LEC Corp. Company, Inc.
Tansukh V. Ganatra Steven L. Schoonover (1)(2)
President and Chief President and Chief
Operating Officer Executive Officer
US LEC Corp. CellXion, Inc.
(1) Member of Audit Committee
(2) Member of Compensation Committee
Executive Officers
- --------------------------------------------------------------------------------
Richard T. Aab
Chairman of the Board and
Chief Executive Officer
Tansukh V. Ganatra
President and Chief
Operating Officer
Michael K. Robinson
Executive Vice President -
Chief Financial Officer
Gary D. Grefrath
Executive Vice President -
Administration
David C. Conner
Executive Vice President -
Engineering and Operations and
Chief Technology Officer
Michael K. Simmons
Executive Vice President -
Corporate Development
Aaron D. Cowell, Jr.
Executive Vice President,
General Counsel and
Secretary
Craig K. Simpson
Executive Vice President -
Sales
Corporate Information
- --------------------------------------------------------------------------------
Form 10-K/Investor Contact
A copy of the Company's Annual Report on Form 10-K, filed with the Securities
and Exchange Commission, may be obtained from the Company at no charge. Requests
for the Annual Report on Form 10-K and other investor contacts should be
directed to Michael K. Robinson, Executive Vice President and Chief Financial
Officer, at the Company's corporate office.
Common Stock and Dividend Information
The Company's common stock trades on The Nasdaq National Market under the symbol
CLEC. As of March 8, 1999, US LEC Corp. had approximately 6,744 beneficial
holders of its common stock. Of that total, 148 were stockholders of record. To
date, the Company has not paid cash dividends on its common stock. The Company
currently intends to retain earnings to support operations and finance expansion
and therefore does not anticipate paying cash dividends in the foreseeable
future.
The following table sets forth the high and low sales price information as
reported by Nasdaq during the period indicated since the Company's common stock
began trading publicly on April 24, 1998.
Stock Price*
1998 High Low
- ------------------------------------------------------------------------------
First Quarter N/A N/A
Second Quarter $27.00 $15.00
Third Quarter $25.88 $7.31
Fourth Quarter $14.81 $9.50
*No public market for the stock prior to April 24, 1998
Annual Stockholders' Meeting
The annual meeting of stockholders will be held on
Tuesday, April 20, 1999, at 10:00 a.m. local time at the
Company's corporate office.
Corporate Office
US LEC Corp.
Transamerica Square
401 North Tryon Street, Suite 1000
Charlotte, North Carolina 28202
704-319-1000
Internet Address
http://www.uslec.com
Registrar and Transfer Agent
First Union National Bank
Charlotte, North Carolina
Independent Auditors
Deloitte & Touche LLP
Charlotte, North Carolina
Legal Counsel
Moore & Van Allen, PLLC
Charlotte, North Carolina
Swidler Berlin Shereff Friedman, LLP
Washington, D.C.
EXHIBIT 21
SUBSIDIARIES OF REGISTRANT
US LEC of North Carolina Inc. (North Carolina Corporation)
US LEC of Georgia Inc. (Delaware Corporation)
US LEC of Tennessee Inc. (Delaware Corporation)
US LEC of Florida Inc. (North Carolina Corporation)
US LEC of South Carolina Inc. (Delaware Corporation)
US LEC of Alabama Inc. (North Carolina Corporation)
US LEC of Maryland Inc. (North Carolina Corporation)
US LEC of Pennsylvania Inc. (North Carolina Corporation)
US LEC of Virginia L.L.C. (Delaware Limited Liability Company)
EXHIBIT 23
INDEPENDENT AUDITORS' CONSENT
US LEC Corp.
We consent to the incorporation by reference in Registration Statement
No. 333-6167 of US LEC Corp. and subsidiaries on Form S-8 of our report dated
February 6, 1999 (February 26, 1999 as to Note 6), which report includes an
emphasis of a matter paragraph as to a significant portion of the Company's
accounts receivables and revenues relating to reciprocal compensation currently
in dispute; incorporated by reference in this annual Report on Form 10-K of US
LEC Corp. and subsidiaries for the year ended December 31, 1998.
DELOITTE & TOUCHE LLP
Charlotte, North Carolina
March 30, 1999
<TABLE> <S> <C>
<ARTICLE> 5
<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> DEC-31-1998
<CASH> 0
<SECURITIES> 0
<RECEIVABLES> 78,238
<ALLOWANCES> 12,024
<INVENTORY> 0
<CURRENT-ASSETS> 112,184
<PP&E> 61,277
<DEPRECIATION> 5,058
<TOTAL-ASSETS> 170,203
<CURRENT-LIABILITIES> 35,969
<BONDS> 0
0
0
<COMMON> 274
<OTHER-SE> 112,701
<TOTAL-LIABILITY-AND-EQUITY> 170,203
<SALES> 0
<TOTAL-REVENUES> 84,716
<CGS> 0
<TOTAL-COSTS> 33,646
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 237
<INCOME-PRETAX> 22,732
<INCOME-TAX> 9,305
<INCOME-CONTINUING> 0
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 13,427
<EPS-PRIMARY> 0.53
<EPS-DILUTED> 0.52
</TABLE>
