SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 1999
Commission file number 0-24061
US LEC Corp.
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(Exact name of registrant as specified in its charter)
Delaware
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(State or other jurisdiction of incorporation or organization)
56-2065535
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(I.R.S. Employer Identification No.)
Transamerica Square, 401 North Tryon Street, Suite 1000
-------------------------------------------------------
Charlotte, North Carolina 28202
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(Address of principal executive offices) (Zip Code)
(704) 319-1000
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(Registrant's telephone number, including area code)
N/A
---
(Former name, former address and former fiscal year,
if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes ( X ) No ( )
- --------------------------------------------------------------------------------
As of November 12, 1999, there were 10,361,100 shares of Class A Common Stock
and 17,075,270 shares of Class B Common Stock outstanding.
1
<PAGE>
US LEC CORP.
TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
Condensed Consolidated Statements of Operations - Three and nine month periods
ended September 30, 1999 and 1998
Condensed Consolidated Balance Sheets - September 30, 1999 and December 31, 1998
Condensed Consolidated Statements of Cash Flows - Nine month periods ended
September 30, 1999 and 1998
Condensed Consolidated Statement of Stockholders' Equity - Nine month period
ended September 30, 1999
Notes to Condensed Consolidated Financial Statements
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
ITEM 5. OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
SIGNATURES
2
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US LEC Corp. and Subsidiaries
Condensed Consolidated Statements of Operations
(In Thousands, Except Per Share Data)
(Unaudited)
<TABLE>
<CAPTION>
Three months Nine months
ended September 30, ended September 30,
1999 1998 1999 1998
-------- -------- --------- --------
<S> <C> <C> <C> <C>
Revenue, Net $ 47,348 $ 22,291 $ 127,113 $ 54,269
Cost of Services 19,524 7,296 53,987 21,306
-------- -------- --------- --------
Gross Margin 27,824 14,995 73,126 32,963
Selling, General and Administrative Expenses 13,707 6,690 35,180 16,863
Depreciation and Amortization 3,124 1,547 8,121 2,914
-------- -------- --------- --------
Earnings from Operations 10,993 6,758 29,825 13,186
Other (Income) Expense
Interest Income (164) (705) (938) (1,434)
Interest Expense 785 1 1,952 224
-------- -------- --------- --------
Earnings Before Income Taxes 10,372 7,462 28,811 14,396
Provision for Income Taxes 4,170 2,999 11,619 5,784
-------- -------- --------- --------
Net Earnings $ 6,202 $ 4,463 $ 17,192 $ 8,612
======== ======== ========= ========
Net Earnings Per Common Share:
Basic $ 0.23 $ 0.16 $ 0.63 $ 0.35
======== ======== ========= ========
Diluted $ 0.22 $ 0.16 $ 0.61 $ 0.34
======== ======== ========= ========
Weighted Average Number of Shares Outstanding:
Basic 27,428 27,420 27,426 24,579
======== ======== ========= ========
Diluted 28,520 27,905 28,367 25,032
======== ======== ========= ========
</TABLE>
See notes to condensed consolidated financial statements
3
<PAGE>
US LEC Corp. and Subsidiaries
Condensed Consolidated Balance Sheets
(In Thousands, Except Share Data)
<TABLE>
<CAPTION>
(Unaudited)
September 30, December 31,
1999 1998
------------------- -------------------
<S> <C> <C>
Assets
Current Assets
Cash and cash equivalents $ 8,056 $ 41,965
Restricted cash 1,172 1,167
Accounts receivable (net of allowance of $33,425 at
September 30, 1999 and $12,024 at December 31, 1998) 158,677 66,214
Prepaid expenses and other assets 1,804 2,838
------------------- -------------------
Total current assets 169,709 112,184
Property and Equipment, Net 86,249 56,219
Other Assets 2,419 1,800
------------------- -------------------
Total Assets $ 258,377 $ 170,203
=================== ===================
Liabilities and Stockholders' Equity
Current Liabilities:
Accounts payable $ 28,122 $ 13,509
Deferred revenue 1,490 829
Accrued network costs 28,520 9,866
Deferred income taxes 13,829 7,108
Accrued expenses - other 10,603 4,657
------------------- -------------------
Total current liabilities 82,564 35,969
------------------- -------------------
Deferred Income Taxes 5,388 1,259
Long-Term Debt 40,000 20,000
Stockholders' Equity
Common stock-Class A, $.01 par value (72,925 authorized
shares, 10,359 outstanding at September 30, 1999) 104 103
Common stock-Class B, $.01 par value (17,075 authorized
shares, 17,075 outstanding at September 30, 1999) 171 171
Additional paid-in capital 106,904 106,800
Retained earnings 23,246 5,901
------------------- -------------------
Total stockholders' equity 130,425 112,975
------------------- -------------------
Total Liabilities and Stockholders' Equity $ 258,377 $ 170,203
=================== ===================
</TABLE>
See notes to condensed consolidated financial statements
4
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US LEC Corp. and Subsidiaries
Condensed Consolidated Statements of Cash Flows
(In Thousands) (Unaudited)
<TABLE>
<CAPTION>
Nine Months Ended
September 30,
1999 1998
--------- ---------
<S> <C> <C>
Operating Activities
Net earnings $17,192 $8,612
--------- --------
Adjustments to reconcile net earnings to net cash used in operating activities:
Depreciation and amortization 8,121 2,914
Accounts receivable allowance 21,401 6,007
Stock compensation - 75
Disposal of Property & Equipment 120 32
Deferred compensation 153 91
Deferred income taxes 10,869 -
Changes in assets and liabilities which provided (used) cash:
Accounts receivable (113,864) (45,180)
Prepaid expenses and other assets 933 (516)
Accounts payable 11,787 2,003
Deferred revenue 661 (630)
Accrued network costs 18,654 8,001
Accrued expenses - other 5,308 3,946
--------- --------
Total adjustments (35,857) (23,257)
--------- --------
Net cash used in operating activities (18,665) (14,645)
--------- --------
Investing Activities
Purchase of property and equipment (34,356) (38,490)
Restricted cash (5) (828)
--------- --------
Net cash used in investing activities (34,361) (39,318)
--------- --------
Financing Activities
Proceeds from public stock offering - 87,142
Proceeds from exercise of stock options and warrants 85 472
Proceeds from long-term debt 20,000 -
Payment of loan fees (968) -
--------- --------
Net cash provided by financing activities 19,117 87,614
--------- --------
Net (Decrease) Increase in Cash and Cash Equivalents (33,909) 33,651
Cash and Cash Equivalents, Beginning of Period 41,965 3,189
--------- --------
Cash and Cash Equivalents, End of Period $ 8,056 $ 36,840
========= ========
Supplemental Cash Flow Disclosures
Cash Paid for Interest $ 1,816 $ 505
========= ========
Cash Paid for Taxes $ - $1,860
========= ========
</TABLE>
See notes to condensed consolidated financial statements
5
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US LEC Corp. and Subsidiaries
Condensed Consolidated Statement of Stockholders' Equity
For the Nine Months Ended September 30, 1999
(In Thousands)
(Unaudited)
<TABLE>
<CAPTION>
Class A Class B Additional Retained
Common Stock Common Stock Paid-in Capital Earnings Total
------------ ------------ --------------- -------- ---------
<S> <C> <C> <C> <C> <C>
Balance, December 31, 1998 $ 103 $ 171 $ 106,800 $ 5,901 $ 112,975
Exercise of stock options and warrants 1 - 85 - 86
Tax effect related to warrants and options - - 19 - 19
Unearned Compensation - Stock Options - - 153 153
Net earnings - - - 17,192 17,192
------------ ------------ --------------- -------- ---------
Balance, September 30, 1999 $ 104 $ 171 $ 106,904 $ 23,246 $ 130,425
============ ============ =============== ======== =========
</TABLE>
See notes to condensed consolidated financial statements
6
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US LEC CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES
The accompanying unaudited condensed consolidated financial statements
of US LEC Corp. and its subsidiaries ("US LEC" or the "Company") have been
prepared in accordance with generally accepted accounting principles for interim
financial information and the instructions to Form 10-Q and Article 10 of
Regulation S-X. Accordingly, they do not include all of the information and
notes required by generally accepted accounting principles for complete
financial statements. In the opinion of management, all adjustments considered
necessary for a fair presentation for the periods indicated have been included.
Operating results for the three and nine month periods ended September 30, 1999
are not necessarily indicative of the results that may be expected for the year
ending December 31, 1999. The balance sheet at December 31, 1998 has been
derived from the audited balance sheet at that date, but does not include all of
the information and notes required by generally accepted accounting principles
for complete financial statements. The accompanying financial statements should
be read in conjunction with the audited consolidated financial statements and
related notes thereto included in the Company's Annual Report on Form 10-K for
the year ended December 31, 1998, which is on file with the U.S. Securities and
Exchange Commission (the "SEC"). Certain amounts in the 1998 financial
statements have been reclassified to conform to the 1999 presentation.
2. RESTRICTED CASH
The restricted cash balance as of September 30, 1999 and December 31, 1998
serves as collateral for letters of credit related to certain office leases.
3. EARNINGS PER COMMON AND COMMON EQUIVALENT SHARE
Earnings per common and common equivalent share are based on net income
divided by the weighted average common shares outstanding during the period.
Outstanding options and warrants are included in the calculation of dilutive
earnings per common share to the extent they are dilutive. The Company's basic
and diluted weighted average number of shares (in thousands of shares) for the
three and nine month periods ended September 30, 1999 and 1998 were as follows:
<TABLE>
<CAPTION>
Three Months Nine Months
Ended September 30 Ended September 30
1999 1998 1999 1998
------ ------- ------- ------
<S> <C> <C> <C> <C>
Basic Weighted Average Number of Shares Outstanding 27,428 27,420 27,426 24,579
Dilutive Stock Options 831 237 689 133
Dilutive Stock Warrants 261 248 252 320
------ ------ ------ ------
Diluted Weighted Average Number of Shares Outstanding 28,520 27,905 28,367 25,032
====== ====== ====== ======
</TABLE>
7
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS --- (CONTINUED)
4. INCOME TAXES
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.
5. LONG-TERM DEBT
On June 30, 1999, the Company amended the existing senior secured loan
agreement with General Electric Capital Corporation and First Union National
Bank to increase the amount available under the loan agreement from $50.0
million to $75.0 million. The credit facility is now comprised of (i) a $50.0
million revolving credit facility with a term of one year and an option to
convert into a seven-year term loan on the termination date and (ii) a $25.0
million reducing revolving credit facility with a nine-year term. The interest
rate for the facility is a floating rate based, at the Company's option, on a
base rate (as defined in the loan agreement) or the London Interbank Offered
Rate, plus a specified margin. The amount outstanding under the credit facility
at September 30, 1999 was $40.0 million. Advances under the agreement as of
September 30, 1999 bear interest at an annual rate of approximately 9.1%. The
credit facility is subject to certain financial covenants, the most significant
of which relate to the maintenance of levels of revenue, earnings and debt
ratios. The credit facility is secured by a pledge of the capital stock of the
Company's principal operating subsidiaries and a security interest in a
substantial portion of the Company's and its operating subsidiaries' equipment,
receivables, leasehold improvements and general intangibles. Proceeds from the
credit facility have been and will be used to fund capital expenditures and
working capital requirements and for other general corporate purposes.
6. COMMITMENTS AND CONTINGENCIES
DISPUTED RECIPROCAL COMPENSATION REVENUE - A majority of the Company's
revenue is derived from reciprocal compensation amounts due from incumbent local
exchange carriers ("ILECs"), principally BellSouth Telecommunications, Inc.
("BellSouth"). In August 1997, BellSouth notified the Company and other
competitive local exchange carriers ("CLECs") that it considered traffic
terminated to Enhanced Service Providers ("ESPs"), including Internet service
providers ("ISPs"), to be interstate traffic, and therefore not subject to
reciprocal compensation, and that BellSouth would not pay (or bill) reciprocal
compensation under interconnection agreements for this traffic. BellSouth is
disputing the portion of reciprocal compensation billed by the Company related
to the transport and termination of local traffic from its customers to ESPs,
including ISPs and information service providers primarily on the basis that
such traffic does not terminate in the same local exchange and, as described
below, the portion of the billings related to traffic on certain networks
(collectively referred to as "Disputed Reciprocal Compensation"). The Company
recorded Disputed Reciprocal Compensation revenue of approximately $42 million,
$24 million and $69 million for fiscal 1998, respectively, and the three and
nine months ended September 30, 1999, net of a $12 million, $7 million and $21
million allowance, respectively. Management believes that the Company has earned
and is legally entitled to this revenue and payments are due from BellSouth
pursuant to the interconnection agreements that BellSouth has with the Company.
On February 26, 1998, following a petition by the Company, the North
Carolina Utilities Commission (the "NCUC") ordered BellSouth to bill and pay for
all such traffic (the "NCUC Order"). 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 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 related issues
by the Federal Communications Commission ("FCC"). This action was filed against
the Company and the NCUC. In June 1999, the U.S. District Court dismissed
BellSouth's petition without prejudice and remanded back to the NCUC for further
8
<PAGE>
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS --- (CONTINUED)
review. Following the U.S District Court's remand, on June 22, 1999, the NCUC
denied BellSouth's request for a further stay of the NCUC Order. On July 16,
1999, the Company received an $11.2 million payment from BellSouth for a portion
of the Disputed Reciprocal Compensation earned from North Carolina operations,
and subject to the NCUC Order.
Other than denying BellSouth's request for a further stay, the only
action taken by the NCUC with respect to the remand from the U.S. District Court
is that the NCUC filed an appeal with the U.S. Fourth Circuit Court of Appeals
(the "4th Circuit") a notice of appeal of the U.S. District Court's order that
rejected the NCUC's claims, including its claim that the 11th Amendment to the
United States Constitution bars BellSouth from making the NCUC a party to this
proceeding in the federal courts. The Company has also appealed and the United
States Justice Department has intervened in the appeal. As of the date of this
filing, no action has yet been taken by the 4th Circuit in connection with this
appeal.
In February 1999, the FCC issued a declaratory ruling (the "FCC
Ruling") which concluded that for jurisdictional purposes most calls delivered
to ISPs should be deemed to continue to internet web sites, which are often
located in other states. Thus, the FCC ruled that such calls are
jurisdictionally "interstate" in nature. However, the FCC further declared that
where parties have agreed in interconnection agreements that reciprocal
compensation must be paid for traffic bound for ISPs, the parties should be
bound by those agreements, as interpreted and enforced by state regulatory
bodies. The FCC also recognized that some commissions may reconsider their
decisions in light of its ruling. As noted, the NCUC had ruled on February 26,
1998 in favor of the Company with respect to payment for traffic bound to ISPs
under the Company's first interconnection agreement with BellSouth. To date,
state regulatory bodies in at least eighteen different states have considered
the effect of the FCC Ruling and have overwhelmingly reaffirmed their earlier
decisions requiring payment of reciprocal compensation for this type of traffic
or for the first time determined that such compensation is due. Included among
these states are Alabama and Florida, both of which are in BellSouth's operating
territory. In this regard, the Alabama Public Service Commission concluded that
the treatment of ISP traffic as local was so prevalent in the industry at the
time BellSouth entered into interconnection agreements with CLECs that, if it is
so intended, BellSouth had an obligation to negate such local treatment in the
agreements by specifically delineating that ISP traffic was not local traffic
subject to the payment of reciprocal compensation. The Florida Public Service
Commission reached a similar conclusion. In an arbitration of the terms of a new
interconnection agreement between BellSouth and another CLEC, the NCUC recently
determined that, until the FCC issues a definitive ruling pursuant to the notice
of proposed rulemaking which was part of the FCC Ruling, reciprocal compensation
should continue to be paid under the new interconnection agreement. While US LEC
was not a party to this arbitration, management believes this decision to be
favorable in light of the remand (discussed above).
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 from BellSouth. Also on September 14, 1998,
BellSouth filed a complaint with the NCUC seeking to be relieved from its
obligations under its interconnection agreement with the Company to pay
reciprocal compensation for traffic related to networks including that operated
by Metacomm, LLC ("Metacomm"), a customer of BellSouth and the Company and, as
of June 1998, a related party of the Company. The two proceedings were
consolidated for purposes of discovery, which concluded June 16, 1999, and
hearings concluded in August 1999 with respect to BellSouth's complaint.
Hearings concerning US LEC's complaint have been continued by the NCUC pending
an order in the BellSouth complaint. The BellSouth proceeding primarily involves
the treatment of traffic over a network established by Metacomm and whether,
under the interconnection agreements between the Company and BellSouth and the
Telecommunications Act of 1996 (the "Telecom Act"), BellSouth is required to pay
reciprocal compensation to the Company for traffic associated with this network,
or whether BellSouth has breached its interconnection agreements with the
Company by failing to pay reciprocal compensation for this traffic.
In the NCUC proceedings filed September 14, 1998, BellSouth claims
principally that the traffic on Metacomm's network does not qualify for
reciprocal compensation because the Metacomm network was designed to generate
reciprocal compensation and that such traffic does not constitute
"telecommunications"
9
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS --- (CONTINUED)
subject to the reciprocal compensation payment provisions of the Telecom Act and
the Company's interconnection agreements with BellSouth. In addition BellSouth's
has identified other issues on which it bases its claim that the traffic on the
Metacomm network is not compensable, including (1) that the Company agreed to
share reciprocal compensation with Metacomm, (2) that, as disclosed in the
Company's Form 10-Q for the period ended September 30, 1998, Richard T. Aab, the
largest shareholder of the Company and the Chairman of its Board of Directors,
acquired a controlling interest in Metacomm, (3) that the reciprocal
compensation has been billed on an "always-on" basis even though there is no
measurement of the amount of data traversing the network that is originated by
customers of Metacomm, (4) that a portion of the billed traffic includes traffic
during periods when Metacomm had not yet connected customers to its network or
when customers of Metacomm may not have been sending data over the network, (5)
that the Metacomm network includes facilities that cross LATA boundaries and,
therefore, data traversing these facilities is not local (and, therefore, is
ineligible for reciprocal compensation), (6) that Metacomm is a reseller of US
LEC's services, not an end-user, and (7) that the Metacomm network is a
quasi-dedicated network which should not be eligible for reciprocal
compensation.
It is the Company's understanding that Metacomm is engaged in the
business of developing and operating a high-speed, always-on data network in
North Carolina and its network provides users with continuous access to data,
wide area network services, software applications and other services, including
access to the Internet. In the course of the these proceedings, the Company
concluded, based on positions taken and information provided by Metacomm, that
Metacomm's related traffic should not be considered to be solely ISP traffic
because its network provides additional services and functions to users.
Notwithstanding this determination, the Company believes BellSouth will continue
to contend the Disputed Reciprocal Compensation related to the Metacomm network
traffic is subject, in the first instance, to the resolution of the ISP issue.
The Company has recorded approximately $50 million, $25 million and $75 million
of gross revenue, before allowances and before late payment charges, for fiscal
1998 and the three and nine months ended September 30, 1999, respectively,
related to reciprocal compensation revenue generated as a result of Metacomm
network traffic.
When the Metacomm network was originally developed, the Company agreed
to pay Metacomm commissions equal to a specified percentage of the reciprocal
compensation the Company receives from ILEC's for the network traffic. The
Company recorded approximately $20 million, $10 million and $30 million for
fiscal 1998 and the three and nine months ended September 30, 1999,
respectively, in reciprocal compensation commission expense earned by Metacomm,
which is included in cost of services in the accompanying financial statements.
As of September 30, 1999, the Company had a liability to Metacomm in the amount
of $19 million, which is recorded in accrued network costs in the accompanying
financial statements. The Company and Metacomm are parties to agreements by
which commissions earned by Metacomm related to reciprocal compensation are not
payable until the related reciprocal compensation is collected from the ILEC.
However, in fiscal 1998 and the three and nine months ended September 30, 1999,
the Company paid Metacomm $8 million, $3 million and $9 million prior to
collecting the earned reciprocal compensation from BellSouth. These payments are
subject to a repayment agreement if the related reciprocal compensation is
ultimately not collected from BellSouth.
The Company believes that calls to establish, maintain and manage data
network connections and intra-network communications generated by data
processing routers, which are necessary to maintain the functionality and
integrity of the Metacomm network, are within the definition of
"telecommunications" under the Telecom Act and constitute compensable traffic
subject to reciprocal compensation under the interconnection agreements the
Company has with BellSouth. The Company also believes that the issues raised by
BellSouth as additional bases for nonpayment do not excuse BellSouth from its
obligation to pay reciprocal compensation under its interconnection agreement
with the Company. Accordingly, the Company intends to defend vigorously against
BellSouth's claims and to prosecute vigorously its claims against BellSouth in
the above proceedings.
As noted above, on July 16, 1999, the Company received a payment of
$11.2 million from BellSouth representing a portion of the amounts due the
Company for ISP reciprocal compensation in North Carolina. In making the
payment, BellSouth stated that it was for ISP traffic the NCUC had ordered it to
pay for in February
10
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS --- (CONTINUED)
1998, including late fees, and that it was reserving all of its appeal rights
with respect to the payment. BellSouth also stated that this payment did not
include any amounts at issue in its September 14, 1998 NCUC proceeding. This
partial payment did not cover all outstanding amounts the Company claims are due
from BellSouth in North Carolina and other states the Company serves. For
example, while the Company has outstanding amounts due from BellSouth for ISP
and other traffic in Tennessee, Georgia and Florida, BellSouth has not paid
these amounts, presumably because no orders specific to US LEC have been entered
by state commissions in those states directing BellSouth to pay the Company.
However, state commissions in these states have issued rulings in favor of other
competitive carriers, and as discussed above, the state commissions in Florida
and Alabama have made rulings subsequent to the FCC Ruling. To address this
issue, the Company has filed the following additional actions against BellSouth
related to delinquent reciprocal compensation payments, none of which involve
Metacomm or any similar network:
o On July 1, 1999, the Company filed a complaint against BellSouth
before the Georgia Public Service Commission ("GAPSC").
o On July 2, 1999, the Company filed a complaint against BellSouth
before the Florida Public Service Commission ("FLPSC").
o On August 6, 1999, the Company filed a complaint against BellSouth
before the Tennessee Regulatory Authority ("TRA").
The proceedings before the GPSC, the FLPSC and the TRA are all in early
stages.
Management believes that the Company will ultimately obtain favorable
results in the state proceedings described above before the NCUC, GAPSC, FLPSC
and the TRA; 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 any of the state commissions, and in particular the NCUC, or in
any appeal or review of a favorable decision by the U.S. District Court, state
commissions, or the FCC, or if either the FCC or any of the applicable state
commissions 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 gross trade accounts receivable as of
September 30, 1999 included approximately $146 million of earned but uncollected
Disputed Reciprocal Compensation (before a $33 million allowance and before late
payment charges) of which approximately $125 million was generated as a result
of traffic related to the Metacomm network.
In June 1999, the Company adopted an existing agreement to extend local
interconnection with BellSouth replacing the previous interconnection agreement,
which expired on June 15, 1999. The adopted interconnection agreement with
BellSouth is scheduled to terminate on December 31, 1999. The Company's ability
to obtain favorable terms for interconnection following December 31, 1999 will
depend on a number of factors, including decisions of the FCC and state
regulatory authorities. However, the Company intends to pursue such agreements
vigorously and does not anticipate any interruption in interconnection service.
11
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS --- (CONTINUED)
7. STOCKHOLDERS' EQUITY
INITIAL PUBLIC OFFERING -- In the second quarter of 1998, US LEC
completed an offering of 6.3 million shares of Class A Common Stock (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.
STOCK OPTIONS -- The Company adopted the US LEC Corp. Omnibus Stock
Plan (the "Plan") in January 1998. At the Annual Meeting of the Stockholders
held on April 20, 1999, the Company's stockholders voted to amend the Plan to
increase the number of Class A Common Stock reserved for issuance under the
Plan from 1.3 million to 2.0 million shares. As of September 30, 1999, the
Company had granted stock options, net of forfeitures, to purchase an aggregate
of 1.4 million shares of Class A Common Stock.
12
<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
Except for historical information, this report contains forward-looking
statements subject to uncertainties and risks, and as a result, the actual
results of US LEC Corp. and its subsidiaries ("US LEC" or the "Company") 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, issues
related to Year 2000, uncertainties regarding its dealings with 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 summarized in the "Forward-Looking Statements and
Risk Factors" section and elsewhere in the Company's annual report on Form 10-K
for the period ended December 31, 1998, and in other reports which are on file
with the U.S. Securities and Exchange Commission.
OVERVIEW
US LEC is a rapidly growing 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, enhanced service providers ("ESPs"), including Internet service
providers ("ISPs"), and government agencies. US LEC was founded in June 1996
after passage of the Telecommunications Act of 1996 ("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. US LEC
currently provides local, long-distance, data and enhanced services to customers
in selected markets in North Carolina, Florida, Georgia, Tennessee, Virginia,
Alabama, Pennsylvania and Mississippi. In addition, US LEC is currently
certified to provide telecommunications services in South Carolina, Washington,
D.C., Maryland, Kentucky, Delaware and New Jersey. US LEC's current network is
comprised of fifteen Lucent 5ESS(R) AnyMedia digital switches in Charlotte,
Raleigh/Durham, Greensboro/Winston Salem, Orlando, Miami, Tampa/St. Petersburg,
Jacksonville, Atlanta, Memphis, Nashville, Knoxville, Norfolk/Virginia Beach,
Richmond, Birmingham and Philadelphia, in addition to its Alcatel MegaHub(R)
600ES switch in Charlotte. As of September 30, 1999, the Company had 356,828
Equivalent Access Lines in service. A detailed explanation of how the Company
calculates Equivalent Access Lines is provided below.
RESULTS OF OPERATIONS
THREE AND NINE MONTHS ENDED SEPTEMBER 30, 1999 COMPARED WITH THE THREE AND NINE
MONTHS ENDED SEPTEMBER 30, 1998
Net revenue increased to $47.3 million for the quarter ended September
30, 1999 from $22.3 million for the quarter ended September 30, 1998. For the
nine months ended September 30, 1999 and 1998, revenue was $127.1 million and
$54.3 million, respectively. The significant increase in revenue 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. The Company's core business revenue continued to grow, as well as
the revenue related to reciprocal compensation. Core business revenue, or
revenue other than reciprocal compensation, increased to $17.2 million for the
quarter ended September 30, 1999 from $8.6 million for the quarter ended
September 30, 1998. For the nine months ended September 30, 1999 and 1998, core
business revenue was $43.7 million and $20.2 million, respectively. Reciprocal
compensation revenue increased to $30.1 million for the quarter ended September
30, 1999 from $13.7 million for the quarter ended September 30, 1998, net of an
$7.3 million and $6.0 million allowance, respectively. For the nine months ended
September 30, 1999 and 1998, reciprocal compensation revenue was $83.4 million
and $34.1 million, net of a $21.3 million and $6.0 allowance, respectively.
Given uncertainties associated with the reciprocal compensation issues, the
Company
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recorded an $7.3 million allowance against reciprocal compensation
revenue and related receivables during the quarter ended September 30, 1999,
bringing the allowance for the nine months ended September 30, 1999 to $21.3
million and the total allowance to $33.4 million at September 30, 1999. Unless
otherwise specified, the results of operations reflected in this report are net
of these and other normal operating adjustments. The allowance was made for the
uncertainty associated with the current judicial and regulatory proceedings
related to reciprocal compensation revenue, and does not reflect a change in the
Company's commitment to pursue the matter to a successful conclusion. (See also
DISPUTED RECIPROCAL COMPENSATION REVENUE appearing below for a further
discussion related to reciprocal compensation and other disputed amounts due
from BellSouth.)
Billable minutes of use ("MOUs") were approximately 7.0 billion in the
third quarter of 1999 compared to 3.1 billion in the third quarter of 1998.
Year-to-date MOUs were 19.4 billion in the nine month period ended September 30,
1999 compared to 6.4 billion in the nine month period ended September 30, 1998.
Billable trunks increased by 10,240 to 69,199 at September 30, 1999 compared to
29,981 billable trunks at September 30, 1998. Equivalent Access Lines ("EALs")
increased from 152,018 at September 30, 1998 to 356,828 at September 30, 1999.
Equivalent Access Lines is a term used by US LEC to quantify the size of its
network. EALs 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 of what multiplier to use 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.
Cost of services is comprised primarily of leased transport, facility
installation, commissions and usage charges. Cost of services increased from
$7.3 million, or 33% of revenue, for the quarter ended September 30, 1998, to
$19.5 million, or 41% of revenue, for the quarter ended September 30, 1999 and
from $21.3 million, or 39% of revenue, to $54.0 million, or 42% of revenue, for
the comparable nine month year-to-date periods. The increase in cost of services
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 the third quarter 1999
increased to $13.7 million, or 29% of revenue, compared to $6.7 million, or 30%
of revenue for the third quarter 1998. These expenses increased to $35.2 million
for the first nine months of 1999, or 28% of revenue, compared to $16.9 million,
or 31% of revenue for the comparable period in 1998. These increases were
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 the three and nine months ended
September 30, 1999 increased to $3.1 million from $1.5 million and to $8.1
million from $2.9 million, respectively, over the comparable 1998 periods due to
the increase in depreciable assets in service related to US LEC's network
expansion. Depreciation and amortization will continue to increase in
conjunction with spending on capital asset deployment related to US LEC's
network expansion.
Interest income for the three and nine months ended September 30, 1999
was $0.2 million and $0.9 million, respectively, compared to interest income of
$0.7 million and $1.4 million for the three and nine months ended September 30,
1998, respectively.
Interest expense for the three and nine months ended September 30,
1999 was $0.8 million and $2.0 million, respectively, compared to interest
expense of $0.0 million and $0.2 million for the three and nine months ended
September 30, 1998, respectively. This increase in interest expense was
primarily due to borrowings under the Company's credit facility.
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Provision for income taxes for the three and nine months ended
September 30, 1999 was $4.2 million and $11.6, respectively, compared to $3.0
million and $5.8 million for the three and nine months ended September 30, 1998,
respectively. Income taxes were based on an effective tax rate of approximately
40%.
As a result of the foregoing, net income for the three and nine months
ended September 30, 1999 amounted to $6.2 million, or $.22 per share (diluted),
and $17.2 million, or $.61 per share (diluted), respectively, compared to net
income of $4.5 million, or $.16 per share (diluted), and $8.6 million, or $.34
per share (diluted) for the three and nine months ended September 30, 1998,
respectively.
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 $34.3 million and $38.5 million for the nine months
ended September 30, 1999 and 1998, respectively. The Company anticipates that it
will have substantial capital requirements in connection with its planned
expansion into additional locations during the balance of 1999 and beyond. On
June 30, 1999, the Company amended the existing senior secured loan agreement
with General Electric Capital Corporation and First Union National Bank to
increase the amount available under the loan agreement from $50.0 million to
$75.0 million. As of September 30, 1999, the outstanding amount under the loan
agreement was $40.0 million; therefore, $35.0 million is available to borrow
under the Loan Agreement. Funding for expansion beyond the Company's planned
network deployment in 1999 may require additional financing unless the Company
receives payment of a significant portion of the outstanding receivable due from
BellSouth. There can be no assurance that the Company will receive such payment
from BellSouth nor can there be assurance that the Company will be able to
secure additional financing in amounts or under terms acceptable to the Company.
Cash used in operating activities was approximately $18.6 million for
the nine months ended September 30, 1999 compared to $14.6 million during the
comparable 1998 period. The increase in cash used in operating activities was
primarily due to a $53.3 million increase related to accounts receivable (net of
allowances) offset by increases in net income of $8.6 million, depreciation of
$5.2 million, prepaid and other assets of $1.4 million, accounts payable of $9.7
million, accrued expense and accrued network cost of $12.0 million, deferred
revenue of $1.3 million and an increase in deferred taxes of $10.9 million. The
majority of the Company's accounts receivable at September 30, 1999 represented
amounts due from BellSouth for reciprocal compensation, facility charges, toll
and other charges. Although in July 1999, the Company received a payment of
$11.2 million from BellSouth representing a portion of the amounts due the
Company for reciprocal compensation in North Carolina, management expects
receivables due from BellSouth to continue to increase until the judicial and
regulatory proceedings with BellSouth are resolved. (See DISPUTED RECIPROCAL
COMPENSATION REVENUE appearing below for a further discussion related to
reciprocal compensation and other disputed amounts due from BellSouth). The
increase in depreciation was due to the increase in depreciable assets in
service related to US LEC's network expansion. The increase in accounts payable,
accrued expenses, accrued network cost, prepaid expenses and other assets and
deferred revenue was related to the continued expansion of the Company. The
increase in deferred taxes was due to timing differences between book and tax
income as of September 30, 1999.
Cash used in investing activities decreased to $34.4 million for the
nine months ended September 30, 1999 from $39.3 million during the nine months
ended September 30, 1998. The investing activities are 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 1999.
Cash provided by financing activities decreased to $19.1 million for
the nine months ended September 30, 1999 from $87.6 million during the first
nine months of 1998. The decrease was primarily due to the $87.1 million of net
proceeds from the public stock offering in 1998 partially offset by $20.0 of
borrowing under the Company's credit facility in 1999, which is discussed above.
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DISPUTED RECIPROCAL COMPENSATION REVENUE
A majority of the Company's revenue is derived from reciprocal compensation
amounts due from incumbent local exchange carriers ("ILECs"), principally
BellSouth Telecommunications, Inc. ("BellSouth"). In August 1997, BellSouth
notified the Company and other competitive local exchange carriers ("CLECs")
that it considered traffic terminated to Enhanced Service Providers ("ESPs"),
including Internet service providers ("ISPs"), to be interstate traffic, and
therefore not subject to reciprocal compensation, and that BellSouth would not
pay (or bill) reciprocal compensation under interconnection agreements for this
traffic. BellSouth is disputing the portion of reciprocal compensation billed by
the Company related to the transport and termination of local traffic from its
customers to ESPs, including ISPs and information service providers primarily on
the basis that such traffic does not terminate in the same local exchange and,
as described below, the portion of the billings related to traffic on certain
networks (collectively referred to as "Disputed Reciprocal Compensation"). The
Company recorded Disputed Reciprocal Compensation revenue of approximately $42
million, $24 million and $69 million for fiscal 1998, respectively, and the
three and nine months ended September 30, 1999, net of a $12 million, $7 million
and $21 million allowance, respectively. Management believes that the Company
has earned and is legally entitled to this revenue and payments are due from
BellSouth pursuant to the interconnection agreements that BellSouth has with the
Company.
On February 26, 1998, following a petition by the Company, the North
Carolina Utilities Commission (the "NCUC") ordered BellSouth to bill and pay for
all such traffic (the "NCUC Order"). 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 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 related issues
by the Federal Communications Commission ("FCC"). This action was filed against
the Company and the NCUC. In June 1999, the U.S. District Court dismissed
BellSouth's petition without prejudice and remanded back to the NCUC for further
review. Following the U.S District Court's remand, on June 22, 1999, the NCUC
denied BellSouth's request for a further stay of the NCUC Order. On July 16,
1999, the Company received an $11.2 million payment from BellSouth for a portion
of the Disputed Reciprocal Compensation earned from North Carolina operations,
and subject to the NCUC Order.
Other than denying BellSouth's request for a further stay, the only
action taken by the NCUC with respect to the remand from the U.S. District Court
is that the NCUC filed an appeal with the U.S. Fourth Circuit Court of Appeals
(the "4th Circuit") a notice of appeal of the U.S. District Court's order that
rejected the NCUC's claims, including its claim that the 11th Amendment to the
United States Constitution bars BellSouth from making the NCUC a party to this
proceeding in the federal courts. The Company has also appealed and the United
States Justice Department has intervened in the appeal. As of the date of this
filing, no action has yet been taken by the 4th Circuit in connection with this
appeal.
In February 1999, the FCC issued a declaratory ruling (the "FCC
Ruling") which concluded that for jurisdictional purposes most calls delivered
to ISPs should be deemed to continue to internet web sites, which are often
located in other states. Thus, the FCC ruled that such calls are
jurisdictionally "interstate" in nature. However, the FCC further declared that
where parties have agreed in interconnection agreements that reciprocal
compensation must be paid for traffic bound for ISPs, the parties should be
bound by those agreements, as interpreted and enforced by state regulatory
bodies. The FCC also recognized that some commissions may reconsider their
decisions in light of its ruling. As noted, the NCUC had ruled on February 26,
1998 in favor of the Company with respect to payment for traffic bound to ISPs
under the Company's first interconnection agreement with BellSouth. To date,
state regulatory bodies in at least eighteen different states have considered
the effect of the FCC Ruling and have overwhelmingly reaffirmed their earlier
decisions requiring payment of reciprocal compensation for this type of traffic
or for the first time determined that such compensation is due. Included among
these states are Alabama and Florida, both of which are in BellSouth's operating
territory. In this regard, the Alabama Public Service Commission concluded that
the treatment of ISP traffic as local was so prevalent in the industry at the
time BellSouth entered into interconnection agreements with CLECs that, if it is
so intended, BellSouth had an obligation to negate such local treatment in the
agreements by specifically delineating
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that ISP traffic was not local traffic subject to the payment of reciprocal
compensation. The Florida Public Service Commission reached a similar
conclusion. In an arbitration of the terms of a new interconnection agreement
between BellSouth and another CLEC, the NCUC recently determined that, until the
FCC issues a definitive ruling pursuant to the notice of proposed rulemaking
which was part of the FCC Ruling, reciprocal compensation should continue to be
paid under the new interconnection agreement. While US LEC was not a party to
this arbitration, management believes this decision to be favorable in light of
the remand (discussed above).
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 from BellSouth. Also on September 14, 1998,
BellSouth filed a complaint with the NCUC seeking to be relieved from its
obligations under its interconnection agreement with the Company to pay
reciprocal compensation for traffic related to networks including that operated
by Metacomm, LLC ("Metacomm"), a customer of BellSouth and the Company and, as
of June 1998, a related party of the Company. The two proceedings were
consolidated for purposes of discovery, which concluded June 16, 1999, and
hearings concluded in August 1999 with respect to BellSouth's complaint.
Hearings concerning US LEC's complaint have been continued by the NCUC pending
an order in the BellSouth complaint. The BellSouth proceeding primarily involves
the treatment of traffic over a network established by Metacomm and whether,
under the interconnection agreements between the Company and BellSouth and the
Telecommunications Act of 1996 (the "Telecom Act"), BellSouth is required to pay
reciprocal compensation to the Company for traffic associated with this network,
or whether BellSouth has breached its interconnection agreements with the
Company by failing to pay reciprocal compensation for this traffic.
In the NCUC proceedings filed September 14, 1998, BellSouth claims
principally that the traffic on Metacomm's network does not qualify for
reciprocal compensation because the Metacomm network was designed to generate
reciprocal compensation and that such traffic does not constitute
"telecommunications" subject to the reciprocal compensation payment provisions
of the Telecom Act and the Company's interconnection agreements with BellSouth.
In addition BellSouth's has identified other issues on which it bases its claim
that the traffic on the Metacomm network is not compensable, including (1) that
the Company agreed to share reciprocal compensation with Metacomm, (2) that, as
disclosed in the Company's Form 10-Q for the period ended September 30, 1998,
Richard T. Aab, the largest shareholder of the Company and the Chairman of its
Board of Directors, acquired a controlling interest in Metacomm, (3) that the
reciprocal compensation has been billed on an "always-on" basis even though
there is no measurement of the amount of data traversing the network that is
originated by customers of Metacomm, (4) that a portion of the billed traffic
includes traffic during periods when Metacomm had not yet connected customers to
its network or when customers of Metacomm may not have been sending data over
the network, (5) that the Metacomm network includes facilities that cross LATA
boundaries and, therefore, data traversing these facilities is not local (and,
therefore, is ineligible for reciprocal compensation), (6) that Metacomm is a
reseller of US LEC's services, not an end-user, and (7) that the Metacomm
network is a quasi-dedicated network which should not be eligible for reciprocal
compensation.
It is the Company's understanding that Metacomm is engaged in the
business of developing and operating a high-speed, always-on data network in
North Carolina and its network provides users with continuous access to data,
wide area network services, software applications and other services, including
access to the Internet. In the course of the these proceedings, the Company
concluded, based on positions taken and information provided by Metacomm, that
Metacomm's related traffic should not be considered to be solely ISP traffic
because its network provides additional services and functions to users.
Notwithstanding this determination, the Company believes BellSouth will continue
to contend the Disputed Reciprocal Compensation related to the Metacomm network
traffic is subject, in the first instance, to the resolution of the ISP issue.
The Company has recorded approximately $50 million, $25 million and $75 million
of gross revenue, before allowances and before late payment charges, for fiscal
1998 and the three and nine months ended September 30, 1999, respectively,
related to reciprocal compensation revenue generated as a result of Metacomm
network traffic.
When the Metacomm network was originally developed, the Company agreed
to pay Metacomm
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commissions equal to a specified percentage of the reciprocal compensation the
Company receives from ILEC's for the network traffic. The Company recorded
approximately $20 million, $10 million and $30 million for fiscal 1998 and the
three and nine months ended September 30, 1999, respectively, in reciprocal
compensation commission expense earned by Metacomm, which is included in cost of
services in the accompanying financial statements. As of September 30, 1999, the
Company had a liability to Metacomm in the amount of $19 million, which is
recorded in accrued network costs in the accompanying financial statements. The
Company and Metacomm are parties to agreements by which commissions earned by
Metacomm related to reciprocal compensation are not payable until the related
reciprocal compensation is collected from the ILEC. However, in fiscal 1998 and
the three and nine months ended September 30, 1999, the Company paid Metacomm $8
million, $3 million and $9 million prior to collecting the earned reciprocal
compensation from BellSouth. These payments are subject to a repayment agreement
if the related reciprocal compensation is ultimately not collected from
BellSouth.
The Company believes that calls to establish, maintain and manage data
network connections and intra-network communications generated by data
processing routers, which are necessary to maintain the functionality and
integrity of the Metacomm network, are within the definition of
"telecommunications" under the Telecom Act and constitute compensable traffic
subject to reciprocal compensation under the interconnection agreements the
Company has with BellSouth. The Company also believes that the issues raised by
BellSouth as additional bases for nonpayment do not excuse BellSouth from its
obligation to pay reciprocal compensation under its interconnection agreement
with the Company. Accordingly, the Company intends to defend vigorously against
BellSouth's claims and to prosecute vigorously its claims against BellSouth in
the above proceedings.
As noted above, on July 16, 1999, the Company received a payment of
$11.2 million from BellSouth representing a portion of the amounts due the
Company for ISP reciprocal compensation in North Carolina. In making the
payment, BellSouth stated that it was for ISP traffic the NCUC had ordered it to
pay for in February 1998, including late fees, and that it was reserving all of
its appeal rights with respect to the payment. BellSouth also stated that this
payment did not include any amounts at issue in its September 14, 1998 NCUC
proceeding. This partial payment did not cover all outstanding amounts the
Company claims are due from BellSouth in North Carolina and other states the
Company serves. For example, while the Company has outstanding amounts due from
BellSouth for ISP and other traffic in Tennessee, Georgia and Florida, BellSouth
has not paid these amounts, presumably because no orders specific to US LEC have
been entered by state commissions in those states directing BellSouth to pay the
Company. However, state commissions in these states have issued rulings in favor
of other competitive carriers, and as discussed above, the state commissions in
Florida and Alabama have made rulings subsequent to the FCC Ruling. To address
this issue, the Company has filed the following additional actions against
BellSouth related to delinquent reciprocal compensation payments, none of which
involve Metacomm or any similar network:
o On July 1, 1999, the Company filed a complaint against BellSouth before the
Georgia Public Service Commission ("GAPSC").
o On July 2, 1999, the Company filed a complaint against BellSouth before the
Florida Public Service Commission ("FLPSC").
o On August 6, 1999, the Company filed a complaint against BellSouth before
the Tennessee Regulatory Authority ("TRA").
The proceedings before the GPSC, the FLPSC and the TRA are all in early
stages.
Management believes that the Company will ultimately obtain favorable
results in the state proceedings described above before the NCUC, GAPSC, FLPSC
and the TRA; 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 any of the state commissions, and in particular the NCUC, or in
any appeal or review of a favorable decision by the U.S. District
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Court, state commissions, or the FCC, or if either the FCC or any of the
applicable state commissions 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 gross trade accounts receivable
as of September 30, 1999 included approximately $146 million of earned but
uncollected Disputed Reciprocal Compensation (before a $33 million allowance and
before late payment charges) of which approximately $125 million was generated
as a result of traffic related to the Metacomm network.
In June 1999, the Company adopted an existing agreement to extend local
interconnection with BellSouth replacing the previous interconnection agreement,
which expired on June 15, 1999. The adopted interconnection agreement with
BellSouth is scheduled to terminate on December 31, 1999. The Company's ability
to obtain favorable terms for interconnection following December 31, 1999 will
depend on a number of factors, including decisions of the FCC and state
regulatory authorities. However, the Company intends to pursue such agreements
vigorously and does not anticipate any interruption in interconnection service.
YEAR 2000 READINESS DISCLOSURE
Many computer systems may 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. No piece of equipment or software, owned or
maintained by the Company predates August 1996, with the majority of all
technology purchases concentrated in the period following March 1997. Since all
of its internal systems are relatively new and there were no legacy systems to
integrate, the Company believes that it does not face material Year 2000 issues
that may afflict many technology owners and that its internal software and
hardware systems will function properly in all material respects with regard to
Year 2000 issues. 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 September 30, 1999, 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 $0.1
million. Management continually reassesses the 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 was
concluded on September 25, 1999. The testing was 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 were
tested and validated using this process. The Company's internal information
technology and systems, based on manufacturer supplied information and internal
testing, are 100% compliant, barring new contradictory information from the
manufactures or vendors. The core of the Company's telecommunication operations,
the Lucent Technologies 5ESS(R) Any Media(TM) switch, is fully compliant at this
time, as are other telecommunications systems owned by the Company. The majority
of the services and facilities vendors to the Company are compliant with the
remainder of these companies anticipating full compliance in the fourth quarter
of 1999. While the Company has no control over vendors of telecommunications
systems and facilities, based on information provided to the Company, we
anticipate that the vendors utilized by the Company will be Year 2000 compliant
by the end of 1999.
The Company has assessed the building access, security, and related
issues at all of its switch locations. Each switch site is accessible by manual
methods in the event of building systems failure. Further, each US LEC switch
site was built with a Year 2000 compliant uninterruptible power supply and a
back-up generator. The Company's corporate office and network operations center
has received assurances from the building management that all systems within
these buildings are Year 2000 compliant. The Company's supporting services are
centralized at the corporate offices. The Year 2000 status of the sales offices
for the remaining US LEC locations is currently being evaluated with no issues
noted to date.
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The Company (as are all other telecommunications providers) is heavily
dependent on the public switched network, over which the Company has little
control. The Company cannot give comfort on the status of the public switched
network or other telecommunications carriers and facility providers (such as
other local exchange carriers ("LECs"), competitive access providers ("CAPs") or
interexchange carriers ("IXCs")).
While management believes that its internal hardware and software
applications are Year 2000 compliant in all material respects, there can be no
absolute assurance until the Year 2000 dates occur 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 SEC 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
LECs, IXCs, CAPs, 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 has developed Year 2000
contingency plans, in conjunction with its disaster recovery plans, in the event
of a Year 2000 related failure including if its suppliers and vendors are not
Year 2000 compliant, but there can be no assurance that the contingency plan
will avoid service disruptions related to Year 2000 issues.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT 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 September 30, 1999, investments consisted primarily of
institutional money market funds. All of the Company's long-term debt consists
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 is evaluating 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.
PART II OTHER INFORMATION
Item 1. Legal Proceedings
US LEC is not currently a party to any material legal proceedings,
other than the NCUC, GAPSC, FLPSC and TRA proceedings related to reciprocal
compensation and other amounts due from BellSouth. Note 6 to the Company's
condensed consolidated statements included elsewhere in this report is
incorporated by reference into the Company's response to this item.
Item 2. Changes in Securities and Use of Proceeds
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Recent Sales of Unregistered Securities
None.
Item 3. Defaults upon Senior Securities
None.
Item 4. Submission of Matters to a Vote of Security Holders
None.
Item 5. Other Information
None.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits:
Exhibit No. Description
----------- -----------
11.1 Statement Regarding Computation of Earnings per Share*
27 Financial Data Schedule (For SEC use only)
* Incorporated by reference to the Company's
Condensed Consolidated Statements of
Operations appearing in Part I of this
report.
(b) Form 8-K:
None during the quarter ended September 30, 1999.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
US LEC Corp.
By:_______________________
Michael K. Robinson
Executive Vice President and
Chief Financial Officer
22
<TABLE> <S> <C>
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