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 June 30, 2000
Commission file number 0-24061
US LEC Corp.
------------
(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.)
Morrocroft III, 6801 Morrison Boulevard Charlotte, North Carolina 28211
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(Address of principal executive offices) (Zip Code)
(704) 319-1000
(Registrant's telephone number, including area code)
Transamerica Square, 401 North Tryon Street, Suite 1000 Charlotte, North
Carolina 28202
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(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 ( )
---- ---
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As of August 14, 2000, there were 10,825,666 shares of Class A Common Stock and
16,834,270 shares of Class B Common Stock outstanding.
<PAGE>
US LEC Corp.
Table of Contents
-----------------
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
Condensed Consolidated Statements of Operations - Three and six
months ended June 30, 2000 and 1999
Condensed Consolidated Balance Sheets - June 30, 2000 and
December 31, 1999
Condensed Consolidated Statements of Cash Flows - Six months
ended June 30, 2000 and 1999
Condensed Consolidated Statement of Stockholders' Equity - Six
months ended June 30, 2000
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
<PAGE>
US LEC Corp. and Subsidiaries
Condensed Consolidated Statements of Operations
(In Thousands, Except Per Share Data)
(Unaudited)
<TABLE>
<CAPTION>
Three months Six months
ended June 30, ended June 30,
2000 1999 2000 1999
-------- ------- --------- --------
<S> <C> <C> <C> <C>
Revenue, Net $ 26,148 $ 43,553 $ 51,511 $ 79,765
Cost of Services 11,714 18,702 22,765 34,463
-------- ------- --------- --------
Gross Margin 14,434 24,851 28,746 45,302
Selling, General and Administrative Expenses 18,764 11,806 34,777 21,472
Loss on Resolution of Disputed Revenue - - 55,345 -
Depreciation and Amortization 5,674 2,676 10,067 4,997
-------- ------- --------- --------
Earnings (Loss) from Operations (10,004) 10,369 (71,443) 18,833
Other (Income) Expense
Interest Income (1,434) (318) (1,548) (774)
Interest Expense 1,110 677 3,114 1,168
-------- ------- --------- --------
Earnings (Loss) Before Income Taxes (9,680) 10,010 (73,009) 18,439
Income Tax Provision - 4,035 (23,727) 7,449
-------- ------- --------- --------
Net Earnings (Loss) $ (9,680) $ 5,975 $ (49,282) $ 10,990
======== ======= ========= ========
Less: Preferred Stock Dividends $ 2,633 $ - $ 2,633 $ -
Net Earnings (Loss) Attributable to Common Stockholders $(12,313) $ 5,975 $ (51,915) $ 10,990
======== ======= ========= ========
Net Earnings (Loss) Per Common Share:
Basic $ (0.45) $ 0.22 $ (1.88) $ 0.40
======== ======= ========= ========
Diluted $ (0.45) $ 0.21 $ (1.88) $ 0.39
======== ======= ========= ========
Weighted Average Number of Shares Outstanding:
Basic 27,636 27,427 27,574 27,425
======== ======= ========= ========
Diluted 27,636 28,381 27,574 28,292
======== ======= ========= ========
</TABLE>
See notes to condensed consolidated financial statements
3
<PAGE>
US LEC Corp. and Subsidiaries
Condensed Consolidated Balance Sheets
(In Thousands)
<TABLE>
<CAPTION>
(Unaudited)
June 30, December 31,
2000 1999
--------- ---------
<S> <C> <C>
Assets
Current Assets
Cash and cash equivalents $ 112,452 $ 15,174
Restricted cash 1,397 1,173
Accounts receivable (net of allowance of $565 at
June 30, 2000 and $40,074 at December 31, 1999) 93,223 193,943
Prepaid expenses and other assets 9,426 2,979
--------- ---------
Total current assets 216,498 213,269
Property and Equipment, Net 160,603 102,002
Deferred Income Taxes 9,452 -
Other Assets 5,951 4,829
--------- ---------
Total Assets $ 392,504 $ 320,100
========= =========
Liabilities and Stockholders' Equity
Current Liabilities
Accounts payable $ 22,677 $ 13,050
Deferred revenue 2,098 1,702
Accrued network costs 10,532 12,911
Accrued commissions, net - related party - 22,809
Deferred income taxes 9,452 15,160
Commissions payable 26,255 23,702
Accrued expenses - other 10,187 10,826
--------- ---------
Total current liabilities 81,201 100,160
--------- ---------
Long-Term Debt 60,000 72,000
Deferred Income Taxes - 8,796
Other Liabilities - Noncurrent 2,968 274
Series A Redeemable Convertible Preferred Stock (see Note 6) 196,509 -
Stockholders' Equity
Common stock-Class A, $.01 par value (122,925 and 72,925 authorized shares, 10,826
and 10,426 outstanding at June 30, 2000 and December 31, 1999, respectively) 108 104
Common stock-Class B, $.01 par value (17,076 authorized shares, 16,834 and 17,076
outstanding at June 30, 2000 and December 31, 1999, respectively) 168 171
Additional paid-in capital (see Note 8) 73,436 108,665
Retained earnings (deficit) (21,886) 29,930
--------- ---------
Total stockholders' equity 51,826 138,870
--------- ---------
Total Liabilities and Stockholders' Equity $ 392,504 $ 320,100
========= =========
</TABLE>
See notes to condensed consolidated financial statements
4
<PAGE>
US LEC Corp. and Subsidiaries
Condensed Consolidated Statements of Cash Flows
(In Thousands) (Unaudited)
<TABLE>
<CAPTION>
Six Months Ended
June 30,
2000 1999
--------- --------
<S> <C> <C>
Operating Activities
Net earnings (Loss) $ (49,282) $ 10,990
--------- --------
Adjustments to reconcile net earnings (loss) to net cash used in operating activities:
Depreciation and amortization 10,068 4,997
Loss on resolution of disputed revenue 55,345 -
Accounts receivable allowance (165) 14,047
Disposal of property & equipment 4 -
Deferred compensation 99 102
Deferred income taxes (23,727) 7,449
Changes in assets and liabilities which provided (used) cash:
Accounts receivable (13,428) (78,643)
Prepaid expenses and other assets (6,039) 904
Other assets (1,563) -
Accounts payable 1,162 7,317
Deferred revenue 396 326
Accrued network costs (3,229) 12,400
Customer commissions payable 2,552 -
Accrued expenses - other 2,315 2,714
--------- --------
Total adjustments 23,790 (28,387)
--------- --------
Net cash used in operating activities (25,492) (17,397)
--------- --------
Investing Activities
Purchase of property and equipment (59,346) (20,870)
Restricted cash (224) -
--------- --------
Net cash used in investing activities (59,570) (20,870)
--------- --------
Financing Activities
Net Proceeds from Issuance of Series A Preferred Stock 193,876 -
Proceeds from exercise of stock options and warrants 662 31
Proceeds from long-term debt 80,000 10,000
Payments on long-term debt (92,000) -
Payment of loan fees (198) (182)
--------- --------
Net cash provided by financing activities 182,340 9,849
--------- --------
Net (Decrease) Increase in Cash and Cash Equivalents 97,278 (28,418)
Cash and Cash Equivalents, Beginning of Period 15,174 41,965
--------- --------
Cash and Cash Equivalents, End of Period $ 112,452 $ 13,547
========= ========
.
Supplemental Cash Flow Disclosures
Cash Paid for Interest $ 3,382 $ 1,004
========= ========
</TABLE>
See notes to condensed consolidated financial statements
5
<PAGE>
US LEC Corp. and Subsidiaries
Condensed Consolidated Statement of Stockholders' Equity
For the Six Months Ended June 30, 2000
(In Thousands)
(Unaudited)
<TABLE>
<CAPTION>
Class A Class B Additional Retained
Common Stock Common Stock Paid-in Capital Earnings (Deficit) Total
------------ ------------ --------------- ------------------ -----
<S> <C> <C> <C> <C> <C>
Balance, December 31, 1999 $ 104 $ 171 $ 108,665 $ 29,930 $ 138,870
Exercise of stock options and warrants 1 - 658 - 659
Conversion of Class B common stock
to Class A Common Stock 3 (3) - - -
Tax effect related to warrants and options - - 228 - 228
Unearned Compensation - Stock Options - - - 99 99
Distribution to Stockholder (see Notes 7 and 8) - - (36,115) - (36,115)
Preferred Stock Dividends - - - (2,633) (2,633)
Net Loss - - - (49,282) (49,282)
--------- --------- ---------- --------- ---------
Balance, June 30, 2000 $ 108 $ 168 $ 73,436 $ (21,886) $ 51,826
========= ========= ========== ========= =========
</TABLE>
See notes to condensed consolidated financial statements
6
<PAGE>
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 six month periods ended June 30, 2000 are
not necessarily indicative of the results that may be expected for the year
ending December 31, 2000. The balance sheet at December 31, 1999 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, as
amended, for the year ended December 31, 1999, which is on file with the U.S.
Securities and Exchange Commission (the "SEC"). Certain amounts in the 1999
financial statements have been reclassified to conform to the 2000 presentation.
2. Restricted Cash
The restricted cash balance as of June 30, 2000 and December 31, 1999
serves as collateral for letters of credit related to certain facility leases.
The June 30, 2000 balance also includes funds held in escrow related to certain
facility lease termination agreements.
3. Earnings (Loss) Per Common and Common Equivalent Share
Earnings (loss) per common and common equivalent share are based on net
income (loss), after consideration of preferred stock dividends, by the weighted
average number of 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 outstanding (in thousands of shares) for the
three and six month periods ended June 30, 2000 and 1999 were as follows:
<TABLE>
<CAPTION>
Three Months Six Months
Ended June 30, Ended June 30,
2000 1999 2000 1999
------- ------- ------ ------
<S> <C> <C> <C> <C>
Basic Weighted Average Number of Shares Outstanding 27,636 27,427 27,574 27,425
Dilutive Stock Options - 696 - 614
Dilutive Stock Warrants - 258 - 253
------- ------- ------ ------
Diluted Weighted Average Number of Shares Outstanding 27,636 28,381 27,574 28,292
------- ------- ------ ------
</TABLE>
7
<PAGE>
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.
Valuation allowances are established when necessary to reduce deferred tax
assets to the amount expected to be realized and are reversed at such time that
realization is believed to be more likely than not.
5. Long-Term Debt
In December 1999, the Company amended its existing senior secured loan
agreement to increase the amount available from $75.0 million to $150.0 million.
The credit facility is comprised of (i) a $125.0 million revolving credit
facility with a term of 18 months with an option that permits the Company to
convert it to a six-year term loan at the end of the 18 month period and (ii) a
$25.0 million reducing revolving credit facility with a six-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 ("LIBOR"), plus a specified margin. As of June 30, 2000,
the amount outstanding under the credit facility was $60 million. Advances under
the agreement as of June 30, 2000 bear interest at an annual rate of
approximately 11%. 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. Series A Redeemable Convertible Preferred Stock
On April 11, 2000, the Company issued $200 million of its Series A
Redeemable Convertible Preferred Stock (the "Preferred Stock") to affiliates of
Bain Capital, Inc. (Bain) and Thomas H. Lee Partners, L.P. (THL). The Preferred
Stock earns dividends on a cumulative basis at an annual rate of 6%, payable
quarterly in shares of Preferred Stock for three years, and at US LEC's option,
in cash or shares of Preferred Stock over the next seven years. Shares of the
Preferred Stock are convertible into shares of Class A Common Stock at an
initial conversion price of $35 per share. All outstanding shares of the
Preferred Stock are subject to mandatory redemption on April 10, 2010. Proceeds
to the Company, net of commissions and other transaction costs, were
approximately $193.9 million. To date, the Company has accrued $2.6 million in
Preferred Stock Dividends. For further information refer to Form 8-K filed with
the SEC on May 12, 2000 and Item 2(c) of Part II of this Report.
7. Commitments and Contingencies
The Metacomm Decision - As the Company has previously reported,
BellSouth Telecommunications, Inc. ("BellSouth") began a proceeding in September
1998 before the North Carolina Utilities Commission ("NCUC") seeking to be
relieved of any obligation under its interconnection agreements with the Company
to pay reciprocal compensation for traffic related to the network operated by
Metacomm, LLC ("Metacomm"), a customer of both the Company and BellSouth. On
March 31, 2000, the NCUC issued an order in this proceeding (the "March 31
Order") that relieves BellSouth from paying reciprocal compensation to the
Company for any minutes of use attributable to Metacomm network traffic and
requires the Company to cease billing BellSouth
8
<PAGE>
Notes to Condensed Consolidated Financial Statements --- (Continued)
reciprocal compensation for minutes of use attributable to the Metacomm or any
similar network as such networks are identified in the March 31 Order. The March
31 Order does not affect in any way the NCUC's order of February 1998 requiring
BellSouth to pay reciprocal compensation to the Company for Internet service
provider ("ISP") traffic in North Carolina (the "NCUC ISP Order"). It relates
solely to traffic on Metacomm's network in North Carolina (the only state in
which Metacomm operated). The Company did not appeal the March 31 Order,
although Metacomm has filed a notice of appeal.
As a result of the March 31 Order, the Company recorded a pre-tax,
non-recurring, non-cash charge of approximately $55 million in the first quarter
of 2000. The charge was composed of the write-off of approximately $153 million
in receivables related to reciprocal compensation revenue offset by previously
established reserves of $39 million and a reduction of $59 million in
commissions payable to Metacomm.
On March 21, 2000, the NCUC issued an interim order (the "March 21
Order") to BellSouth to pay to the Company all reciprocal compensation owing to
the Company for traffic terminated in North Carolina, other than traffic related
to Metacomm and like networks. This order was issued in connection with the
on-going proceeding before the NCUC filed in September 1998 by the Company in
which it seeks payment of reciprocal compensation not related to Metacomm or to
traffic terminated to ISPs, and of other amounts owing to the Company. The
Company's action before the NCUC to recover reciprocal compensation and other
charges for non-Metacomm/non-ISP traffic has been stayed by the NCUC while the
Company and BellSouth conduct NCUC-ordered negotiations to resolve the matter.
The amount due to the Company as a result of this proceeding will be determined
by the negotiations or subsequent ruling by the NCUC regarding the
non-Metacomm/non-ISP charges BellSouth is obligated to pay. The Company is
currently working with BellSouth to determine the amount BellSouth will pay
under the March 21, 2000 Order. Once this is determined, the Company will adjust
the non-recurring charge. The amount recognized in the quarter ended March 31,
2000 is management's best estimate of the non-recurring charge.
The Company had previously recorded $21 million of advances to Metacomm
for commissions payable on reciprocal compensation revenue and a $16 million
receivable for services provided to Metacomm. These amounts have been treated
for financial reporting purposes as a distribution to stockholder and reduced
additional paid-in capital on the Company's balance sheet. The amount owed was
reduced by approximately $1 million in the quarter ended, June 30, 2000 for
refunds due on sales and excise tax amounts previously charged on services
provided to Metacomm. The Company has filed for a refund of the sales and excise
tax from the North Carolina Department of Revenue and Internal Revenue Service.
Richard T. Aab, Chairman of US LEC and its largest stockholder, indirectly
controls Metacomm, and has stated that the remaining balance will be paid no
later than March 31, 2001. The Company's audit committee and Mr. Aab are working
to determine the terms of such payment. The payments will be credited to
additional paid-in capital.
Other Disputed Reciprocal Compensation Revenue - The Company is also a
party to the following material proceedings in which it seeks collection of
outstanding amounts owed by incumbent local telephone companies, primarily
BellSouth, for non-Metacomm related reciprocal compensation, including
reciprocal compensation related to traffic terminating to ISPs and other
customers:
9
<PAGE>
Notes to Condensed Consolidated Financial Statements --- (Continued)
North Carolina -- On February 26, 1998, following a petition by the
Company, the NCUC ordered BellSouth to bill and pay for all ISP-related traffic
(defined above, the "NCUC ISP 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 ISP 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-NC") 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-NC
dismissed BellSouth's petition without prejudice and remanded it back to the
NCUC for further review. Following the U.S District Court-NC's remand, on June
22, 1999, the NCUC denied BellSouth's request for a further stay of the NCUC ISP
Order.
In addition to denying BellSouth's request for a further stay, the NCUC
has filed an appeal with the U.S. Fourth Circuit Court of Appeals (the "4th
Circuit") of the U.S. District Court-NC's order that rejected the NCUC's
defenses, including its defense that the 11th Amendment to the United States
Constitution bars BellSouth from making the NCUC a party to a proceeding in the
federal courts. The Company has also appealed and the United States Justice
Department has intervened in the appeal. The appellate hearing on this matter
and a similar matter involving different parties consolidated with this appeal
by the 4th Circuit occurred in May 2000. The Company cannot predict when the 4th
Circuit will render its decision on this appeal.
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 the
NCUC ISP Order, 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 1998 NCUC proceeding regarding
Metacomm. This partial payment did not cover all outstanding non-Metacomm
related amounts the Company claims are due from BellSouth in North Carolina. In
addition, BellSouth has from time to time made payments to US LEC for reciprocal
compensation related to traffic terminated in North Carolina, but the Company
believes that BellSouth has not paid the entire amount due. The total amount
BellSouth has paid to US LEC for traffic terminated to ISPs in North Carolina
through June 30, 2000 is approximately $13 million (including the $11.2 million
payment referenced above).
Georgia -- On June 30, 1999, the Company filed a complaint against
BellSouth before the Georgia Public Service Commission ("GAPSC") concerning the
Company's first and second interconnection agreements with BellSouth in Georgia.
These interconnection agreements cover the period through June 1999. The hearing
in relation to this complaint concluded January 21, 2000. On May 17, 2000, the
hearing officer reviewing the Company's first and second interconnection
agreements with BellSouth issued a recommended decision to the GAPSC stating
that BellSouth should be ordered to pay US LEC the disputed reciprocal
compensation at the end office rate, pending submission of evidence by the
Company showing that it is entitled to be compensated at the higher tandem rate.
On June 15, 2000, the GAPSC affirmed this recommended decision, and issued an
order requiring BellSouth to pay US LEC reciprocal compensation for traffic to
ISPs and other customers in Georgia at the end office rate (the "GAPSC Order").
On July 12, 2000, US LEC filed evidence with the GAPSC regarding its right to be
compensated at the tandem rate. On July 14, 2000, BellSouth filed an appeal of
the GAPSC Order with the U.S. District Court for the Northern District of
Georgia ("U.S. District Court-GA") and with the Georgia Superior Court in and
for Fulton County, Georgia. BellSouth asked the Georgia state court to cede the
appeal to the U.S. District Court - GA and asked the latter court for permission
to pay amounts due into court to avoid paying US LEC pending appeal. On July 18,
2000, the U.S. District Court- GA granted BellSouth's motion to pay amounts due
into court prior to receipt by the Company of any papers related to that appeal.
The Company has requested reconsideration of the order allowing BellSouth to pay
amounts due into court and is reviewing its options to respond to BellSouth's
appeal to the federal courts. The GAPSC has not yet ruled on the tandem/end
10
<PAGE>
Notes to Condensed Consolidated Financial Statements --- (Continued)
office rate issue. The Company's complaint did not address the third
interconnection agreement in Georgia, which covers the period from June 1999 to
December 1999.
Florida -- On July 2, 1999, the Company filed a complaint against
BellSouth before the Florida Public Service Commission ("FLPSC") seeking
recovery of reciprocal compensation for ISP and other traffic in that state.
There is no hearing scheduled for this matter at this time.
Tennessee -- On August 6, 1999, the Company filed a complaint against
BellSouth before the Tennessee Regulatory Authority ("TRA") seeking recovery of
reciprocal compensation for ISP and other traffic in that state. There is no
hearing scheduled for this matter at this time.
Management believes that the Company will ultimately obtain favorable
results in the state proceedings described above before the FLPSC and the TRA
and in the pending appeal of the NCUC ISP Order and the GAPSC Order.
Management's belief is supported by the determinations of state regulatory
bodies and by courts hearing appeals of the state regulatory decisions, which
are discussed below, notwithstanding the jurisdictional position on ISP traffic
taken by the FCC in February 1999, which has now been vacated, also discussed
below. However, BellSouth may elect to initiate additional proceedings (by way
of appeal or otherwise) challenging amounts owed to the Company. In this regard,
BellSouth recently has asserted a variety of other objections to paying portions
of the reciprocal compensation billed by the Company. They include assertions
that US LEC has miscalculated late payment fees due from BellSouth and that the
Company has billed reciprocal compensation using the wrong rates. The Company
believes BellSouth has asserted these issues and will attempt to raise further
issues, in order to avoid or delay payment. Management believes that the Company
will obtain favorable outcomes to these disputes.
FCC's ISP Ruling and Related Proceedings -- In February, 1999, the FCC
issued a declaratory ruling (the "ISP 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 previously 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 might reconsider their decisions in light of its ruling.
On March 24, 2000, the U.S. Circuit Court for the District of Columbia
(the "D.C. Circuit") vacated the FCC's ISP Ruling. The D.C. Circuit ruled that
the FCC did not give adequate consideration to a number of facts when it found
that ISP calls were jurisdictionally interstate, including the FCC's own past
analyses of how to determine whether calls dialed to telephone numbers within
the local exchange are interstate or intrastate. The D.C. Circuit sent the case
back to the FCC to give the FCC opportunity to reconsider the question in light
of the D.C. Circuit's ruling. On June 23, 2000, the FCC requested comments on
the issues raised by the D.C. Circuit in its remand of the ISP Ruling to the
FCC. Initial comments were filed on July 21, 2000. Reply comments are due to be
filed on August 4, 2000. The Company cannot predict when the FCC will issue its
decision on remand.
To date, state regulatory bodies in at least thirty states have
considered the effect of the FCC's ISP 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, Florida, Georgia and Tennessee, which
together with North Carolina (see discussion above) represent the only states in
BellSouth's operating territory where the Company has significant reciprocal
11
<PAGE>
Notes to Condensed Consolidated Financial Statements --- (Continued)
compensation disputes at June 30, 2000. In this regard, the Alabama Public
Service Commission (the "APSC") 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 was 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 APSC decision was affirmed by the United States
District Court for the Middle District of Alabama. The FLPSC reached a similar
conclusion. The GAPSC and the TRA have also reaffirmed decisions, including the
GAPSC Order, that reciprocal compensation is owed for calls to ISPs. Two
BellSouth states - South Carolina and Louisiana - have ruled that reciprocal
compensation is not due for traffic to ISPs. These decisions, which came before
the FCC's ISP Ruling was vacated by the D.C. Circuit, represent a view adopted
by very few other states, and have been appealed. (The Company does not
currently provide local service in Louisiana and has no reciprocal compensation
recorded to date for traffic in South Carolina or Louisiana.)
State and federal courts considering the issue on appeal have also
universally supported the position that reciprocal compensation is due for
traffic terminated to ISPs. Included among these are decisions of the U.S.
Circuit Courts of Appeal for the Fifth, Seventh and Ninth Circuits, all of which
considered the issue in light of the FCC's ISP Ruling and affirmed the decision
of the state regulatory body that reciprocal compensation is due for traffic
terminated to ISPs. Most recently, on May 3, 2000, the U.S. District Court-GA
affirmed four decisions of the GAPSC in which the GAPSC determined that
reciprocal compensation is due for traffic terminated to ISPs.
If a decision adverse to the Company is issued in any of these
proceedings by any of the state commissions, the 4th Circuit or the U.S.
District Court-GA, or in any appeal or review of a favorable decision, or if
either the FCC or any of the applicable state commissions was 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. Management estimates
the Company's gross trade accounts receivable as of June 30, 2000 included
approximately $45 million of earned but uncollected disputed reciprocal
compensation related to non-Metacomm related ISP traffic.
GTE Reciprocal Compensation Dispute in North Carolina - In addition to
the proceedings involving BellSouth which are discussed above, in February 2000,
the Company received payment from GTE South Incorporated ("GTE") for reciprocal
compensation for traffic in North Carolina, including ISP traffic. This payment
was pursuant to a commercial arbitration award rendered January 4, 2000
resulting from a proceeding before the American Arbitration Association. GTE was
ordered to pay US LEC for all reciprocal compensation for the period ending
September 1999 (approximately $650 thousand). GTE has challenged the decision of
the arbitrator in the U.S. District Court for the Eastern District of North
Carolina. Management believes that GTE will not be successful in this challenge,
but cannot predict when the court will issue its decision.
In addition, the Company has filed arbitration to resolve its
reciprocal compensation dispute with GTE in North Carolina for periods after
September 1999. That arbitration is in the arbitrator selection phase at this
time. Although the Company cannot predict when this dispute will be resolved,
management knows of no reason why the second arbitration should have an outcome
different from the first, favorable arbitration ruling.
Existing BellSouth Interconnection Agreements -- 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 expired on
December 31, 1999 but continues in force until new interconnection agreements
are reached. The Company has adopted
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Notes to Condensed Consolidated Financial Statements --- (Continued)
existing agreements to extend local interconnection with BellSouth in North
Carolina, Louisiana, Mississippi, Alabama, South Carolina and Kentucky. These
agreements are effective as of January 1, 2000. The Company has filed petitions
for arbitration in the remaining states in BellSouth operating territory seeking
to obtain state-ordered interconnection agreements, but the Company anticipates
that it will be able to avoid the arbitration process by adopting
interconnection agreements that are either currently in effect or which will
result from pending arbitrations involving other competitive local exchange
carriers ("CLECs"). These new agreements, once they are entered into, will be
effective as of January 1, 2000. The Company's ability to obtain favorable terms
for interconnection following December 31, 1999 in its principal states of
operation 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. The Company's new interconnection agreements in North
Carolina, Louisiana, Mississippi, Alabama, South Carolina and Kentucky provide
for reciprocal compensation at rates significantly lower than in the Company's
prior interconnection agreements, and the Company anticipates that new
interconnection agreements in Tennessee, Georgia and Florida will also provide
for significantly lower rates.
Disputed Access Revenues - In February 2000, the Company filed suit in
U.S. District Court for the Western District of North Carolina against Sprint
Communications Company L.P. ("Sprint"). This action seeks to collect amounts
owed to the Company for access charges for intrastate and interstate traffic
which was either handed off to Sprint by the Company or terminated to the
Company by Sprint. As of June 30, 2000, Sprint owed the Company approximately
$7.4 million in access charges. Sprint has refused to pay the amounts invoiced
by the Company on the basis that the rates are higher than the amounts that
Sprint is willing to pay. Sprint claims it is not obligated to pay more than an
undefined incumbent local exchange carrier ("ILEC") rate. The Company's invoices
to Sprint are at the rates specified in the Company's state and federal tariffs.
The FCC recently determined that a long distance company may not withhold
interstate access charges on the basis that it believes the charges to be too
high while also continuing to accept the benefits of interconnection with the
local carrier without taking formal action to challenge the rates. The FCC has
ruled that AT&T was obligated to pay such access charges due to its failure to
commence a proceeding or terminate interconnection. (MGC Communications, Inc. v.
AT&T Corp., FCC Release 99-408). In addition, the FCC ruled recently in an
action brought by Sprint against MGC Communications, Inc. ("MGC") that the fact
that a CLEC's filed interstate rates exceeded those of the competing ILECs was
insufficient to establish that the CLEC's rates were excessive. The FCC
dismissed Sprint's challenge to MGC's rates. As a result of these rulings,
management anticipates a favorable resolution of the Company's dispute with
Sprint.
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Notes to Condensed Consolidated Financial Statements --- (Continued)
8. Stockholders' Equity
Stock Options -- The Company adopted the US LEC Corp. Omnibus Stock
Plan (the "Plan") in January 1998. At the Annual Meeting of Stockholders, held
on May 16, 2000, 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
2.0 million to 3.5 million shares. As of June 30, 2000, the Company had granted
stock options, net of forfeitures, to purchase an aggregate of 2.2 million
shares of Class A Common Stock.
Additional Paid-in-Capital - Additional Paid-in Capital has been
reduced by $37 million representing amounts due from Metacomm, which is
indirectly controlled by Richard T. Aab, a majority stockholder of the Company.
The amount due was reduced in the quarter ended June 30, 2000 by approximately
$1 million for refunds due on sales and excise tax amounts previously charged on
services provided to Metacomm. The Company has filed for a refund of the sales
and excise tax from the North Carolina Department of Revenue and Internal
Revenue Service. The Company has been assured by Mr. Aab that the remaining
balance will be paid by either Metacomm or by Mr. Aab, and anticipates payment
of the entire amount by March 31, 2001. Due to Mr. Aab's controlling position in
both Metacomm and the Company, this amount is being treated for financial
reporting purposes as a deemed distribution to the stockholder. At the time such
amounts are paid to the Company, the payment will increase additional paid-in
capital as a capital contribution to the Company.
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ITEM 2.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
Except for the historical information contained herein, this report
contains forward-looking statements, subject to uncertainties and risks,
including the demand for US LEC's services, the ability of the Company to
introduce additional products, the ability of the Company to successfully
attract and retain personnel, competition in existing and potential additional
markets, uncertainties regarding its dealings with ILECs and other
telecommunications carriers and facilities providers, regulatory uncertainties,
the possibility of adverse decisions related to reciprocal compensation owing to
the Company by BellSouth and other carriers, as well as the Company's ability to
begin 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, as amended, for the year
ended December 31, 1999, and in other reports which are on file with the SEC.
OVERVIEW
US LEC is a rapidly growing switch-based competitive local exchange
carrier ("CLEC") that provides integrated telecommunications services to its
customers. The Company primarily serves telecommunication-intensive customers
including businesses, universities, financial institutions, professional service
firms, hospitals, enhanced service providers ("ESPs"), Internet service
providers ("ISPs"), hotels 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 offers local, long-distance, data/Internet and enhanced services to
customers in selected markets in North Carolina, Florida, Georgia, Tennessee,
Virginia, Alabama, Washington D.C., Pennsylvania, Mississippi, Maryland, South
Carolina and Kentucky. In addition, US LEC is currently certified to provide
telecommunications services in Delaware, New Jersey, New York, Ohio, Texas,
Connecticut, Louisiana and Massachusetts. US LEC's current network is comprised
of twenty Lucent 5ESS(R) AnyMedia digital switches in Charlotte, Raleigh/Durham,
Greensboro/Winston-Salem, Orlando, Miami, Tampa/St. Petersburg, Jacksonville,
West Palm Beach, Atlanta, Memphis, Nashville, Knoxville, Chattanooga,
Norfolk/Virginia Beach, Richmond, Birmingham, Philadelphia, Northern
Virginia/Washington D.C., Baltimore and Charleston/Myrtle Beach, in addition to
its Alcatel MegaHub(R) 600ES switch in Charlotte.
RESULTS OF OPERATIONS
Three and Six Months Ended June 30, 2000 Compared With The Three and Six Months
Ended June 30, 1999
Net revenue decreased to $26.1 million for the quarter ended June 30,
2000 from $43.6 million for the quarter ended June 30, 1999. For the six months
ended June 30, 2000 and 1999, revenue was $51.5 million and $79.8 million,
respectively. The significant decrease in revenue resulted from the elimination
of reciprocal compensation revenue related to Metacomm and a reduction of local
interconnect rates, partially offset by 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. Core business revenue, or revenue other than
reciprocal compensation and related facility revenue, increased to $22.9 million
for the quarter ended June 30, 2000 from $12.6 million for the quarter ended
June 30, 1999. For the six months ended June 30, 2000, core business revenue
increased to $45.3 million from $21.7 million in the comparable period of 1999.
Reciprocal compensation revenue decreased to $3.2 million for the quarter ended
June 30, 2000 from $28.6 million for the quarter ended June 30, 1999, net of an
$8.0 million allowance in 1999. For the six months ended June 30, 2000 and 1999,
reciprocal compensation revenue was $6.2 million and $53.2 million,
respectively, net of a $14.0 million allowance in 1999. Given uncertainties
associated with the judicial and regulatory proceedings related to reciprocal
compensation issues, the Company recorded a $8.0 million and $14.0 million
allowance against reciprocal compensation revenue and related receivables during
the quarter and
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six months ended June 30, 1999. Unless otherwise specified, the
results of operations reflected in this report are net of these and other normal
operating adjustments. As a result of the resolution of the most significant
reciprocal compensation issue, the Company believes no allowance is required as
of June 30, 2000. See Disputed Revenue appearing below for a further discussion
related to reciprocal compensation and other disputed amounts.
To quantify the size of its network, the Company uses the number of
Customer Connections for business trunks, ISP/ESP trunks and business lines.
Customer Connections at June 30, 2000, and June 30, 1999, were as follows:
business trunks increased to 64,121 from 28,496, ISP/ESP trunks decreased to
24,027 from 30,463, and business lines increased to 19,167 from 7,887. The
decrease in ISP/ESP trunks was primarily due to the elimination of Metacomm
traffic. Prior to December 1999, the Company quantified the size of its network
by reporting its number of Equivalent Access Lines in service. For a detailed
explanation, please visit the network description section of the Company's web
site at www.uslec.com.
Cost of services is comprised primarily of leased transport, facility
installation, commissions and usage charges. Cost of services decreased from
$18.7 million, or 43% of revenue, for the quarter ended June 30, 1999, to $11.7
million, or 45% of revenue, for the quarter ended June 30, 2000. For the six
month periods ended June 30, 2000, and June 30, 1999, cost of services decreased
from $34.5 million, or 43% of revenue, to $22.8 million, or 44% of revenue. The
decrease in cost of services was primarily a result of the decrease in local
interconnect rates and the elimination of commissions paid on reciprocal
compensation revenue to Metacomm, partially offset by the increase in the size
of US LEC's network, and increased usage by its customers other than Metacomm.
Selling, general and administrative expenses for the second quarter
2000 increased to $18.8 million, or 72% of revenue, compared to $11.8 million,
or 27% of revenue for the second quarter 1999. These expenses increased to $34.8
million for the first six months of 2000, or 68% of revenue, compared to $21.5
million, or 27% of revenue for the comparable period in 1999. 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 litigation.
The loss on the resolution of disputed revenue was a result of the
March 31 NCUC Order that relieves BellSouth from paying reciprocal compensation
to US LEC for any minutes of use attributable to the network operated by
Metacomm, a customer of BellSouth and US LEC, or any similar network. As a
result of this order, the Company recorded a pre-tax non-recurring non-cash
charge of $55 million in the first quarter of 2000. This charge is composed of
the write-off of approximately $153 million in receivables related to reciprocal
compensation revenue offset by a previously established allowance of $39
million, and a reduction of approximately $59 million in reciprocal compensation
commissions payable to Metacomm. The amounts are estimated based on a
methodology that must be agreed to by the NCUC. The Company is currently working
with BellSouth to determine the definitive amounts.
Depreciation and amortization for the three months ended June 30, 2000
increased to $5.7 million from $2.7 million over the comparable 1999 period. For
the six months ended June 30, 2000 depreciation and amortization increased to
$10.1 million from $5.0 million over the comparable 1999 period. The increase in
depreciation and amortization is 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 six months ended June 30, 2000 was
$1.4 million and $1.5 million, respectively, compared to interest income of $0.3
and $0.8 million, respectively, for the three and six months ended June 30,
1999. The increase in interest income in the quarter ended June 30, 2000 was
primarily due to the investing of the proceeds from the issuance of Series A
Redeemable Convertible Preferred Stock on April 11, 2000.
Interest expense for the three and six months ended June 30, 2000 was
$1.1 million and $3.1 million,
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respectively, compared to interest expense of $0.7 million and $1.2 million,
respectively, for the three and six months ended June 30, 1999. This increase in
interest expense was primarily due to borrowings under the Company's credit
facility.
Income taxes for the three and six months ended June 30, 2000 were a
$0.0 and a $23.7 million benefit, respectively, compared to $4.0 million expense
and a $7.4 million expense for the three and six months ended June 30, 1999. The
$23.7 million benefit for the six months ended June 30, 2000 is a net amount
which includes a $5.6 million valuation allowance against deferred tax assets
relating to the anticipated use of federal and state net operating losses.
Net loss for the three and six months ended June 30, 2000 amounted to
$9.7 million and $49.3 million, respectively. Dividends accrued on Series A
Redeemable Convertible Preferred Stock for the three months and six months ended
June 30, 2000 amounted to $2.6 million (See Note 6).
As a result of the foregoing, net loss attributable to common
shareholders for the three and six months ended June 30, 2000 amounted to $12.3
million, or ($0.45) per share (diluted) and $51.9 million, or ($1.88) per share
(diluted), respectively, compared to net income of $6.0 million, or $0.21 per
share (diluted), and $11.0 million, or $0.39 per share (diluted) for the three
and six months ended June 30, 1999.
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 $59.3 million and $20.9 million for the six months
ended June 30, 2000 and 1999, respectively. The Company anticipates that it will
have substantial capital requirements in connection with its planned expansion
into additional locations during the balance of 2000 and beyond. In December
1999, the Company amended its existing senior secured loan agreement to increase
the amount available under the loan agreement from $75.0 million to $150.0
million. As of June 30, 2000, the amount outstanding under the loan agreement
was $60.0 million. As a result, $90.0 million is currently available to borrow
under the loan agreement.
On April 11, 2000, the Company issued $200 million of its Series A
Redeemable Convertible Preferred Stock to affiliates of Bain Capital, Inc.
("Bain") and Thomas H. Lee Partners, L.P. ("THL"). See Note 6 to the condensed
consolidated financial statements that appear elsewhere in this report for a
detailed description of this transaction and the terms of the Preferred Stock.
Proceeds to the Company, net of commissions and other transaction cost, were
approximately $193.9. These proceeds, together with the Company's $150 million
credit facility, will provide funding for the Company's planned network
expansion for the foreseeable future. For further information, refer to the
Company's Form 8-K filed with the SEC on May 12, 2000 and Item 2(c) of Part II
of the Report.
Cash used in operating activities increased to $25.5 million for the
six months ended June 30, 2000 from $17.4 million during the comparable 1999
period. The increase was primarily due to the increase in operational activities
associated with the growth of the Company. Additionally, the majority of the
Company's accounts receivable at June 30, 2000 continue to be amounts due from
BellSouth for reciprocal compensation, facility charges, and other charges.
Although the Company received payment of over $13 million from BellSouth
representing a portion of the amounts due the Company for ISP 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. The Company has the same expectations regarding
receivables from Sprint until those judicial proceedings are also resolved (See
Disputed Revenue appearing below for a further discussion related to reciprocal
compensation and other disputed amounts due from BellSouth).
Cash used in investing activities increased to $59.6 million for the
six months ended June 30, 2000 from $20.9 million during the six months ended
June 30, 1999. The investing activities are primarily related to
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purchases of switching and related telecommunications equipment, office
equipment and leasehold improvements associated with the Company's expansion
into additional locations and markets.
Cash provided by financing activities increased to $182.4 million for
the six months ended June 30, 2000 from $9.8 million during the first six months
of 1999. The increase was primarily due the issuance of $200 million in Series A
Redeemable Convertible Preferred Stock (see above).
Disputed Revenue
The Metacomm Decision - As the Company has previously reported,
BellSouth Telecommunications, Inc. ("BellSouth") began a proceeding in September
1998 before the North Carolina Utilities Commission ("NCUC") seeking to be
relieved of any obligation under its interconnection agreements with the Company
to pay reciprocal compensation for traffic related to the network operated by
Metacomm, LLC ("Metacomm"), a customer of both the Company and BellSouth. On
March 31, 2000, the NCUC issued an order in this proceeding (the "March 31
Order") that relieves BellSouth from paying reciprocal compensation to the
Company for any minutes of use attributable to Metacomm network traffic and
requires the Company to cease billing BellSouth reciprocal compensation for
minutes of use attributable to the Metacomm or any similar network as such
networks are identified in the March 31 Order. The March 31 Order does not
affect in any way the NCUC's order of February 1998 requiring BellSouth to pay
reciprocal compensation to the Company for Internet service provider ("ISP")
traffic in North Carolina (the "NCUC ISP Order"). It relates solely to traffic
on Metacomm's network in North Carolina (the only state in which Metacomm
operated). The Company did not appeal the March 31 Order, although Metacomm has
filed a notice of appeal.
As a result of the March 31 Order, the Company recorded a pre-tax,
non-recurring, non-cash charge of approximately $55 million in the first quarter
of 2000. The charge was composed of the write-off of approximately $153 million
in receivables related to reciprocal compensation revenue offset by previously
established reserves of $39 million and a reduction of $59 million in
commissions payable to Metacomm.
On March 21, 2000, the NCUC issued an interim order (the "March 21
Order") to BellSouth to pay to the Company all reciprocal compensation owing to
the Company for traffic terminated in North Carolina, other than traffic related
to Metacomm and like networks. This order was issued in connection with the
on-going proceeding before the NCUC filed in September 1998 by the Company in
which it seeks payment of reciprocal compensation not related to Metacomm or to
traffic terminated to ISPs, and of other amounts owing to the Company. The
Company's action before the NCUC to recover reciprocal compensation and other
charges for non-Metacomm/non-ISP traffic has been stayed by the NCUC while the
Company and BellSouth conduct NCUC-ordered negotiations to resolve the matter.
The amount due to the Company as a result of this proceeding will be determined
by the negotiations or subsequent ruling by the NCUC regarding the
non-Metacomm/non-ISP charges BellSouth is obligated to pay. The Company is
currently working with BellSouth to determine the amount BellSouth will pay
under the March 21, 2000 Order. Once this is determined, the Company will adjust
the non-recurring charge. The amount recognized in the quarter ended March 31,
2000 is management's best estimate of the non-recurring charge.
The Company had previously recorded $21 million of advances to Metacomm
for commissions payable on reciprocal compensation revenue and a $16 million
receivable for services provided to Metacomm. These amounts have been treated
for financial reporting purposes as a distribution to stockholder and reduced
additional paid-in capital on the Company's balance sheet. The amount owed was
reduced by approximately $1 million in the quarter ended, June 30, 2000 for
refunds due on sales and excise tax amounts previously charged on services
provided to Metacomm. The Company has filed for a refund of the sales and excise
tax from the North Carolina Department of Revenue and Internal Revenue Service.
Richard T. Aab, Chairman of US LEC and its largest stockholder, indirectly
controls Metacomm, and has stated that the remaining balance will be paid no
later than March 31, 2001. The Company's audit committee and Mr. Aab are working
to determine the terms of such payment. The payments will be credited to
additional paid-in capital.
Other Disputed Reciprocal Compensation Revenue - The Company is also a
party to the following
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material proceedings in which it seeks collection of outstanding amounts owed by
incumbent local telephone companies, primarily BellSouth, for non-Metacomm
related reciprocal compensation, including reciprocal compensation related to
traffic terminating to ISPs and other customers:
North Carolina -- On February 26, 1998, following a petition by the
Company, the NCUC ordered BellSouth to bill and pay for all ISP-related traffic
(defined above, the "NCUC ISP 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 ISP 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-NC") 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-NC
dismissed BellSouth's petition without prejudice and remanded it back to the
NCUC for further review. Following the U.S District Court-NC's remand, on June
22, 1999, the NCUC denied BellSouth's request for a further stay of the NCUC ISP
Order.
In addition to denying BellSouth's request for a further stay, the NCUC
has filed an appeal with the U.S. Fourth Circuit Court of Appeals (the "4th
Circuit") of the U.S. District Court-NC's order that rejected the NCUC's
defenses, including its defense that the 11th Amendment to the United States
Constitution bars BellSouth from making the NCUC a party to a proceeding in the
federal courts. The Company has also appealed and the United States Justice
Department has intervened in the appeal. The appellate hearing on this matter
and a similar matter involving different parties consolidated with this appeal
by the 4th Circuit occurred in May 2000. The Company cannot predict when the 4th
Circuit will render its decision on this appeal.
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 the
NCUC ISP Order, 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 1998 NCUC proceeding regarding
Metacomm. This partial payment did not cover all outstanding non-Metacomm
related amounts the Company claims are due from BellSouth in North Carolina. In
addition, BellSouth has from time to time made payments to US LEC for reciprocal
compensation related to traffic terminated in North Carolina, but the Company
believes that BellSouth has not paid the entire amount due. The total amount
BellSouth has paid to US LEC for traffic terminated to ISPs in North Carolina
through June 30, 2000 is approximately $13 million (including the $11.2 million
payment referenced above).
Georgia -- On June 30, 1999, the Company filed a complaint against
BellSouth before the Georgia Public Service Commission ("GAPSC") concerning the
Company's first and second interconnection agreements with BellSouth in Georgia.
These interconnection agreements cover the period through June 1999. The hearing
in relation to this complaint concluded January 21, 2000. On May 17, 2000, the
hearing officer reviewing the Company's first and second interconnection
agreements with BellSouth issued a recommended decision to the GAPSC stating
that BellSouth should be ordered to pay US LEC the disputed reciprocal
compensation at the end office rate, pending submission of evidence by the
Company showing that it is entitled to be compensated at the higher tandem rate.
On June 15, 2000, the GAPSC affirmed this recommended decision, and issued an
order requiring BellSouth to pay US LEC reciprocal compensation for traffic to
ISPs and other customers in Georgia at the end office rate (the "GAPSC Order").
On July 12, 2000, US LEC filed evidence with the GAPSC regarding its right to be
compensated at the tandem rate. On July 14, 2000, BellSouth filed an appeal of
the GAPSC Order with the U.S. District Court for the Northern District of
Georgia ("U.S. District Court-GA") and with the Georgia Superior Court in and
for Fulton County, Georgia. BellSouth asked the Georgia state court to cede the
appeal to the U.S. District Court - GA and asked the latter court for permission
to pay amounts due into court to avoid paying US LEC pending appeal. On July 18,
2000, the U.S. District Court- GA granted BellSouth's motion to pay amounts due
into court prior to receipt by the Company of any papers related to that appeal.
The Company has requested reconsideration of the order allowing BellSouth to pay
amounts due into court and is reviewing its options to respond to BellSouth's
appeal to the federal courts. The GAPSC has not yet ruled on the tandem/end
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office rate issue. The Company's complaint did not address the third
interconnection agreement in Georgia, which covers the period from June 1999 to
December 1999.
Florida -- On July 2, 1999, the Company filed a complaint against
BellSouth before the Florida Public Service Commission ("FLPSC") seeking
recovery of reciprocal compensation for ISP and other traffic in that state.
There is no hearing scheduled for this matter at this time.
Tennessee -- On August 6, 1999, the Company filed a complaint against
BellSouth before the Tennessee Regulatory Authority ("TRA") seeking recovery of
reciprocal compensation for ISP and other traffic in that state. There is no
hearing scheduled for this matter at this time.
Management believes that the Company will ultimately obtain favorable
results in the state proceedings described above before the FLPSC and the TRA
and in the pending appeal of the NCUC ISP Order and the GAPSC Order.
Management's belief is supported by the determinations of state regulatory
bodies and by courts hearing appeals of the state regulatory decisions, which
are discussed below, notwithstanding the jurisdictional position on ISP traffic
taken by the FCC in February 1999, which has now been vacated, also discussed
below. However, BellSouth may elect to initiate additional proceedings (by way
of appeal or otherwise) challenging amounts owed to the Company. In this regard,
BellSouth recently has asserted a variety of other objections to paying portions
of the reciprocal compensation billed by the Company. They include assertions
that US LEC has miscalculated late payment fees due from BellSouth and that the
Company has billed reciprocal compensation using the wrong rates. The Company
believes BellSouth has asserted these issues and will attempt to raise further
issues, in order to avoid or delay payment. Management believes that the Company
will obtain favorable outcomes to these disputes.
FCC's ISP Ruling and Related Proceedings -- In February, 1999, the FCC
issued a declaratory ruling (the "ISP 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 previously 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 might reconsider their decisions in light of its ruling.
On March 24, 2000, the U.S. Circuit Court for the District of Columbia
(the "D.C. Circuit") vacated the FCC's ISP Ruling. The D.C. Circuit ruled that
the FCC did not give adequate consideration to a number of facts when it found
that ISP calls were jurisdictionally interstate, including the FCC's own past
analyses of how to determine whether calls dialed to telephone numbers within
the local exchange are interstate or intrastate. The D.C. Circuit sent the case
back to the FCC to give the FCC opportunity to reconsider the question in light
of the D.C. Circuit's ruling. On June 23, 2000, the FCC requested comments on
the issues raised by the D.C. Circuit in its remand of the ISP Ruling to the
FCC. Initial comments were filed on July 21, 2000. Reply comments are due to be
filed on August 4, 2000. The Company cannot predict when the FCC will issue its
decision on remand.
To date, state regulatory bodies in at least thirty states have
considered the effect of the FCC's ISP 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, Florida, Georgia and Tennessee, which
together with North Carolina (see discussion above) represent the only states in
BellSouth's operating territory where the Company has significant reciprocal
compensation disputes at June 30, 2000. In this regard, the Alabama Public
Service Commission (the "APSC") 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 was 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 APSC decision was affirmed by the United States
District Court for the Middle District of Alabama. The FLPSC reached a similar
conclusion. The GAPSC and the TRA have also 20
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reaffirmed decisions, including the GAPSC Order, that reciprocal compensation is
owed for calls to ISPs. Two BellSouth states - South Carolina and Louisiana -
have ruled that reciprocal compensation is not due for traffic to ISPs. These
decisions, which came before the FCC's ISP Ruling was vacated by the D.C.
Circuit, represent a view adopted by very few other states, and have been
appealed. (The Company does not currently provide local service in Louisiana and
has no reciprocal compensation recorded to date for traffic in South Carolina or
Louisiana.)
State and federal courts considering the issue on appeal have also
universally supported the position that reciprocal compensation is due for
traffic terminated to ISPs. Included among these are decisions of the U.S.
Circuit Courts of Appeal for the Fifth, Seventh and Ninth Circuits, all of which
considered the issue in light of the FCC's ISP Ruling and affirmed the decision
of the state regulatory body that reciprocal compensation is due for traffic
terminated to ISPs. Most recently, on May 3, 2000, the U.S. District Court-GA
affirmed four decisions of the GAPSC in which the GAPSC determined that
reciprocal compensation is due for traffic terminated to ISPs.
If a decision adverse to the Company is issued in any of these
proceedings by any of the state commissions, the 4th Circuit or the U.S.
District Court-GA, or in any appeal or review of a favorable decision, or if
either the FCC or any of the applicable state commissions was 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. Management estimates
the Company's gross trade accounts receivable as of June 30, 2000 included
approximately $45 million of earned but uncollected disputed reciprocal
compensation related to non-Metacomm related ISP traffic.
GTE Reciprocal Compensation Dispute in North Carolina - In addition to
the proceedings involving BellSouth which are discussed above, in February 2000,
the Company received payment from GTE South Incorporated ("GTE") for reciprocal
compensation for traffic in North Carolina, including ISP traffic. This payment
was pursuant to a commercial arbitration award rendered January 4, 2000
resulting from a proceeding before the American Arbitration Association. GTE was
ordered to pay US LEC for all reciprocal compensation for the period ending
September 1999 (approximately $650 thousand). GTE has challenged the decision of
the arbitrator in the U.S. District Court for the Eastern District of North
Carolina. Management believes that GTE will not be successful in this challenge,
but cannot predict when the court will issue its decision.
In addition, the Company has filed arbitration to resolve its
reciprocal compensation dispute with GTE in North Carolina for periods after
September 1999. That arbitration is in the arbitrator selection phase at this
time. Although the Company cannot predict when this dispute will be resolved,
management knows of no reason why the second arbitration should have an outcome
different from the first, favorable arbitration ruling.
Existing BellSouth Interconnection Agreements -- 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 expired on
December 31, 1999 but continues in force until new interconnection agreements
are reached. The Company has adopted existing agreements to extend local
interconnection with BellSouth in North Carolina, Louisiana, Mississippi,
Alabama, South Carolina and Kentucky. These agreements are effective as of
January 1, 2000. The Company has filed petitions for arbitration in the
remaining states in BellSouth operating territory seeking to obtain
state-ordered interconnection agreements, but the Company anticipates that it
will be able to avoid the arbitration process by adopting interconnection
agreements that are either currently in effect or which will result from pending
arbitrations involving other competitive local exchange carriers ("CLECs").
These new agreements, once they are entered into, will be effective as of
January 1, 2000. The Company's ability to obtain favorable terms for
interconnection following December 31, 1999 in its principal states of operation
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.
The
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<PAGE>
Company's new interconnection agreements in North Carolina, Louisiana,
Mississippi, Alabama, South Carolina and Kentucky provide for reciprocal
compensation at rates significantly lower than in the Company's prior
interconnection agreements, and the Company anticipates that new interconnection
agreements in Tennessee, Georgia and Florida will also provide for significantly
lower rates.
Disputed Access Revenues - In February 2000, the Company filed suit in
U.S. District Court for the Western District of North Carolina against Sprint
Communications Company L.P. ("Sprint"). This action seeks to collect amounts
owed to the Company for access charges for intrastate and interstate traffic
which was either handed off to Sprint by the Company or terminated to the
Company by Sprint. As of June 30, 2000, Sprint owed the Company approximately
$7.4 million in access charges. Sprint has refused to pay the amounts invoiced
by the Company on the basis that the rates are higher than the amounts that
Sprint is willing to pay. Sprint claims it is not obligated to pay more than an
undefined incumbent local exchange carrier ("ILEC") rate. The Company's invoices
to Sprint are at the rates specified in the Company's state and federal tariffs.
The FCC recently determined that a long distance company may not withhold
interstate access charges on the basis that it believes the charges to be too
high while also continuing to accept the benefits of interconnection with the
local carrier without taking formal action to challenge the rates. The FCC has
ruled that AT&T was obligated to pay such access charges due to its failure to
commence a proceeding or terminate interconnection. (MGC Communications, Inc. v.
AT&T Corp., FCC Release 99-408). In addition, the FCC ruled recently in an
action brought by Sprint against MGC Communications, Inc. ("MGC") that the fact
that a CLEC's filed interstate rates exceeded those of the competing ILECs was
insufficient to establish that the CLEC's rates were excessive. The FCC
dismissed Sprint's challenge to MGC's rates. As a result of these rulings,
management anticipates a favorable resolution of the Company's dispute with
Sprint.
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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 June 30, 2000, 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 as well as the proceeding with
Sprint related to access revenues and the arbitration with GTE related to
reciprocal compensation. Note 7 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
On April 11, 2000, the Company issued $200 million of its Series A
Redeemable Convertible Preferred Stock (the "Preferred Stock") to affiliates of
Bain Capital, Inc. ("Bain") and Thomas H. Lee Partners, L.P. ("THL"). The
Preferred Stock earns dividends on a cumulative basis at an annual rate of 6%,
payable quarterly in shares of Preferred Stock for three years and, at US LEC's
option, in cash or shares of Preferred Stock over the next seven years. Shares
of the Preferred Stock are convertible into shares of Class A Common Stock at an
initial conversion price of $35 per share. All outstanding shares of the
Preferred Stock are subject to mandatory redemption on April 10, 2010. Proceeds
to the Company, net of commissions and other transaction costs, were
approximately $193.9 million. The Preferred Stock was offered and sold by the
Company in reliance upon the exemption from registration provided by Section
4(2) of the Securities Act of 1933, as amended (the Securities Act"), for
transactions by an issuer not involving any public offering. The Company
conducted no general solicitation in connection with the transaction and
received a representation from each of the purchasers that he, she or it was an
"accredited investor" as defined by Rule 501(a) promulgated under the Securities
Act.
Item 3. Defaults upon Senior Securities
None.
Item 4. Submission of Matters to a Vote of Security Holders
The Annual Meeting of the Stockholders of US LEC Corp. was held on May
16, 2000. At the Annual Meeting, five matters were considered, acted upon and
approved: (1) the election of three Class A Directors and two Class B Directors
of the Company for a one-year term and until their successors are duly elected
and qualified; (2) an amendment to the US LEC Corp. 1998 Omnibus Stock Plan to
increase the number of shares of
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Class A Common Stock reserved for issuance under the plan from 2,000,000 to
3,500,000; (3) adoption of the US LEC Corp. Employee Stock Purchase Plan; (4) an
amendment to the Company's Restated Certificate of Incorporation increasing the
number of authorized shares of Class A Common Stock from 72,924,728 to
122,924,728; and (5) an amendment to the Company's Restated Certificate of
Incorporation to permit the Board of Directors to declare and pay a stock
dividend on shares of Class B Common Stock in shares of Class A Common Stock,
subject to receipt of the consent of the holders of a majority of Class B Common
Stock.
(1) Indicated below are the total votes in favor of each director
nominee and the total votes withheld:
<TABLE>
<CAPTION>
Votes*
-------------------------------------------------------------
Nominee Common Stock For Withheld Authority
----------------------------------------------------------------------------------------- -----------------------------
<S> <C> <C> <C>
David M. Flaum Class A 2,932,033 66,975
Class B 170,752,700 -
----------- ------
173,684,733 66,975
John W. Harris Class A 2,932,033 66,975
Class B 170,752,700 -
----------- ------
173,684,733 66,975
Steven L. Schoonover Class A 2,932,233 66,975
Class B 170,752,700 -
----------- ------
173,684,933 66,775
Richard T. Aab Class B 170,752,700 -
Tansukh V. Ganatra Class B 170,752,700 -
</TABLE>
(2) Indicated below are the total votes in favor of the amendment to US
LEC Corp. 1998 Omnibus Stock Plan, the total votes against the amendment and the
total votes abstaining:
Votes*
----------------------------------------------------------
Common Stock For Against Abstained
---------------------------------------------------------------------------
Class A 1,017,773 1,482,315 498,920
Class B 170,752,700 - -
----------- ------------ ------------
Total 171,770,473 1,482,315 498,920
(3) Indicated below are the total votes in favor of the adoption of the
US LEC Corp. Employee Stock Purchase Plan:
Votes*
----------------------------------------------------
Common Stock For Against Abstained
---------------------------------------------------------------------------
Class A 2,443,781 56,307 498,920
Class B 170,752,700 - -
----------- ------------ ------------
Total 173,196,481 56,307 498,920
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(4) Indicated below are the total votes in favor of the amendment to
the Company's Restated Certificate of Incorporation increasing the number of
Authorized Shares:
Votes*
--------------------------------------------------
Common Stock For Against Abstained
--------------------------------------------------- --------------------
Class A 2,137,539 366,649 494,820
Class B 170,752,700 - -
----------- ----------- ------------
Total 172,890,239 366,649 494,820
(5) Indicated below are the total votes in favor of the amendment to
the Company's Restated Certificate of Incorporation to permit the Board of
Directors to declare and pay a stock dividend on shares of Class B Common Stock
in shares of Class A Common Stock, subject to receipt of the consent of the
holders of a majority of Class B Common Stock:
Votes*
---------------------------------------------------
Common Stock For Against Abstained
--------------------------------------------------------------------------
Class A 2,391,183 112,905 494,920
Class B 170,752,700 - -
----------- ----------- ------------
Total 173,143,883 112,905 494,920
*Each share of Class A Common Stock has one vote and each share of
Class B Common Stock has 10 votes on all matters on which holders of Class A
Common Stock are entitled to vote.
Item 5. Other Information
None.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits:
Exhibit No. Description
----------- -----------
4.1 Preferred Stock Purchase Agreement, dated
April 11, 2000 (1)
4.2 Option Agreement, dated April 11, 2000 (1)
4.3 Corporate Governance Agreement, dated April
11, 2000 (1)
4.4 Registration Rights Agreement, dated April
11, 2000 (1)
11.1 Statement Regarding Computation of Earnings
per Share(2)
27 Financial Data Schedule (For SEC use only)
(1) Incorporated by reference to the Company's
Current Report on Form 8-K filed May 12, 2000.
(2) Incorporated by reference to the Company's
Condensed Consolidated
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Statements of Operations appearing in Part I of this report.
(b) Form 8-K:
The Company filed a current Report on Form 8-K on April 3, 2000 related
to the North Carolina Utilities Commissions order relieving BellSouth
Telecommunications, Inc. of any obligation to pay reciprocal
compensation to US LEC Corp. for minutes attributable to a network
operated by Metacomm, L.L.C.
The Company filed a current Report on Form 8-K on May 12, 2000 related
to the $200 million - equity investment in the Company by Bain Capital,
Inc. and Thomas H. Lee Partners, L.P.
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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:_______________________
August 14, 2000
Michael K. Robinson
Executive Vice President
and Chief Financial Officer
