<PAGE> 1
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
---------------
FORM 10-Q
(Mark one) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended September 30, 1998
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the Transition Period From ___________ to _______________.
Commission File Number: 0-24509
ALLEGIANCE TELECOM, INC.
(Exact name of registrant as specified in its certificate)
Delaware 75-2721491
(State or other jurisdiction (IRS Employer Identification No.)
of incorporation or organization)
1950 STEMMONS FREEWAY SUITE 3026 DALLAS, TEXAS 75207
(Address of principal executive offices) (Zip Code)
(214) 261-7100
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports) and (2) has been subject to such
filing requirements for the past 90 days.
[X] Yes [ ] No
AS OF NOVEMBER 5, 1998, THE REGISTRANT HAS 50,341,554 SHARES OF COMMON
STOCK, PAR VALUE $0.01 PER SHARE OUTSTANDING.
<PAGE> 2
ALLEGIANCE TELECOM, INC. AND SUBSIDIARIES
FORM 10-Q INDEX
<TABLE>
<CAPTION>
PAGE NO.
--------
<S> <C>
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets as of September 30, 1998 and
December 31, 1997....................................................................... 3
Condensed Consolidated Statements of Operations for the Three
and Nine Months Ended September 30, 1998 and the Period from
Inception (April 22, 1997) through September 30, 1997................................... 4
Condensed Consolidated Statements of Cash Flows for the Nine
Months Ended September 30, 1998 and the Period from
Inception (April 22, 1997) through September 30, 1997................................... 5
Notes to Condensed Consolidated Financial Statements.................................... 6
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations............................................................... 12
PART II. OTHER INFORMATION
Item 1. Legal Proceedings............................................................... 22
Item 2. Changes in Securities and Use of Proceeds....................................... 22
Item 3. Defaults upon Senior Securities................................................. 22
Item 4. Submission of Matters to a Vote of Security Holders............................. 22
Item 5. Other Information............................................................... 22
Item 6. Exhibits and Reports on Form 8-K................................................ 22
</TABLE>
2
<PAGE> 3
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
ALLEGIANCE TELECOM, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(Dollars in thousands, except share amounts)
<TABLE>
<CAPTION>
September 30, 1998 December 31, 1997
------------------ -----------------
(unaudited) (audited)
<S> <C> <C>
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $404,745.1 $ 5,726.4
Short-term investments 50,256.0 --
Short-term investments, restricted 22,094.7 --
Accounts receivable (net of allowance for doubtful accounts
of $152.9 and $0, respectively) 2,031.9 4.3
Prepaid expenses and other current assets 1,711.4 245.2
---------- ----------
Total current assets 480,839.1 5,975.9
PROPERTY AND EQUIPMENT:
Property and equipment 104,259.0 23,912.6
Accumulated depreciation and amortization (3,718.0) (12.7)
---------- ----------
Property and equipment, net 100,541.0 23,899.9
OTHER NON-CURRENT ASSETS:
Deferred debt issuance costs (net of accumulated amortization of $485.9
and $0, respectively) 16,326.2 --
Long-term investments, restricted 47,798.0 --
Other assets 1,268.0 171.2
---------- ----------
Total other non-current assets 65,392.2 171.2
---------- ----------
Total assets $646,772.3 $ 30,047.0
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
CURRENT LIABILITIES:
Accounts payable $ 6,716.8 $ 2,261.7
Accrued liabilities and other 25,676.3 1,668.0
---------- ----------
Total current liabilities 32,393.1 3,929.7
LONG-TERM DEBT 463,751.6 --
REDEEMABLE CUMULATIVE CONVERTIBLE
PREFERRED STOCK - 0 and 40,498,062 shares issued and outstanding
at September 30, 1998 and December 31, 1997, respectively -- 33,409.4
REDEEMABLE WARRANTS 8,506.7 --
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' EQUITY (DEFICIT):
Common stock - 50,341,554 and 426 shares issued and
outstanding at September 30, 1998 and December 31, 1997, respectively 503.4 --
Additional paid-in capital 416,095.6 3,008.4
Deferred compensation (15,531.5) (2,798.4)
Deferred management ownership allocation charge (33,002.2) --
Accumulated deficit (225,944.4) (7,502.1)
---------- ----------
Total stockholders' equity (deficit) 142,120.9 (7,292.1)
---------- ----------
Total liabilities and stockholders' equity (deficit) $646,772.3 $ 30,047.0
========== ==========
</TABLE>
The accompanying notes are an integral part of these
condensed consolidated financial statements.
3
<PAGE> 4
ALLEGIANCE TELECOM, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Dollars in thousands, except per share amounts)
<TABLE>
<CAPTION>
Period From
Inception
(April 22, 1997)
Three Months Ended Nine Months Ended through
September 30, 1998 September 30, 1998 September 30, 1997
------------------ ------------------ ------------------
(unaudited) (unaudited) (unaudited)
<S> <C> <C> <C>
REVENUES $ 2,785.7 $ 4,200.6 $ --
OPERATING EXPENSES:
Network 2,920.3 4,506.0 --
Selling 3,751.8 6,212.8 1.5
General and administrative 9,547.3 19,862.4 898.0
Management ownership allocation charge 160,534.4 160,534.4 --
Non-cash deferred compensation 1,389.9 3,758.7 --
Depreciation and amortization 2,491.8 3,705.3 --
-------------- -------------- --------------
Total operating expenses 180,635.5 198,579.6 899.5
Loss from operations (177,849.8) (194,379.0) (899.5)
OTHER (EXPENSE) INCOME:
Interest income 7,463.0 13,059.1 24.6
Interest expense (13,380.3) (25,278.4) --
-------------- -------------- --------------
Total other (expense) income (5,917.3) (12,219.3) 24.6
NET LOSS (183,767.1) (206,598.3) (874.9)
ACCRETION OF REDEEMABLE PREFERRED
STOCK AND WARRANT VALUES (125.5) (11,844.0) (409.1)
-------------- -------------- --------------
NET LOSS APPLICABLE TO COMMON STOCK $ (183,892.6) $ (218,442.3) $ (1,284.0)
============== ============== ==============
NET LOSS PER SHARE, basic and diluted $ (3.69) $ (13.02) $ (3,014.12)
============== ============== ==============
WEIGHTED AVERAGE NUMBER OF SHARES
OUTSTANDING, basic and diluted 49,794,368 16,780,802 426
============== ============== ==============
</TABLE>
The accompanying notes are an integral part of these
condensed consolidated financial statements.
4
<PAGE> 5
ALLEGIANCE TELECOM, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
<TABLE>
<CAPTION>
Period From
Inception
Nine Months (April 22, 1997)
Ended through
September 30, 1998 September 30, 1997
------------------ ------------------
(unaudited) (unaudited)
<S> <C> <C>
Cash Flows from Operating Activities
Net loss $(206,598.3) $ (874.9)
Adjustments to reconcile net (loss) to cash
provided by operating activities
Depreciation and amortization 3,705.3 --
Provision for uncollectible accounts receivable 152.9 --
Accretion of senior discount notes 20,114.0 --
Amortization of original issue discount 387.8 --
Amortization of deferred debt issuance costs 485.9 --
Management ownership allocation charge and
amortization of deferred compensation 164,293.1 --
Increase in receivables (2,180.5) (6.0)
Increase in prepaid expenses and other current assets (1,466.2) (51.3)
Increase (decrease) in accounts payable (1,453.6) 79.4
Increase in accrued liabilities 13,158.5 423.2
Increase in other assets (1,096.8) (21.2)
---------- ----------
Net cash used in operations (10,497.9) (450.8)
Cash Flows from Investing Activities
Capital expenditures (63,550.2) (17.3)
Investment in short-term and long-term investments (120,148.7) --
---------- ----------
Net cash used in investing activities (183,698.9) (17.3)
Cash Flows from Financing Activities
Proceeds from issuance of senior discount notes 443,212.1 --
Proceeds from issuance of redeemable warrants 8,183.6 --
Debt issuance costs (16,812.1) --
Proceeds from issuance of redeemable preferred stock -- 5,004.7
Proceeds from issuance of common stock -- 0.1
Proceeds from redeemable capital contributions 20,880.4 --
Refund overpayment of redeemable capital contributions (5.3) --
Proceeds from initial public offering 137,756.8 --
---------- ----------
Net cash provided from financing activities 593,215.5 5,004.8
---------- ----------
Net increase in cash and cash equivalents 399,018.7 4,536.7
Cash and cash equivalents, beginning of period 5,726.4 --
---------- ----------
Cash and cash equivalents, end of period $404,745.1 $ 4,536.7
========== ==========
</TABLE>
The accompanying notes are an integral part of these
condensed consolidated financial statements.
5
<PAGE> 6
ALLEGIANCE TELECOM, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
THREE AND NINE MONTHS ENDED SEPTEMBER 30, 1998
(DOLLARS IN THOUSANDS, EXCEPT SHARE AMOUNTS)
(UNAUDITED)
1. GENERAL:
Allegiance Telecom, Inc., a competitive local exchange carrier ("CLEC"),
seeks to become a leading provider of voice, data, and Internet services to
business, government, and other institutional users in major metropolitan areas
across the United States. Allegiance Telecom, Inc. and its subsidiaries are
referred to herein as the "Company."
The Company's development plan is focused on offering services in 24 of the
largest U.S. metropolitan areas. As of September 30, 1998, Allegiance is
operational in six Phase I markets: New York City, Dallas, Atlanta, Fort Worth,
Chicago and Los Angeles; and is in the process of deploying networks in seven
other markets: San Francisco, Boston, Washington D.C., Northern New Jersey,
Oakland, San Diego and San Jose. In addition, the Company has switching
equipment on order for two of its other target markets, Philadelphia and
Houston.
Until December 16, 1997, the Company was in the development stage. From the
Company's initial funding in August 1997 to December 16, 1997, its principal
activities included developing business plans, procuring governmental
authorizations, raising capital, hiring management and other key personnel,
working on the design and development of its local exchange telephone networks
and operations support systems, acquiring equipment and facilities and
negotiating interconnection agreements. Accordingly, the Company has incurred
operating losses and operating cash flow deficits.
The Company's success will be affected by the problems, expenses, and delays
encountered in connection with the formation of any new business, and the
competitive environment in which the Company intends to operate. The Company's
performance will further be affected by its ability to assess potential markets,
secure financing or raise additional capital, implement expanded interconnection
and collocation with the facilities of incumbent local exchange carriers
("ILECs"), lease adequate trunking capacity from the ILECs or other CLECs,
purchase and install switches in additional markets, implement efficient
operations support systems and other back office systems, develop a sufficient
customer base, and attract, retain, and motivate qualified personnel. The
Company's networks and the provisioning of telecommunications services are
subject to significant regulation at the federal, state and local levels. Delays
in receiving required regulatory approvals or the enactment of new adverse
regulation or regulatory requirements may have a material adverse effect upon
the Company. Although management believes that the Company will be able to
successfully mitigate these risks, there is no assurance that the Company will
be able to do so or that the Company will ever operate profitably.
Expenses are expected to exceed revenues in each location in which the
Company offers service until a sufficient customer base is established. It is
anticipated that obtaining a sufficient customer base will take a number of
years, and positive cash flows from operations are not expected in the near
future.
2. BASIS OF PRESENTATION:
The accompanying unaudited condensed consolidated financial statements have
been prepared by the Company in accordance with generally accepted accounting
principles for interim financial information and are in the form prescribed by
the Securities and Exchange Commission in instructions to Form 10-Q and Article
10 of Regulation S-X. Accordingly, they do not include all of the information
and footnotes required by generally accepted accounting principles for complete
financial statements. Because the Company did not commence operations until
August 1997, the results of operations and cash flows for the three and nine
month periods ending September 30, 1997 are identical. The interim unaudited
financial statements should be read in conjunction with the audited financial
statements of the Company as of and for the three month period ended March 31,
1998 and for the year ended December 31, 1997 and the second quarter 1998 Form
10-Q. In the opinion of management, all adjustments (consisting only of normal
recurring adjustments) considered necessary for a fair presentation have been
included. Operating results for the three and nine months ended September 30,
1998 are not necessarily indicative of the results that may be expected for the
year ending December 31, 1998.
6
<PAGE> 7
Certain amounts in the prior period's consolidated financial statements have
been reclassified to conform with the current period presentation.
3. REPORTING ON THE COST OF START-UP ACTIVITIES:
On April 3, 1998, the American Institute of Certified Public Accountants
issued Statement of Position No. 98-5, "Reporting on the Costs of Start-up
Activities" ("SOP 98-5"). SOP 98-5 requires start-up activities and organization
costs to be expensed as incurred and that start-up costs capitalized prior to
the adoption of SOP 98-5 be reported as the cumulative effect of a change in
accounting principle. The Company adopted SOP 98-5 during the second quarter of
1998. Adoption of SOP 98-5 did not have an affect on the Company, inasmuch as
the Company had previously expensed all such costs.
4. REVENUE RECOGNITION:
Revenue is recognized in the month in which service is provided, except for
local reciprocal compensation which is recorded on a cash basis. The propriety
of CLECs, such as Allegiance, to earn local reciprocal compensation is the
subject of numerous regulatory and legal challenges, and until this issue is
ultimately resolved, Allegiance has determined to recognize this revenue only
upon receipt.
5. SHORT-TERM INVESTMENTS:
Short-term investments consist primarily of commercial paper with original
maturities at date of purchase beyond three months and less than 12 months. Such
short-term investments are carried at their accreted value, which approximates
fair value, due to the short period of time to maturity.
6. RESTRICTED INVESTMENTS:
Restricted investments consist entirely of U.S. government securities
purchased in connection with the 12 7/8% Notes (see Note 9) to secure the first
three years' (six semi-annual) interest payments on these Notes. Such
investments are stated at accreted value, which approximates fair value, and are
shown in both current and long-term assets, based upon the maturity dates of
each of the securities.
7. PROPERTY AND EQUIPMENT:
Property and equipment includes network equipment, leasehold improvements,
software, furniture and fixtures and office equipment and other and
construction-in-progress of network equipment, leasehold improvements, software
and office equipment and other. These assets are stated at cost, which includes
direct costs and capitalized interest and are depreciated once placed in service
using the straight-line method. Interest expense for the three and nine months
ended September 30, 1998 was $14,231.6 and $27,073.1 before the capitalization
of $851.3 and $1,794.7 of interest related to construction-in-progress for the
three and nine months ended September 30, 1998, respectively. Repair and
maintenance costs are expensed as incurred.
7
<PAGE> 8
Property and equipment at September 30, 1998 and December 31, 1997, consisted
of the following:
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31, USEFUL LIVES
1998 1997 (IN YEARS)
------------- ------------ ------------
<S> <C> <C> <C>
Network equipment .................... $ 35,190.3 $ -- 5-7
Leasehold improvements ............... 8,765.1 37.5 5-10
Software ............................. 6,314.5 -- 3
Office equipment and other ........... 3,735.7 89.9 2
Furniture and fixtures ............... 1,518.3 150.2 5
---------- ----------
Property and equipment, in
service ......................... 55,523.9 277.6
Less: Accumulated depreciation ....... (3,718.0) (12.7)
---------- ----------
Property and equipment in
service, net ..................... 51,805.9 264.9
Construction-in-progress network
equipment ....................... 34,269.9 19,989.9
Construction-in-progress leasehold
improvements .................... 11,743.2 2,458.7
Construction-in-progress software .... 2,058.1 --
Construction-in-progress office
equipment and other ............. 663.9 1,186.4
---------- ----------
Property and equipment, net ... $100,541.0 $ 23,899.9
========== ==========
</TABLE>
8. CAPITAL LEASE:
On May 29, 1998, the Company signed a capital lease agreement for three,
four-fiber rings, with a term of ten years and a renewal term of ten years, at
an expected total cost of $3,485.0, a portion of which was paid in 1998. The
remainder is expected to be paid in 1999, contingent upon the timing of
completion of network segments.
9. LONG-TERM DEBT:
On February 3, 1998, the Company raised gross proceeds of approximately
$250,477.2 in an offering of 445,000 Units (the "Unit Offering"), each of which
consisted of one 11 3/4% Senior Discount Note due 2008 (the "11 3/4% Notes") and
one warrant to purchase .0034224719 shares of Common Stock (the "Redeemable
Warrants") at an exercise price of $.01 per share, subject to certain
antidilution provisions. Of the gross proceeds, $242,293.6 was allocated to the
11 3/4% Notes and $8,183.6 was allocated to the Redeemable Warrants. The
Redeemable Warrants became exercisable in connection with the initial public
offering of Common Stock (see Note 11) in July 1998, and each warrant may now
purchase 1.45898399509 shares of Common Stock as a result of the stock split
(see Note 11).
A Registration Statement on Form S-4 (File No. 333-49013) registering the
Company's 11 3/4% Notes, and offering to exchange (the "Exchange Offer") any and
all of the outstanding 11 3/4% Notes for Series B 11 3/4% Notes due 2008 (the
"Series B Notes"), was declared effective by the Securities and Exchange
Commission on May 22, 1998. The Exchange Offer terminated on June 23, 1998 after
substantially all of the outstanding 11 3/4% Notes were exchanged. The terms and
conditions of the Series B Notes are identical to those of the 11 3/4% Notes in
all material respects.
The Series B Notes have a principal amount at maturity of $445,000.0 and an
effective interest rate of 12.45%. The Series B Notes mature on February 15,
2008. From and after February 15, 2003, interest on the Series B Notes will be
payable semi-annually in cash at the rate of 11 3/4% per annum.
The Company must make an offer to purchase the Redeemable Warrants for cash
at the Relevant Value upon the occurrence of a Repurchase Event. A Repurchase
Event is defined to occur when (i) the Company consolidates with or merges into
another person if the common stock thereafter issuable upon exercise of the
Redeemable Warrants is
8
<PAGE> 9
not registered under the Securities Exchange Act of 1934, as amended (the
"Exchange Act") or (ii) the Company sells all or substantially all of its assets
to another person, if the common stock thereafter issuable upon the exercise of
the Redeemable Warrants is not registered under the Exchange Act, unless the
consideration for such a transaction is cash. The Relevant Value is defined to
be the fair market value of the common stock as determined by the trading value
of the securities if publicly traded or at an estimated fair market value
without giving effect to any discount for lack of liquidity, lack of registered
securities, or the fact that the securities represent a minority of the total
shares outstanding. As required by SEC accounting standards the Company is
recognizing the potential future redemption value of the Redeemable Warrants by
recording accretion of the Redeemable Warrants to their estimated fair market
value at February 3, 2008 using the effective interest method. Accretion
recorded in the three and nine months ended September 30, 1998 was $125.5 and
$323.2, respectively.
The Series B Notes are redeemable by the Company, in whole or in part, any
time on or after February 15, 2003, at 105.875% of their principal amount at
maturity, plus accrued and unpaid interest, declining to 100% of their principal
amount at maturity, plus accrued and unpaid interest on and after February 15,
2006. In addition, at any time prior to February 15, 2001, the Company may, at
its option, redeem up to 35% of the principal amount at maturity of the Series B
Notes in connection with one or more Public Equity Offerings (as defined in the
Indenture relating to the Series B Notes) at 111.750% of the accreted value on
the redemption date; provided that at least $289.3 million aggregate principal
amount at maturity of the Series B Notes remains outstanding after such
redemption.
In July 1998, the Company raised approximately $200,918.5 of gross proceeds
from the sale of its 12 7/8% Senior Notes due 2008 (the "July 1998 Debt
Offering") of which approximately $69,033.4 was used to purchase U.S. government
securities, which were placed in a pledged account to secure and fund the first
six scheduled payments of interest on such notes (see Note 6).
The 12 7/8% Senior Notes due 2008 (the "12 7/8% Notes") have a principal
amount at maturity of $205,000.0. The 12 7/8% Notes mature on May 15, 2008.
Interest on the 12 7/8% Notes will be payable semi-annually in cash at the rate
of 12 7/8% on May 15 and November 15 of each year, commencing November 15, 1998.
The 12 7/8% Notes are redeemable by the Company, in whole or in part, at any
time on or after May 15, 2003, at 106.438% of their principal amount, plus
accrued interest, declining to 100% of their principal amount, plus accrued
interest, on or after May 15, 2006. In addition, prior to May 15, 2001, the
Company may redeem up to 35% of the aggregate principal amount of the 12 7/8%
Notes with the proceeds of one or more Public Equity Offerings (as defined in
the Indenture relating to the 12 7/8% Notes) at 112.875% of their principal
amount, plus accrued interest, provided, however, that after any such redemption
at least 65% of the aggregate principal amount of the 12 7/8% Notes originally
issued remain outstanding.
The Series B Notes and the 12 7/8% Notes carry certain restrictive covenants
that, among other things, limit the ability of the Company to incur
indebtedness, create liens, engage in sale-leaseback transactions, pay dividends
or make distributions in respect of their capital stock, redeem capital stock,
make investments or certain other restricted payments, sell assets, issue or
sell stock of certain Subsidiaries, enter into transactions with any holder of
5% or more of any class of capital stock of the Company or effect a
consolidation or merger. In addition, upon a change of control, the Company is
required to make an offer to purchase Series B notes at a price equal to 101% of
their accreted amount plus accrued interest, if any and the 12 7/8% Notes at
101% of their principal amount plus accrued interest. However, these limitations
are subject to a number of important qualifications and exceptions (as defined
in the indentures relating to each series of notes). The Company was in
compliance with all such restrictive covenants at September 30, 1998.
10. COMMITMENTS AND CONTINGENCIES:
The Company has entered into various operating lease agreements, with
expirations through 2009, for office space and equipment.
9
<PAGE> 10
Future minimum lease obligations related to the Company's operating leases as of
September 30, 1998 are as follows:
<TABLE>
<S> <C>
1998 $ 4,421.2
1999 6,787.5
2000 6,845.7
2001 6,087.3
2002 5,559.5
2003 5,550.4
Thereafter $22,020.5
</TABLE>
Total rent expense for the three and nine months ended September 30, 1998,
was $815.4 and $1,575.7, respectively, and was $2.7 for the period ended
September 30, 1997.
In October 1997, the Company entered into a five-year general agreement with
Lucent Technologies, Inc. ("Lucent") establishing terms and conditions for the
purchase of Lucent products, services, and licensed materials. This agreement
includes a three-year exclusivity commitment for the purchase of products and
services related to new switches. The agreement contains no minimum purchase
requirements.
11. CAPITALIZATION
In connection with its initial public offering of Common Stock, the Company
increased the number of authorized common shares and preferred shares to 150
million and 1 million, respectively, and effected a 426.2953905 for-one stock
split which is reflected in the net loss per share amounts and the weighted
number of shares outstanding reflected on the statements of operations, and the
shares outstanding on the balance sheets.
On July 7, 1998, the Company raised $150,000.0 of gross proceeds in the
Company's initial public offering of Common Stock. The Company sold 10,000,000
shares of its Common Stock at a price of $15 per share.
On July 7, 1998, certain venture capital investors (the "Fund Investors")
and certain management investors (the "Management Investors") owned 95.0% and
5.0%, respectively, of the ownership interests of Allegiance LLC, an entity that
owned substantially all of the Company's outstanding capital stock. As a result
of the successful initial public offering, Allegiance LLC was dissolved and its
assets (which consisted almost entirely of such capital stock) have been
distributed to the Fund Investors and the Management Investors in accordance
with Allegiance LLC's Limited Liability Company Agreement (the "LLC Agreement").
The LLC Agreement provided that the equity allocation between the Fund Investors
and the Management Investors be 66.7% and 33.3%, respectively, based upon the
valuation implied by the initial public offering. Under generally accepted
accounting principles, the Company recorded the increase in the assets of
Allegiance LLC allocated to the Management Investors as a $193,536.6 increase in
additional paid-in capital, of which $122,475.5 was recorded as a non-cash,
non-recurring charge to operating expense and $71,061.1 was recorded as a
deferred management ownership allocation charge. The deferred charge was
amortized at $38,058.9 during the third quarter of 1998 and will be further
amortized at $6,777.5, $18,870.2, $7,175.7 and $178.8 during the fourth quarter
of 1998, and the years 1999, 2000 and 2001, respectively, which is the period
over which the Company has the right to repurchase certain of the securities (at
the lower of fair market value or the price paid by the employee) in the event
the management employee's employment with the Company is terminated.
In connection with the consummation of the initial public offering, the
outstanding shares of the Company's Redeemable Cumulative Convertible Preferred
Stock (the "Preferred Stock") have been converted into 40,341,128 shares of
Common Stock and the obligation of Allegiance LLC to make additional capital
contributions to the Company (and the obligation of the members of Allegiance
LLC to make capital contributions to it) has terminated. Upon such conversion of
the Preferred Stock, the obligation of the Company to redeem the Preferred Stock
also terminated and, therefore, the accretion of the Preferred Stock value
recorded to the date of the initial public offering, $15,335.0, was reclassified
to additional paid-in capital in the stockholders' equity section of the balance
sheet in the third quarter of 1998, along with $50,470.3 in proceeds from the
issuance of the Preferred Stock and redeemable capital contributions.
10
<PAGE> 11
12. LOSS PER SHARE:
The net loss per share amounts reflected on the statements of operations and
the number of shares outstanding on the balance sheets reflect a 426.2953905
for-one stock split, which occurred in connection with the initial public
offering of common stock (the "IPO") (see Note 11). The preferred shares,
warrants and options were not included in the net loss per share calculation as
the effect from the conversion would be antidilutive. The net loss applicable to
common stock includes the accretion of redeemable preferred stock and warrant
values of $125.5 and $11,844.0 for the three and nine months ended September 30,
1998, and $409.1 for the period ended September 30, 1997, respectively.
13. COMPREHENSIVE INCOME:
In September 1997, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 130, "Reporting Comprehensive Income"
("SFAS 130"). SFAS 130 establishes reporting and disclosure requirements for
comprehensive income and its components within the financial statements. The
Company's comprehensive income components were immaterial for the three and nine
months ending September 30, 1998 and the Company had no comprehensive income
components as of December 31, 1997; therefore, comprehensive income is the same
as net income for both periods.
14. RELATED PARTIES
In connection with the Unit Offering, the IPO and the July 1998 Debt
Offering, the Company incurred approximately $6,956.5 and $11,331.5 in fees to
an affiliate of an investor in the Company of for the three and nine months
ended September 30, 1998, respectively.
15. LEGAL MATTERS:
On August 29, 1997, WorldCom, Inc. ("WorldCom") sued the Company and two
individual employees. In its complaint, WorldCom alleges that these employees
violated certain noncompete and nonsolicitation agreements by accepting
employment with the Company and by soliciting then current WorldCom employees to
leave WorldCom's employment and join the Company. In addition, WorldCom claims
that the Company tortiously interfered with WorldCom's relationships with its
employees, and that the Company's behavior constituted unfair competition.
WorldCom seeks injunctive relief and damages, although it has filed no motion
for a temporary restraining order or preliminary injunction. The Company denies
all claims and will vigorously defend itself. The Company does not expect the
ultimate outcome to have a material adverse effect on the results of operations
or financial condition of the Company.
On October 7, 1997, the Company filed a counterclaim against WorldCom for,
among other things, attempted monopolization of the "one stop shopping"
telecommunications market, abuse of process, and unfair competition. WorldCom
did not move to dismiss the attempted monopolization claim, but has moved to
dismiss the abuse of process and unfair competition claims. On March 4, 1998,
the court dismissed the claim for unfair competition.
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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
OVERVIEW
Allegiance seeks to be a premier provider of telecommunications services to
business, government and other institutional users in major metropolitan areas
across the United States. Allegiance anticipates offering an integrated set of
telecommunications products and services including local exchange, local access,
domestic and international long distance, enhanced voice, data and a full suite
of Internet services. Allegiance plans to establish networks in 24 of the
largest U.S. markets.
RESULTS OF OPERATIONS
Sales and Revenues
The Company commenced operations in August 1997. During the period from August
to September, 1997 Allegiance did not sell any services or open any markets. At
that time, the Company devoted substantial effort in developing its business
plans, initiating applications for governmental authorizations, hiring
management and other key personnel, working on the design and development of its
local exchange telephone networks and operations support systems, acquiring
equipment and facilities and negotiating interconnection agreements. Inasmuch as
the Company has significantly increased the scope and size of its operations
from its infancy during the third quarter of 1997, comparisons of the third
quarter 1998 results with the third quarter of 1997 are not meaningful.
The net loss (after the non-cash one-time management allocation charge and
amortization of deferred compensation and a portion of the deferred management
allocation charge) for the third quarter of 1998 was $183.9 million and was
$218.4 million for the nine months ended September 30, 1998. Earnings before
interest, taxes, depreciation, amortization, management ownership allocation
charge and non-cash deferred compensation ("EBITDA") for the same periods was a
negative $13.4 million and negative $26.4 million, respectively. EBITDA excludes
the non-cash charges to operations described in the preceding sentence totaling
$161.9 million and $164.3 million for the three and nine months ended September
30, 1998, respectively.
The Company expects to continue to experience increasing operating losses
and negative EBITDA as a result of its development activities and as it expands
its operations. The Company does not expect to achieve positive EBITDA in any
market until at least two to three years after it commences initial service in
such market.
The Company opened three new markets during the third quarter of 1998: Fort
Worth, Chicago and Los Angeles. Allegiance is now operational in six markets,
including New York City, Dallas, Atlanta, Fort Worth, Chicago and Los Angeles.
Allegiance is in the process of deploying networks in seven markets: San
Francisco, Oakland, Boston, Washington D.C., Northern New Jersey, San Diego and
San Jose. The Company has collocation applications pending in Orange County and
plans to initiate the collocation application process for Long Island, New York
central offices during the fourth quarter of 1998. In addition to the above, the
Company has switching equipment on order for two of its other target markets,
Philadelphia and Houston. The Company plans to continue to open markets at the
rate of one per month during the fourth quarter, and into the first eight months
of 1999.
The Company generated $2.8 million and $4.2 million in revenue during the
three months and nine months ended September 30, 1998, respectively. The third
quarter revenues represent a 133% increase compared to revenues for the second
quarter of 1998. The Company installed approximately 14,900 lines during the
third quarter of 1998, an increase of 86% compared with 8,000 lines installed in
the second quarter of 1998. At September 30, 1998, the Company has a total
installed base of 25,900 lines, which compares with 11,000 access lines
installed at June 30, 1998.
The Company has significantly increased sales of facilities-based lines,
while de-emphasizing reselling of ILEC provided services. Of the 14,900 access
lines installed during the third quarter of 1998, 73% are facility-based. At the
end of the third quarter, facility-based lines represented 47% of the total
installed base. Allegiance will continue to emphasize the sale and installation
of facility-based lines over resale lines. The Company estimates that resale
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services will continue to diminish proportionally and will ultimately represent
no more than 5% of all lines installed.
Through September 30, 1998, the Company had sold a total approximately
43,400 access lines. Lines sold in the third quarter were 22,300, compared with
16,400 in the second quarter, a 36% increase. Facility-based lines accounted for
86% of third quarter sales and represented 64% of all sales through September
30, 1998.
Sales are expected to increase from the level realized in the third quarter
of 1998 as new markets are opened, and as sales teams in existing markets are
increased. Allegiance presently has 17 sales teams, a total of 231 sales
personnel, and plans to add 11 new sales teams before the end of 1998. Markets
expected to become operational in the fourth quarter of 1998 are San Francisco,
Oakland and Boston. Three teams will initially address the San Francisco and
Oakland markets, and two new teams will sell in the Boston market during the
fourth quarter. Two new teams will be added early in the fourth quarter to sell
in Dallas and Fort Worth and two new teams in Los Angeles. There will be one new
team added in each of the New York and Atlanta markets also in the fourth
quarter.
The Company does not use agents to sell its services, and has no plans to
do so in the future.
Allegiance generated revenue of approximately $53 per average line during
September 1998. Such amount is the result of the sales effort to date focusing
on basic local services for small and medium sized business customers and a
majority of installed lines being high capacity local connections. Allegiance's
sales teams will begin to focus their sales effort on long distance and Internet
services during the fourth quarter of 1998, and the Company expects the revenue
per line to increase accordingly. The Company does not accept orders for long
distance service only; the Company rejects orders which do not include local
service.
Revenues realized to date have been derived exclusively from sales of
telecommunications services, principally local service. The Company has not
recognized any revenue from so-called "reciprocal compensation" from inception
to date, and does not plan to recognize any such revenue except upon receipt of
cash.
ILECs around the country have been contesting whether the obligation to pay
reciprocal compensation to CLECs should apply to local telephone calls from ILEC
customers to Internet service providers served by the CLECs. The ILECs claim
that this traffic is interstate in nature and therefore should be exempt from
compensation arrangements applicable to local, intrastate calls. CLECs have
contended that the interconnection agreements provide no exception for local
calls to Internet service providers and reciprocal compensation is therefore
applicable. The FCC recently held that GTE's ADSL service, which provides a
dedicated connection (rather than circuit switched dial-up) that permits an
Internet service provider to provide its end user with high-speed access to the
Internet, is a special access service with more than a de minimis amount of
interstate traffic. This Order (GTE ADSL Order) determined that GTE's ADSL
service is properly tariffed at the federal level but if GTE or any other ILECs
were to offer an xDSL service that is intrastate in nature, that service should
be tariffed at the state level.
Under the Eighth Circuit decisions, the states have primary jurisdiction
over the determination of reciprocal compensation arrangements and as a result,
the treatment of this issue can vary from state to state. Currently, 23 state
commissions, three federal courts and one state court have ruled that reciprocal
compensation arrangements do apply to calls to Internet service providers.
Certain of these rulings are subject to appeal. Additional disputes over the
appropriate treatment of Internet service provider traffic are pending in other
states. The NARUC adopted a resolution in favor of applying reciprocal
compensation to calls to Internet service providers. The FCC made clear that
its GTE ADSL Order did not determine whether reciprocal compensation is owed
pursuant to existing interconnection agreements, state arbitration decisions and
federal court decisions. The FCC indicated that it intends to issue a separate
order specifically addressing reciprocal compensation issues. The Company
anticipates that Internet service providers will be among its target customers,
and adverse decisions in these proceedings could limit the Company's ability to
service this group of customers profitably.
The Company has had no sales of customer premise equipment, no revenue from
installation of customer premise equipment, no revenue from system integration
activities, no wireless revenue and no data or internet
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service provider revenue. The Company expects to initiate data and Internet
services during the fourth quarter of 1998. The Company has no plans to sell
wireless services in the foreseeable future.
Operating Expenses
Network Costs (Cost of Services). Under its "smart build" strategy,
Allegiance plans to deploy digital switching platforms with local and long
distance capability and initially lease fiber trunking capacity from the ILECs
and other CLECs to connect the Company's switch with its transmission equipment
collocated in ILEC central offices. Allegiance will lease unbundled copper loop
lines and high capacity digital lines from the ILECs to connect the Company's
customers and other carriers' networks to the Company's network. Allegiance
plans to lease dark fiber capacity or overbuild specific network segments as
economically justified by traffic volume growth or when these arrangements
otherwise become more attractive than leasing unbundled network elements. During
the third quarter, Allegiance increased the number of ILEC central offices in
which it is collocated by 44. Thus, Allegiance is collocated in a total of 51
central offices at September 30, 1998, and has DS3 hub connections to three
additional ILEC central offices. Through the process of achieving collocation in
the 51 offices the Company has determined that it takes six to seven months
before a typical collocation site will be ready to generate revenue, instead of
the three-month period the Company had originally estimated. As a result of the
longer lead time, Allegiance has adjusted its network planning and is now
delivering completed central office collocation applications to ILECs six to
seven months in advance of the desired revenue ready date. The Company has 159
central office collocations currently in various stages of process, from
applications pending, to deposits for construction, to equipment being installed
and tested. Allegiance estimates it will have a total of 90 central office
collocations in service or revenue ready by the end of 1998.
For the three and nine months ended September 30, 1998, the Company incurred
network costs of approximately $2.9 million and $4.5 million, respectively. No
such costs were incurred during 1997.
The Company is moving to the next stage of its "smart build" strategy in New
York City where the Company has entered into a lease agreement with Metromedia
Fiber Network, Inc. for three "dark fiber" rings in Manhattan with an extension
into Brooklyn. Allegiance is accounting for the Metromedia Fiber Network lease
as a capital lease, based on the terms and conditions of the lease agreement.
The Company anticipates that any future dark fiber leases will have roughly
similar terms and conditions, and therefore it is likely that such additional
dark fiber leases, if any, will also be accounted for as capital leases. In
addition, Allegiance expects to increase the capacity of its switches, and may
add additional switches, in a market as demand warrants.
The Company expects switch site lease costs will be a significant part of
the Company's ongoing cost of services. The costs to lease unbundled copper loop
lines and high capacity digital lines from the ILECs will vary by ILEC and are
regulated by state authorities pursuant to the Telecommunications Act of 1996.
The Company believes that in most of the markets it plans to enter there are
multiple carriers in addition to the ILEC from which it could lease trunking
capacity; typically at lower prices than the ILEC price. The Company expects
that the costs associated with these leases will increase with customer volume
and will be a significant part of the Company's ongoing cost of services.
To enter a market and make ubiquitous calling available to its customers,
Allegiance must enter into an interconnection agreement with the ILEC in such
market. Typically these agreements set the cost per minute to be charged by each
party for the calls which have traversed between each carrier's network. These
costs will grow in proportion to the Company's customers outbound call volume
and are expected to be a major portion of the Company's cost of services.
However, the Company does expect to generate increased revenue from the ILECs as
the Company's customers inbound calling volume increases. To the extent the
Company's customers' outbound call volume is equivalent to their inbound call
volume, the Company expects that its interconnection costs paid to the ILECs
will be substantially offset by the interconnection revenues received from the
ILECs.
The Company has entered into one resale agreement with a long distance
carrier to provide the Company with transmission services. The Company expects
to enter into resale agreements with other carriers in the future. Such
agreements typically provide for the resale of long distance services on a
per-minute basis and may contain minimum volume commitments; however, the
existing resale agreement does not contain any minimum volume
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commitments. Under such agreements, if a company fails to meet any minimum
volume commitments, it may be obligated to pay underutilization charges. If a
company underestimates its need for transmission capacity under such agreements,
it may be required to obtain capacity through more expensive means. These costs
will increase as the Company's customers' long distance calling volume
increases, and the Company expects that these costs will be a significant
portion of its cost of long distance services. As traffic on specific routes
increases, the Company may lease long distance trunk capacity.
Collocation costs are also expected to be a significant part of the
Company's network development and ongoing cost of services. Under the
Telecommunications Act, carriers like the Company must be allowed to place their
equipment within the central offices of the ILEC for the purposes of
interconnecting its network with that of the ILEC. For example, Allegiance uses
collocation to access the ILECs unbundled networks elements. This collocation
can be a physical space or cage within the ILEC central office where the Company
places its equipment or it can consist of "virtual collocation" where the ILEC
places equipment within the central office and maintains the equipment on behalf
of the Company. In the virtual collocation scenario, the Company does not have
physical access to the ILEC's central office. For use of their central offices
for collocation, ILECs typically charge both a start-up fee as well as a monthly
recurring fee. In addition, the Company is required to invest a significant
amount of funds to develop the central office collocation sites and to deploy
the transmission and distribution electronics.
Another network alternative is a DS3 hub arrangement whereby the Company
connects its switching equipment to an ILEC central office through a leased,
high capacity circuit. The Company then purchases, from the ILEC, multiplexing
services and high capacity circuits to customer premises to connect the customer
to the Allegiance network. Typically, the hubbing arrangement is implemented in
advance of collocation; but it may continue indefinitely depending upon the
quantity and type of services provided over that facility.
The cost of collocation has exceeded the Company's estimates in some
instances because of changes in configuration of transmission equipment and
because of certain requirements imposed by ILECs on the first company requesting
collocation in a specific central office. ILECs generally require the company
initially requesting collocation to reimburse the ILEC for the cost associated
with a minimum buildout space and this minimum space is often greater than the
amount Allegiance actually requests for its use. In those instances in which
Allegiance is the company initially requesting collocation, it will be rebated a
portion of the costs paid as additional companies commit to collocation in the
same central office. While these circumstances have led, and will continue to
lead, to greater than anticipated capital expenditures, the Company believes
these additional expenditures will be offset by the benefits of the Company
entering its selected markets earlier than its competitors.
Selling, General and Administrative Expenses. The Company's selling, general
and administrative expenses will include its infrastructure costs, including
selling and marketing costs, customer care, billing, corporate administration,
personnel and network maintenance.
The Company incurred $13.3 million and $26.1 million for selling and general
and administrative expenses during the three and nine month periods ending
September 30, 1998, respectively. These increased expenses resulted primarily
from an expansion of the Company's staffing from less than 50 at December 31,
1997, and approximately 250 at June 30, 1998, to approximately 460 full-time
staff at September 30, 1998. Sales personnel represent approximately 50% of
total staff at September 30, 1998. Also, as the Company has increased the
deployment of its network, its costs associated with monitoring that network has
increased as well. Network monitoring costs during the three and nine month
periods ending September 30, 1998 totaled $.9 million.
The Company plans to employ a large direct sales force in each market and to
build a national sales force as the Company grows. To attract and retain a
highly qualified sales force, the Company offers its sales and customer care
personnel a compensation package emphasizing commissions and stock options. The
Company expects to incur significant, and increased, selling and marketing costs
as it continues to expand its operations. In addition, Allegiance plans to offer
sales promotions to win customers, especially in the first few years as its
establishes its market presence.
Allegiance has acquired and is integrating back office systems to facilitate
a smooth, efficient order management, provisioning, installation, trouble
management, billing and collection, and customer service process.
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Allegiance has licensed and is using MetaSolv software for order management and
customer provisioning, Lucent's ConnectVu for switch provisioning and Intertech
for billing.
The Company is actively working toward "electronic bonding" between the
Allegiance operating support systems and those of the ILEC which will permit
creation of service requests on-line and real-time monitoring of the
provisioning and installation process. During the third quarter of 1998,
Allegiance expended significant effort in developing such an electronic bond
with Bell Atlantic in New York. Currently, the electronic bond is being
subjected to a high volume, production test in which all new orders taken by
Allegiance for the New York market are relayed to Bell Atlantic electronically.
The test is expected to successfully conclude during the fourth quarter of 1998,
at which time the electronic bond will be placed into production.
Electronic bonding is expected to result in significant productivity
improvements by reducing the period between the time of sale and the time a
customer's line is installed in the Allegiance network and accepted by the
customer. The Bell Atlantic test has demonstrated a reduction of elapsed time
from the conveyance of a service request to the ILEC to the receipt of
communication from the ILEC that the service order has been received and
confirmed as complete in as little as five minutes. This is a significant
reduction in elapsed time; confirmation of receipt and completeness of previous
orders has taken as little as three to four hours to as long as several days or
weeks.
In addition to the electronic bonding process with Bell Atlantic, Allegiance
and Southwestern Bell and Pacific Bell have agreed to begin discussions about
the possibility of using the same template Allegiance uses with Bell Atlantic to
pass service requests between these parties.
During the second quarter of 1998, Allegiance achieved permanent local
number portability in New York with Bell Atlantic and in Texas with Southwestern
Bell. During the third quarter of 1998, Allegiance achieved permanent local
number portability in Georgia with Bell South, in Illinois with Ameritech and
in California with Pacific Bell. Allegiance uses DSET Corporation's Service
Order Administration Gateway for local number portability implementation.
Along with the development cost of the systems, the Company will also incur
ongoing expenses for customer care and billing. As the Company's strategy
stresses the importance of personalized customer care, the Company expects that
its customer care department will become a larger part of the Company's ongoing
administrative expenses. The Company also expects billing costs to increase as
its number of customers, and the call volume, increases. Billing is expected to
be a significant part of the Company's ongoing administrative expenses.
Allegiance will incur other costs and expenses, including the costs
associated with the maintenance of its network, administrative overhead, office
leases and bad debts. The Company expects that these costs will grow
significantly as its expands its operations and that administrative overhead
will be a large portion of these expenses during the start-up phase of the
Company's business. However, the Company expects these expenses to become
smaller as a percentage of the Company's revenue as the Company builds its
customer base.
The magnitude of the loss for the third quarter is principally due to the
management ownership allocation charge. On July 7, 1998, the Fund Investors and
the Management Investors owned 95.0% and 5.0%, respectively, of the ownership
interests of Allegiance LLC, an entity that owned substantially all of the
Company's outstanding capital stock. As a result of the Company's initial public
offering of common stock, the assets of Allegiance LLC (which consisted almost
entirely of such capital stock) have been distributed to the Fund Investors and
the Management Investors in accordance with the LLC Agreement.
The LLC Agreement provided that the equity allocation between the Fund
Investors and the Management Investors be 66.7% and 33.3%, respectively, based
upon the valuation implied by the initial public offering. Under generally
accepted accounting principles, the Company recorded the increase in the assets
of Allegiance LLC allocated to the Management Investors as a $193.5 million
increase in additional paid-in capital, of which $122.5 million was recorded as
a non-cash, non-recurring charge to operating expense and $71.0 million was
recorded as a deferred management ownership allocation charge. The deferred
charge was amortized at $38.0 million during the third quarter of 1998 and will
be further amortized at $6.8 million, $18.8 million, $7.2 million and $.2
million during the fourth quarter of 1998, and the years 1999, 2000, 2001,
respectively, which is the period over which the
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Company has the right to repurchase the securities (at the lower of fair market
value or the price paid by the employee) in the event the management employee's
employment with the Company is terminated.
In addition to the above expenses, the Company recognized $1.4 million and
$3.8 million amortization of deferred stock compensation expense for the three
and nine months periods ended September 30, 1998, respectively, also a non-cash
charge. Interest expense for the three months then ended was $13.4 million, and
for the nine months ending at the same date, it was $25.3 million. These amounts
reflect the issuance of the 11 3/4% Notes during February 1998 and 12 7/8% Notes
during July 1998. Interest income during such periods was $7.5 million and $13.1
million, respectively, resulting from the investment of cash not used in
operations or network rollout. The amount of invested cash increased between the
second and third quarters, reflecting the net proceeds of both the initial
public offering and the 12 7/8% Notes.
As required by accounting principles promulgated by the Securities and
Exchange Commission, the Company has recorded the potential redemption value of
Redeemable Warrants in the potential event that they are redeemed at fair market
value in February 2008. Amounts are accreted using the effective interest method
and management's estimates of the future fair market value of the warrants when
redemption is first permitted. Amounts accreted increase the recorded value of
the Redeemable Warrants on the balance sheet and result in a non-cash charge to
increase the net loss applicable to Common Stock. Accretion of $.1 million and
$.3 million has been recorded for the three and nine month periods ending
September 30, 1998, respectively.
Until the consummation of the Company's initial public offering in July
1998, Allegiance also recorded the potential redemption values of Redeemable
Convertible Preferred Stock, in the potential event that they would be redeemed
at fair market value in August 2004. At the time of the initial public offering,
such preferred stock was converted into Common Stock. Accordingly, the amounts
accreted for the Redeemable Convertible Preferred Stock were reclassified as an
increase to additional paid-in capital in the stockholders' equity section of
the balance sheet, and there has been, and will be, no additional accretion of
Redeemable Convertible Preferred Stock values beyond that point in time.
Accretion of $0.0 and $11,520.8 was recorded for the three and nine months
ending September 30, 1998, respectively, and $409.1 was recorded for the period
ending September 30, 1997.
FINANCIAL CONDITION
The balance sheet of Allegiance at September 30, 1998 reflects additional
cash, unrestricted short-term investments, short-term and long-term restricted
investments, deferred debt issuance costs, long-term debt and redeemable
warrants compared to the December 31, 1997 balance sheet as a result of the Unit
Offering in February 1998 wherein 11 3/4% Notes and Redeemable Warrants were
sold, the initial public offering of Common Stock and issuance of 12 7/8% Notes
in July 1998. In accordance with the terms of the 12 7/8% Notes, the Company
purchased, and placed in a pledged account, U.S. government securities which
will be used to pay the first three years' (or six semi-annual installments)
interest payments on the 12 7/8% Notes. Such securities are reflected in the
balance sheet at accreted value at September 30, 1998 of approximately $69.9
million, $22.1 million of which is classified as current assets, and $47.8
million of which is classified in other, non-current assets.
Accounts receivable increased during the same period as the Company's
networks in New York City, Dallas and Atlanta became operational.
Property and Equipment, net of accumulated depreciation, increased between
September 30, 1998 and December 31, 1997 from capital expenditures incurred in
building out the Company's networks in New York City, Dallas, Atlanta, Chicago,
Los Angeles, San Francisco, Boston, Fort Worth, Washington, D.C., Oakland and
Houston, from developing operations support and other systems required to
effectively manage the business and to provide general office space and
equipment for employees.
Accounts payable and accrued liabilities have increased consistent with
operations and the Company's policy to make use of working capital in funding
network construction and operations. Redeemable Convertible Preferred Stock
outstanding at December 31, 1997 was converted to Common Stock in July 1998 at
the closing of the initial public offering.
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Accumulated deficit increased consistent with the net loss for the nine
months ending September 30, 1998. There have been no dividends declared from
inception to date.
LIQUIDITY AND CAPITAL RESOURCES
Allegiance plans to establish networks in the 24 largest U.S. metropolitan
markets. Total funds required for the buildout of the networks and to fund
operating losses to Positive Free Cash Flow (operating cash flow from a market
sufficient to fund such market's operating costs and capital expenditures) is
estimated to be approximately $700 million.
In October 1997, the Company entered into a five-year general agreement with
Lucent establishing terms and conditions for the purchase of Lucent products,
services and licensed materials. The agreement includes a three-year exclusivity
commitment for the purchase of products and services related to new switches.
The agreement contains no minimum purchase requirements.
Also, as part of its network deployment, in October 1997, the Company
acquired two Lucent Series 5ESS(R)-2000 digital switches in New York City and
Atlanta and certain furniture and fixtures in Dallas from US ONE Communications,
Inc. for an aggregate purchase price of $19.3 million. The Company has also
purchased from Lucent, switches for the Dallas, Chicago, Los Angeles, San
Francisco, Boston and Washington, D.C. markets. The Company has ordered, and
made initial payments for, switching equipment for two additional target
markets, the Philadelphia and Houston. The cost of all of these switches and
related equipment and installation will be approximately $49.7 million.
Allegiance's financing plan is predicated on the pre-funding of each
market's expansion to Positive Free Cash Flow. This approach is designed to
allow the Company to be opportunistic and raise capital on more favorable terms
and conditions.
To pre-fund its market expansion, the Company raised approximately $50.1
million from Management Investors and Fund Investors and received approximately
$240.7 million of net proceeds, after deducting underwriting discounts and
commissions and other expenses payable by the Company, from the sale of 11 3/4%
Notes due 2008 and attached Redeemable Warrants in February 1998.
On February 3, 1998, the Company raised gross proceeds of approximately
$250.5 million in an offering of 445,000 Units, each of which consists of one
11 3/4% Note and one warrant to purchase .0034224719 shares of Common Stock at
an exercise price of $.01 per share, subject to certain antidilution provisions.
Of the gross proceeds, $242.3 million was allocated to the initial accreted
value of the 11 3/4% Notes and $8.2 million was allocated to the Redeemable
Warrants. The 11 3/4% Notes were the subject of an Exchange Offer during the
second quarter of 1998 and were exchanged for Series B Notes which contain
substantially identical terms and conditions. The Redeemable Warrants became
exercisable in connection with the Company's initial public offering of common
stock in July 1998, and each warrant may now purchase 1.45898399509 shares of
Common Stock as a result of a 426.2953905 for-one stock split in connection with
the Company's initial public offering.
The Series B Notes have a principal amount at maturity of $445.0 million and
an effective interest rate of 12.45%. The Series B Notes mature on February 15,
2008. From and after February 15, 2003, interest on the Series B will be payable
semi-annually in cash at the rate of 11 3/4% per annum. The accretion of
original issue discount
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will cause an increase in indebtedness from September 30, 1998 to February 15,
2008 of $187.6 million. The net proceeds from the sale of the Series B Notes
have been, and are continuing to be, used to fund the completion of networks in
the Company's initial 12 target markets. See Note 9 to the financial statements
contained in Part I which includes a summary of the terms and conditions related
to the Series B Notes and the Redeemable Warrants.
Following completion of the Unit Offering, the Company increased the scope
of its business plan to, among other things, accommodate (i) an expansion of the
Company's network buildout in the New York, Chicago, Los Angeles and San
Francisco markets to include additional central offices, thereby giving the
Company access to a larger number of potential customers in those markets, (ii)
an accelerated and expanded deployment of data, Internet and enhanced services
in the Company's markets and (iii) the acceleration of network deployment in its
target markets. To fund these activities, the Company consummated an initial
public offering of its common stock and sold the 12 7/8% Notes (the "July 1998
Debt Offering") during the second quarter of 1998. These sales were consummated
on July 7, 1998 and the Company raised net proceeds of approximately $262.6
million, bringing the Company's total capital raised since inception to
approximately $553.8 million.
The 12 7/8% Notes issued July 1998, mature May 15, 2008. Interest is payable
in cash semi-annually, commencing November 15, 1998. Gross proceeds of
approximately $200.9 million were realized from the sale. The 12 7/8% Notes were
sold at less than par, resulting in an effective rate of 13 1/4%, and the value
of the notes is being accreted (using the effective interest method prescribed
by SEC) from the $200.9 million gross proceeds realized at the time of the sale
to the aggregate value at maturity, $205.0 million, over the period ending May
15, 2008. In connection with the sale of the 12 7/8% Notes, the Company
purchased U.S. government securities for approximately $69.0 million and placed
them in a pledged account to fund interest payments for the first three years
the 12 7/8% Notes are outstanding. The remaining proceeds will be used, in
conjunction with the net proceeds of the Company's initial public offering of
Common Stock, to fund the development of networks in six of its 24 target
markets, the data and ISP network, as well as an expansion of the networks in
New York City, Chicago, Los Angeles and San Francisco markets. See Note 9 to the
financial statements contained in Part I which includes a summary of the terms
and conditions related to the 12 7/8% Notes.
For the nine month period ending September 30, 1998, the proceeds of the
Unit Offering, together with additional Equity Contributions received in 1998,
as well as cash in bank at the beginning of 1998, have been used, in part, to
fund the buildout of networks in New York City, Dallas, Atlanta, Fort Worth,
Chicago and Los Angeles each of which is operational, as well as networks under
development in San Francisco, Boston, Oakland, Washington, D.C., Philadelphia
and Houston, to fund the development of operations support and other systems
required to effectively manage the business and to provide general office space
and equipment for its employees. Capital resources not required for the above
purposes were used to fund the operations of the Company; excess amounts
available were used to purchase short-term investments or money market
investments.
As of September 30, 1998, Allegiance had approximately $455.0 million of
cash and short term investments. Such amount excludes the restricted U.S.
Government securities which have been placed in a pledged account. The Company
believes, based on its business plan, that the net proceeds from the capital
raising activities completed thus far will be sufficient to pre-fund its market
deployment in its initial 18 markets to Positive Free Cash Flow. The Company
will require up to an estimated additional $200 million to completely fund its
remaining six target markets.
The Company recently initiated discussions with commercial and investment
banks, vendors and equipment lease finance companies for the purposes of
evaluating the feasibility of raising up to an additional $200 million in
financing on or before December 31, 1998. Allegiance will not expend any funds,
other than minimum amounts required to incorporate and become certified to do
business, for the unfunded six markets, until such time as the permanent
financing required to rollout the network and fund the operations to Positive
Free Cash Flow in these markets is obtained. There can be no assurance that such
financing will be available on terms acceptable to the Company or at all, or
that the Company's estimate of additional funds required is accurate.
The actual amount and timing of the Company's future capital requirements
may differ materially from the Company's estimates as a result of, among other
things, the demand for the Company's services and regulatory, technological and
competitive developments (including additional market developments and new
opportunities) in the Company's industry. The Company also expects that it will
require additional financing (or require financing sooner than anticipated) if:
(i) the Company's development plans or projections change or prove to be
inaccurate; (ii) the Company engages in any acquisitions; or (iii) the Company
alters the schedule or targets of its roll-out plan. Sources of additional
financing may include commercial bank borrowings, vendor financing, or the
private or public sale of equity or debt securities. There can be no assurance
that such financing will be available on terms acceptable to the Company or at
all.
Because the Company's cost of rolling out its networks and operating its
business, as well as the Company's revenues, will depend on a variety of factors
(including the ability of the Company to meet its roll-out schedules, negotiate
favorable prices for purchases of equipment, and develop, acquire and integrate
the necessary operations support systems and other back office systems, as well
as the number of customers and the services for which they
19
<PAGE> 20
subscribe, the nature and penetration of new services that may be offered by the
Company, regulatory changes and changes in technology), actual costs and
revenues will vary from expected amounts, possibly to a material degree, and
such variations are likely to affect the Company's future capital requirements.
Accordingly, there can be no assurance that the Company's actual capital
requirements will not exceed the anticipated amounts described above. Further,
the exact amount of the Company's future capital requirements will depend upon
many factors, including the cost of the development of its networks in each of
its markets, the extent of competition and pricing of telecommunications
services in its markets, and the acceptance of the Company's services.
IMPACT OF THE YEAR 2000
The "year 2000" issue generally describes the various problems that may
result from the improper processing of dates and date-sensitive calculations by
computers and other equipment as a result of computer hardware and software
using two digits to identify the year in a date. If a computer program or other
piece of equipment fails to properly process dates including and after the year
2000, date-sensitive calculations may be inaccurate. The failure to process
dates could result in system failures or miscalculations causing disruptions in
operations including, among other things, a temporary inability to process
transactions, send invoices or engage in other routine business activities.
State of Readiness. Generally, the Company has identified two areas for year
2000 review: internal systems and operations, and external systems and services.
As a new enterprise, the Company is not burdened internally with legacy systems
that are not year 2000 ready. As it develops its network and support systems,
the Company intends to ensure that all systems will be year 2000 ready. The
Company is purchasing its operations support systems with express
specifications, warranties and remedies that all systems be year 2000 ready. In
addition, all vendors supplying third party software and hardware to the Company
are required to warrant year 2000 readiness. However, there can be no assurance
until the year 2000 that all systems will then function adequately. Also, the
Company intends to sell its telecommunications services to companies that may
rely upon computerized systems to make payments for such services, and to
interconnect certain portions of its network and systems with other companies'
networks and systems. These transactions and interactions potentially will
expose the Company to year 2000 problems. The Company intends to contact its
external suppliers, vendors and providers to obtain information about their year
2000 readiness and, based on that information, to assess the extent to which
these external information technology and non-information technology systems
(including embedded technology) could cause a material adverse effect on the
Company's operations in the event that the systems fail to properly process
date-sensitive calculations after December 31, 1999.
The Company's assessment of its year 2000 readiness will be ongoing as it
continues to develop its own operations support system and becomes reliant on
the systems of additional third parties as a result of the geographic expansion
of its business into additional markets. As a result, the Company may in the
future identify a significant internal or external year 2000 issue which, if not
remedied in a timely manner, could have a material adverse effect on the
Company's business, financial condition and results of operations.
Costs to Address Year 2000 Issues. Other than time spent by the Company's
internal information technology and other personnel, the Company has not
incurred any significant costs in identifying year 2000 issues. The Company does
not anticipate any significant costs to make its internal systems year 2000
compliant because no remediation is expected to be required. Because no material
year 2000 issues have yet been identified in connection with external sources,
the Company cannot reasonably estimate costs which may be required for
remediation or for implementation of contingency plans. As the Company gathers
information relating to external sources of year 2000 issues, the Company will
reevaluate its ability to estimate costs associated with year 2000 issues. There
can be no assurance that as additional year 2000 issues are addressed, the
Company's costs to remediate such issues will be consistent with its historical
costs.
Risks of Year 2000 Issues. Because no material year 2000 issues have yet
been identified, the Company cannot reasonably ascertain the extent of the risks
involved in the event that any one system fails to process date-sensitive
calculations accurately. Potential risks include the inability to process
customer billing accurately or in a timely manner, the inability to provide
accurate financial reporting to management, auditors, investors and others,
litigation costs associated with potential suits from customers and investors,
delays in implementing other information
20
<PAGE> 21
technology projects as a result of work by internal personnel on year 2000
issues, delays in receiving payment or equipment from customers or suppliers as
a result of their systems' failure, and the inability to occupy and operate in a
facility. Any one of these risks, if they materialize, could individually have a
material adverse effect on the Company's business, financial condition or
results of operations.
As all of the Company's information technology and non-information
technology systems and products relating to the Company's external issues are
manufactured or supplied by third parties outside of the Company's control,
there can be no assurance that each one of those third parties' systems will be
year 2000 ready. In particular, the Company will be dependent upon other ILECs,
long distance carriers and others on whose services the Company depends for
interconnection and completion of off-network calls. These interconnection
arrangements are material to the Company's ability to conduct its business and
failure by any of these providers to be year 2000 ready may have a material
adverse effect on the Company's business in the affected market. Moreover,
although the Company has taken every precaution to purchase its internal systems
to be fully year 2000 ready, there can be no assurance that every vendor will
fully comply with the contract requirements. If some or all of the Company's
internal and external systems fail or are not year 2000 ready in a timely
manner, there could be a material adverse effect on the Company's business,
financial condition or results of operations.
Contingency Plans. Even though the Company has not identified any specific
year 2000 issues, the Company believes that the design of its networks and
support systems could provide the Company with certain operating contingencies
in the event material external systems fail. In all of its markets, however, the
Company has or intends to establish interconnection agreements with the ILECs
and other regional and international carriers and should one of these carriers
fail for any reason including year 2000 problems there may be little the Company
can do to mitigate the impact of such a failure on the Company's operations. The
Company has provisioned its operations facilities and systems to be fully backed
up with auxiliary power generators capable of operating all equipment and
systems for indeterminate periods should power supplies fail. The Company also
has the ability to relocate headquarters and administrative personnel to one of
its backed-up facilities should power and other services at its Dallas
headquarters fail. Because of the inability of the Company's contingency plans
to eliminate the negative impact that disruptions in ILEC service or the service
of other carriers would create, there can be no assurance that the Company will
not experience numerous disruptions that could have a material effect on the
Company's operations and its ability to service its indebtedness.
21
<PAGE> 22
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
On August 29, 1997, WorldCom, Inc. ("WorldCom") sued the Company and two
individual employees. In its complaint, WorldCom alleges that these employees
violated certain noncompete and nonsolicitation agreements by accepting
employment with the Company and by soliciting then current WorldCom employees to
leave WorldCom's employment and join the Company. In addition, WorldCom claims
that the Company tortiously interfered with WorldCom's relationships with its
employees, and that the Company's behavior constituted unfair competition.
WorldCom seeks injunctive relief and damages, although it has filed no motion
for a temporary restraining order or preliminary injunction. The Company denies
all claims and will vigorously defend itself. The Company does not expect the
ultimate outcome to have a material adverse effect on the results of operations
or financial condition of the Company and an estimate of possible loss cannot be
made at this time.
On October 7, 1997, the Company filed a counterclaim against WorldCom for,
among other things, attempted monopolization of the "one stop shopping"
telecommunications market, abuse of process, and unfair competition. WorldCom
did not move to dismiss the attempted monopolization claim, but has moved to
dismiss the abuse of process and unfair competition claims. On March 4, 1998,
the court dismissed the claim for unfair competition.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
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) Exhibit Index
EXHIBIT
NUMBER DESCRIPTION
11.1 Statement regarding computation of per share loss for
the three months ended September 30, 1998
11.2 Statement regarding computation of per share loss for
the period ended September 30, 1997
11.3 Statement regarding computation of per share loss for
the nine months ended September 30, 1998
27.1 Financial Data Schedule
(B) No reports on Form 8-K were filed by the Registrant during the three
months ended September 30, 1998.
22
<PAGE> 23
SIGNATURE
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.
ALLEGIANCE TELECOM, INC.
Dated: November 5, 1998 By: /s/ ROYCE J. HOLLAND
Name: Royce J. Holland
Title: Chairman and Chief Executive Officer
By: /s/ THOMAS M. LORD
Name: Thomas M. Lord
Title: Executive Vice President and Chief
Financial Officer
23
<PAGE> 24
INDEX TO EXHIBITS
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
- ------- -----------
<S> <C>
11.1 Statement regarding computation of per share loss for
the three months ended September 30, 1998
11.2 Statement regarding computation of per share loss for
the period ended September 30, 1997
11.3 Statement regarding computation of per share loss for
the nine months ended September 30, 1998
27.1 Financial Data Schedule
</TABLE>
<PAGE> 1
Exhibit 11.1
Allegiance Telecom, Inc.
Computation of per Share Earnings (Loss)
Three Months Ended September 30, 1998
<TABLE>
<CAPTION>
Number of Shares Percent Outstanding Equivalent Shares
---------------- ------------------- -----------------
<S> <C> <C> <C>
Prior to Initial Public Offering
1997 Common Stock Offering 426 1.10% 5
After Initial Public Offering
1997 Common Stock Offering 426 98.91% 421
1998 Common Stock Offering 10,000,000 98.91% 9,891,304
Preferred Stock Converted to Common Stock 40,341,128 98.91% 39,902,637
-------------
49,794,368
WEIGHTED AVERAGE SHARES OUTSTANDING 49,794,368
NET LOSS APPLICABLE TO COMMON STOCK $(183,892,618)
NET LOSS PER SHARE, BASIC AND DILUTED $(3.69)
=============
</TABLE>
<PAGE> 1
Exhibit 11.2
Allegiance Telecom, Inc.
Computation of per Share Earnings (Loss)
Period Ended September 30, 1997
<TABLE>
<CAPTION>
Number of Shares Percent Outstanding Equivalent Shares
---------------- ------------------- -----------------
<S> <C> <C> <C>
1997 Common Stock Offering 426 100.00% 426
-----------
WEIGHTED AVERAGE SHARES OUTSTANDING 426
NET LOSS APPLICABLE TO COMMON STOCK $(1,284,013)
NET LOSS PER SHARE, BASIC AND DILUTED $ (3,014.12)
-----------
</TABLE>
<PAGE> 1
Exhibit 11.3
Allegiance Telecom, Inc.
Computation of per Share Earnings (Loss)
Nine Months Ended September 30, 1998
<TABLE>
<CAPTION>
Number of Shares Percent Outstanding Equivalent Shares
---------------- ------------------- -----------------
<S> <C> <C> <C>
Prior to Initial Public Offering
1997 Common Stock Offering 426 66.67% 284
After Initial Public Offering
1997 Common Stock Offering 426 33.33% 142
1998 Common Stock Offering 10,000,000 33.33% 3,333,333
Preferred Stock Converted to Common Stock 40,341,128 33.33% 13,447,043
-------------
16,780,802
WEIGHTED AVERAGE SHARES OUTSTANDING 16,780,802
NET LOSS APPLICABLE TO COMMON STOCK $(218,442,275)
NET LOSS PER SHARE, BASIC AND DILUTED $ (13.02)
=============
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
CONDENSED CONSOLIDATED BALANCE SHEET AT SEPTEMBER 30, 1998 AND FROM THE
CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS FOR THE NINE MONTHS ENDED
SEPTEMBER 30, 1998 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FORM
10-Q FOR THE PERIOD ENDED SEPTEMBER 30, 1998.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> SEP-30-1998
<CASH> 404,745
<SECURITIES> 50,256
<RECEIVABLES> 2,185
<ALLOWANCES> 153
<INVENTORY> 0
<CURRENT-ASSETS> 480,839
<PP&E> 104,259
<DEPRECIATION> 3,718
<TOTAL-ASSETS> 646,772
<CURRENT-LIABILITIES> 32,393
<BONDS> 463,751
0
0
<COMMON> 503
<OTHER-SE> 141,618
<TOTAL-LIABILITY-AND-EQUITY> 646,772
<SALES> 0
<TOTAL-REVENUES> 4,201
<CGS> 0
<TOTAL-COSTS> 4,506
<OTHER-EXPENSES> 167,998
<LOSS-PROVISION> 153
<INTEREST-EXPENSE> 25,278
<INCOME-PRETAX> (218,442)
<INCOME-TAX> 0
<INCOME-CONTINUING> (218,442)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (218,442)
<EPS-PRIMARY> (13.02)
<EPS-DILUTED> (13.02)
</TABLE>
