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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-K
[X] Annual report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 for the fiscal year ended: December 31, 1998 or
[ ] Transition report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 for the transition period from ______________ to
______________.
Commission File Number: 0-24509
ALLEGIANCE TELECOM, INC.
(Exact name of registrant as specified in its charter)
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Delaware 75-2721491
(State of Incorporation) (IRS Employer Identification No.)
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1950 Stemmons Freeway
Suite 3026
Dallas, Texas 75207
(214) 261-7100
(Address of Principal Executive Offices) (Zip Code)
(Registrant's Telephone Number, Including Area Code)
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Securities Registered Pursuant to Section 12(b) of the Act: None
Securities Registered Pursuant to Section 12(g) of the Act: Common Stock, par value $.01, quoted on
the Nasdaq National Market
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Indicate by check mark whether Allegiance (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 it was required to file
such reports), and (2) has been subject to such filing requirements for the past
90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of Allegiance's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]
Based on the closing sales price on the Nasdaq National Market on March 24, 1999
of $26.125, the aggregate market value of our voting stock held by
non-affiliates on such date was approximately $400,981,896. Shares of common
stock held by each director and executive officer and by each person who owns or
may be deemed to own 10% or more of our outstanding common stock have been
excluded, since such persons may be deemed to be affiliates. This determination
of affiliate status is not necessarily a conclusive determination for other
purposes. As of that date, Allegiance Telecom, Inc. had 50,360,886 shares of
common stock issued and outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
o Portions of Allegiance's annual report to stockholders for fiscal year
ended December 31, 1998 are incorporated by reference into Parts II and IV
of this report. This annual report shall be deemed "filed" with the SEC
only with respect to those portions specifically incorporated by reference
in this report.
o Portions of Allegiance's definitive proxy statement for the annual meeting
of stockholders for the fiscal year ended December 31, 1998, which will be
filed with the SEC no later than April 30, 1999, are incorporated by
reference into Part III of this report.
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TABLE OF CONTENTS
TO
ALLEGIANCE TELECOM, INC.'S ANNUAL REPORT ON FORM 10-K
FOR THE YEAR ENDING DECEMBER 31, 1998
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PART I........................................................................................................ 1
Recent Developments ....................................................................................... 1
Item 1. Business ..................................................................................... 1
Item 2. Properties.................................................................................... 22
Item 3. Legal Proceedings............................................................................. 22
Item 4. Submission of Matters to a Vote of Security Holders........................................... 22
Item 4A. Executive Officers of Allegiance.............................................................. 23
PART II....................................................................................................... 25
Item 5. Market for Allegiance's Common Stock and Related Stockholder Matters.......................... 25
Item 6. Selected Financial Data....................................................................... 26
Item 7. Management's Discussion and Analysis of Financial Condition and Results of
Operations................................................................................................. 26
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.................................... 26
Item 8. Consolidated Financial Statements and Supplementary Data...................................... 27
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial
Disclosure................................................................................................. 27
PART III...................................................................................................... 27
Item 10. Directors and Executive Officers of Allegiance................................................ 27
Item 11. Executive Compensation........................................................................ 27
Item 12. Security Ownership of Certain Beneficial Owners and Management................................ 27
Item 13. Certain Relationships and Related Transactions................................................ 27
PART IV....................................................................................................... 28
Item 14. Exhibits, Financial Statement Schedules and Reports
on Form 8-K
Index to Exhibits............................................................................................. E-1
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RECENT DEVELOPMENTS
On March 19, 1999, we announced that we intend to offer 10,000,000 shares of our
common stock in an underwritten primary offering. We also recently retained
Goldman Sachs Credit Partners L.P., TD Securities (USA) Inc. and Morgan Stanley
Senior Funding, Inc. to arrange a senior secured revolving credit facility
maturing December 31, 2005 for a subsidiary of Allegiance Telecom, Inc. These
banks have received commitments for this facility aggregating in excess of $200
million from various lenders. These commitments remain subject to various
conditions including the negotiation and execution of a definitive credit
agreement. Assuming the closing of the common stock offering and of the credit
facility, we plan to accelerate deployment of our networks in Detroit and
Baltimore into 1999.
Based on preliminary information, we estimate that for the three months ended
March 31, 1999, we will have consolidated revenues of $9.7 million and earnings
before interest, income taxes, depreciation and amortization, management
ownership allocation charge and noncash deferred compensation of negative $25
million; and will have made capital expenditures of approximately $60 million.
We believe that for the first quarter of 1999, we will have sold 44,500 lines
and that 32,000 lines will have been installed.
PART I
ITEM 1. BUSINESS
OVERVIEW
Allegiance seeks to be a premier provider of telecommunications services to
business, government and other institutional users in 24 of the largest major
metropolitan areas across the United States. Allegiance offers 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 generally prices these services at a
discount of 5% to 15% below the prices charged by the incumbent local exchange
carriers. Allegiance was founded in April 1997 by a management team led by Royce
J. Holland, the former President, Chief Operating Officer and co-founder of MFS
Communications, and Thomas M. Lord, former Managing Director of Bear, Stearns &
Co. Inc., where he specialized in the telecommunications, information services
and technology industries.
Allegiance believes that the Telecommunications Act, by opening the local
exchange market to competition, has created an attractive opportunity for new
facilities-based competitive local exchange carriers like Allegiance. Most
importantly, the Telecommunications Act stated that these carriers, known as
CLECs, should be able to lease the various elements of the ILECs' networks,
which are necessary for the cost-effective provision of service. This aspect of
the Telecommunications Act, which is referred to as "unbundling" the ILEC
networks, has enabled Allegiance to deploy digital switches with local and long
distance capability and lease fiber optic lines from the ILECs, other CLECs, and
other telecommunications companies to connect Allegiance's switch with its
transmission equipment located in ILEC central offices. Once traffic volume
growth justifies further capital investment, Allegiance may lease dark fiber or
construct its own fiber network.
Allegiance has developed procedures, together with its back office systems
vendors, MetaSolv, DSET, Lucent and Intertech, that it believes will provide it
with a significant competitive advantage in terms of reducing costs, processing
large order volumes and providing customer service. Back office systems enable a
phone company to enter, schedule and track a customer's order from the point of
sale to the installation and testing of service. These systems also include or
interface with trouble management, inventory, billing, collection and customer
service systems.
Allegiance is determined to achieve electronic bonding, the on-line and
real-time connection of Allegiance's operations support systems with those of
the ILECs, with each of the incumbent telecommunications companies in most of
its markets by the end of 1999. On January 8, 1999, Allegiance and Bell Atlantic
became the first facilities-based CLEC and ILEC to formally engage in electronic
bonding after working since April 1998 to develop the necessary software and
processes. This will allow Allegiance to create service requests on-line,
leading to faster installations of customer orders through a reduction in errors
associated with multiple manual inputs. Allegiance expects electronic bonding to
improve productivity by decreasing the period between the time of sale and the
time a
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customer's line is installed in the Allegiance network. In addition, Allegiance
expects that the simplified process will reduce selling, general and
administrative costs.
Allegiance believes that it will be some time before many other CLECs and
telecommunications service companies will be able to implement similar
electronic bonding systems. Unlike Allegiance, which is a new company designing
its systems specifically for electronic bonding, most of these other carriers
have systems that have been in place for years and already support a large
number of customers with ongoing service. Updating these systems can therefore
disrupt service and be much more costly and time consuming.
Allegiance intends to continue network deployment of its initial 24 markets.
Allegiance estimates that these 24 markets will include more than 21 million
non-residential access lines. According to Allegiance estimates, this represents
approximately 44.7% of the total non-residential access lines in the U.S. With a
strategy focusing on the central business districts and suburban commercial
districts in these areas, Allegiance plans to address a majority of the
non-residential access lines in most of its targeted markets.
As of December 31, 1998, Allegiance was operational in nine markets: New York
City, Dallas, Atlanta, Fort Worth, Chicago, Los Angeles, San Francisco, Boston
and Oakland. As of such date, Allegiance was in the process of deploying
networks in eight other markets: Houston, Long Island, Northern New Jersey,
Orange County, San Diego, San Jose, Philadelphia and Washington, D.C.
As of March 15, 1999, Allegiance was operational in eleven markets: New York
City, Dallas, Atlanta, Fort Worth, Chicago, Los Angeles, San Francisco, Boston,
Oakland, Philadelphia and Washington, D.C. As of such date, Allegiance was in
the process of deploying networks in six other markets: Houston, Long Island,
Northern New Jersey, Orange County, San Diego and San Jose.
ALLEGIANCE'S TELECOMMUNICATIONS SERVICES
Allegiance tailors its service offerings to meet the specific needs of the
business, government, and other institutional customers in its target markets.
Management believes that Allegiance's close contact with customers from its
direct sales force and customer care personnel will enable it to tailor its
service offerings to meet customers' needs and to creatively package its
services to provide "one-stop shopping" solutions for those customers.
Local Exchange Services. Allegiance offers local telephone services, including
local dial tone as well as other features such as:
o call forwarding;
o call waiting;
o dial back;
o caller ID; and
o voice mail.
By offering dial tone service, Allegiance also receives originating and
terminating access charges for interexchange calls placed or received by its
subscribers.
Private Branch Exchange/Shared Tenant Services. In areas where telephone density
is high and most telephone customers desire similar services, such as office
buildings, apartments, condominiums or campus-type environments, a private
branch exchange or services such as Centrex are among the most efficient means
of providing telephone services. A private branch exchange, also known as "PBX,"
is a switching system located within an office building and owned by a customer
which allows calls from the outside to be routed directly to the individual
instead of through a central number. PBX also allows for calling within an
office by way of four digit extensions. Centrex is a service that offers
features similar to those of a PBX, except that the switching equipment is
located at the telephone carrier's premises and not at the customer's premises.
The use of the Centrex service eliminates the need for large capital
expenditures on a PBX. Allegiance intends to offer these services in areas where
market potential warrants.
Integrated Services Digital Network and High Speed Data Services. Allegiance
offers high speed data transmission services, such as:
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o wide area network interconnection, which are remote computer communications
systems that allow file sharing among geographically distributed
workgroups; wide area networks typically use links provided by local
telephone companies; and
o broadband Internet access, also known as "wideband," which allows large
quantities of data to be transmitted simultaneously.
These services may be provided via frame relay and dedicated point-to-point
connections. In order to provide these services, Allegiance intends to utilize
leased high capacity connections, such as multiple DS-1, DS-3, T1 or T3
connections, to medium- and large-sized business, government and other
institutional customers. Allegiance may also employ DSL and/or ISDN connections
over unbundled copper wire connections to smaller business users whose
telecommunications requirements may not justify such high capacity connections
or which are located in areas where T1 connections are not available.
Interexchange/Long Distance Services. Allegiance offers a full range of:
o domestic long distance services, such as:
-- interLATA, which are calls that pass one "Local Access and
Transport Area" or "LATA" to another, and such calls must be
carried across the LATA boundary by a long-distance carrier,
-- intraLATA, which is a call that falls within the local service
area of a single local telephone company, and
o international long distance services.
These services include "1+" outbound calling, inbound toll free service, and
such complementary services as calling cards, operator assistance, and
conference calling.
Enhanced Internet Services. Allegiance offers dedicated and dial-up high speed
Internet access services via conventional modem connections, ISDN, and T1 and
higher speed dedicated connections. In addition, Allegiance expects to offer DSL
services beginning in 1999. Dedicated access services are telecommunications
lines dedicated or reserved for use by particular customers.
Web Site Design and Hosting Services. Allegiance plans to offer Web site design
services and Web site hosting on its own computer servers to provide customers
with a complete, easy to use key solution that gives them a presence on the
World Wide Web.
Facilities and Systems Integration Services. Allegiance offers individual
customers assistance with the:
o design and implementation of complete, easy to use solutions in order to
meet their specific needs, including the selection of the customer's
premises equipment, interconnection of local area networks and wide area
networks, and
o implementation of virtual private networks. Virtual private networks
simulate private line networks without actually building a private network
and offer special services such as abbreviated dialing, where a customer
can call between offices in different area codes without having to dial all
eleven digits.
Wholesale Services to Internet Service Providers. Allegiance believes that with
the recent growth in demand for Internet services, numerous Internet service
providers are unable to obtain network capacity rapidly enough to meet customer
demand and eliminate network congestion problems. Allegiance plans to supplement
its core customer product offerings by providing a full array of local services
to Internet service providers, including telephone numbers and switched and
dedicated access to the Internet.
SALES AND CUSTOMER SUPPORT
Allegiance offers an integrated package of local exchange, local access,
domestic and international long distance, enhanced voice, data, and a full suite
of Internet services to small and medium-sized businesses. Unlike large
corporate, government, or other institutional users, small and medium-sized
businesses often have no in-house telecommunications manager. Based on
management's previous experience, Allegiance believes that a direct sales and
customer care program focusing on complete, "one-stop shopping" solutions will
have a competitive advantage in capturing this type of customer's total
telecommunications traffic.
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Although the vast majority of Allegiance's sales force is focused primarily on
the small and medium-sized business market, Allegiance also provides services to
large business, government, and other institutional users, as well as to
Internet service providers, and expects that a significant portion of its
initial revenue will come from these areas of its business. Therefore,
Allegiance has organized its sales and customer care organizations to serve each
of these three markets. Sales and marketing approaches in the telecommunications
market are market-segment specific, and Allegiance believes the following are
the most effective approaches with respect to its three targeted markets:
o Small/medium businesses -- Allegiance uses direct sales.
o Large business, government, and other institutional users -- Allegiance
uses account teams, established business relationships, applications sales
and technical journal articles, and is an exhibitor at trade shows.
o Wholesale carriers, primarily Internet service providers -- Allegiance uses
direct sales, established business relationships, and competitive pricing.
Allegiance organizes account executives into teams of six to eight persons with
a team manager and a sales support specialist. These teams utilize telemarketing
to "qualify" leads and set up initial appointments. Allegiance closely manages
account executives with regard to the number of sales calls per week, with the
goal of eventually calling on every prospective business customer in an account
executive's sales territory. Allegiance uses commission plans and incentive
programs to reward and retain the top performers and encourage strong customer
relationships. The sales team managers for each market report to a city sales
vice president who in turn reports to a regional vice president.
Allegiance's wholesale sales to Internet service providers are performed by
account executives reporting to the vice president of national accounts. The
vice president of national accounts also has responsibility for large corporate,
government, and other institutional accounts, with designated national account
managers and sales support personnel assigned to the major accounts. Unlike the
small and medium-sized business accounts, the national account program is being
built by recruiting national account managers with established business
relationships with large corporate accounts, supported by technical applications
personnel and customer care specialists.
Allegiance has focused its efforts on developing a personalized customer care
program. Allegiance's customer service representatives are available seven days
a week, 24 hours a day. In addition, Allegiance uses customer care specialists
to support its national accounts.
INFORMATION SYSTEMS
Allegiance is continuing to develop its tailored information systems and
procedures for operations support and other back office systems that it believes
will provide a significant competitive advantage in terms of cost, processing
large order volumes, and customer service. These systems are required to enter,
schedule, provision, and track a customer's order from the point of sale to the
installation and testing of service and also include or interface with trouble
management, inventory, billing, collection and customer service systems. The
existing systems currently employed by most ILECs, CLECs and long distance
carriers, which were developed prior to the passage of the Telecommunications
Act, generally require multiple entries of customer information to accomplish
order management, provisioning, switch administration and billing. This process
is not only labor intensive, but it creates numerous opportunities for errors in
provisioning service and billing, delays in installing orders, service
interruptions, poor customer service, increased customer turnover, and
significant added expenses due to duplicated efforts and decreased customer
satisfaction.
Allegiance believes that the practical problems and costs of upgrading existing
systems are often prohibitive for companies whose existing systems support a
large number of customers with ongoing service. Because Allegiance does not have
systems designed prior to the expanded interaction between CLECs and ILECs
introduced by the Telecommunications Act, Allegiance's team of engineering and
information technology professionals experienced in the CLEC industry is free to
develop operations support and other back office systems designed to facilitate
a smooth, efficient order management, provisioning, trouble management, billing
and collection, and customer care process. See "Risk Factors -- We Are Dependent
on Effective Billing, Customer Service and Information Systems and We May Have
Difficulties in Developing These Systems."
Order Management. Allegiance is licensing MetaSolv's order management software.
This product allows the sales team not only to enter customer orders onsite, via
computer and/or over the Internet, but also to monitor the status of the order
as it progresses through the service initiation process.
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Provisioning Management. The licensed order management software also supports
the design and management of the provisioning process, including circuit design
and work flow management. The system has been designed to permit programming
into the system of a standard schedule of tasks which must be accomplished in
order to initiate service to a customer, as well as the standard time intervals
during which each such task must be completed. This way, when a standard order
is selected in the system, each required task in the service initiation process
can be efficiently managed to its assigned time interval.
External Interfaces. Several external interfaces are required to initiate
service for a customer. While some of these are automated via gateways from the
order management software, the most important interfaces, those to the ILEC,
have generally been accomplished via fax or e-mail. In an effort to make this
process more efficient, Allegiance and Bell Atlantic announced on January 8,
1999, the first implementation of electronic bonding between the operations
support system of a facilities-based CLEC and an ILEC.
Electronic bonding will allow Allegiance to access data from the ILEC, submit
service requests electronically, and more quickly attend to errors in the local
service request form because an order is bounced back immediately if the ILEC
determines that there is a mistake. As a result, Allegiance expects to be able
to eventually reduce the time frame required to switch service to Allegiance
from approximately 25 business days to as low as five business days, as compared
to three days currently required to switch to a new long distance carrier.
Electronic bonding should also enable Allegiance to improve its ability to
provide better customer care since Allegiance will more readily be able to
pinpoint where any problems may have occurred with a customer's order.
Network Element Administration. Allegiance licenses their software for
administrating each element of the Allegiance network. Allegiance is currently
developing an interface between its order management system and the network
element manager to integrate data integrity and eliminate redundant data entry.
Customer Billing. Allegiance has selected a billing services provider which
credits the collections made to Allegiance's lock-box. Customer information is
electronically interfaced with this provider from Allegiance's order management
system via a gateway, thereby integrating all repositories of information. We
are continuing to develop other enhancements to the gateway.
Billing Records. Local and intraLATA billing records are generated by the Lucent
Series 5ESS(R)-2000 switches to record customer calling activity. InterLATA
billing records are generated by the long distance carrier with whom Allegiance
has a resale agreement, to record customer calling activity. These records will
be automatically processed by the billing services provider in order to
calculate and produce bills in a customer-specified billing format.
NETWORK DEPLOYMENT
As of March 15, 1999, Allegiance was operational in eleven markets: New York
City, Dallas, Atlanta, Fort Worth, Chicago, Los Angeles, San Francisco, Boston,
Oakland, Philadelphia and Washington, D.C. As of such date, Allegiance was in
the process of deploying networks in six other markets: Houston, Long Island,
Northern New Jersey, Orange County, San Diego, and San Jose.
The following table sets forth the initial markets targeted by Allegiance and
the current buildout schedule. The order and timing of network deployment may
vary and will depend on a number of factors, including recruiting city
management, the regulatory environment, Allegiance's results of operations and
the existence of specific market opportunities, such as acquisitions. Allegiance
may also elect not to deploy networks in each such market.
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MARKET SIZE AND BUILDOUT SCHEDULE
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ESTIMATED TOTAL
NON-RESIDENTIAL % OF TOTAL INITIAL
ACCESS LINES (1) U.S. NON-RESIDENTIAL FACILITIES-BASED
MARKET (THOUSANDS) ACCESS LINES (2) SERVICE DATE (3)
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New York City........... 3,298(4) 6.7%(4) March 1998
Dallas, TX.............. 867(5) 1.8%(5) April 1998
Atlanta, GA............. 612 1.2% April 1998
Fort Worth, TX.......... --(5) -- (5) July 1998
Chicago, IL............. 1,951 4.0% September 1998
Los Angeles, CA......... 3,430(6) 7.0%(6) October 1998
San Francisco, CA....... 2,148(7) 4.4%(7) November 1998
Boston, MA.............. 649 1.3% December 1998
Oakland, CA............. --(7) -- (7) December 1998
Philadelphia, PA........ 1,754 3.6% February 1999
Washington, D.C......... 871 1.8% March 1999
San Jose, CA............ --(7) -- (7) 1999
Northern New Jersey..... --(4) -- (4) 1999
Houston, TX............. 765 1.6% 1999
Orange County, CA.. --(6) -- (6) 1999
San Diego, CA........... 790 1.6% 1999
Long Island, NY......... --(4) -- (4) 1999
Baltimore, MD........... 639 1.3% 1999
Detroit, MI............. 821 1.7% 1999
Denver, CO.............. 632 1.3% 2000
Seattle, WA............. 779 1.6% 2000
Cleveland, OH........... 654 1.3% 2000
Miami, FL............... 769 1.6% 2000
St. Louis, MO........... 449 0.9% 2000
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Total......... 21,878 44.7%
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(1) Data as of December 31, 1996.
(2) Based on an estimated 49.0 million U.S. non-residential access lines as of
December 31, 1996.
(3) Refers to the first month during which Allegiance could offer
facilities-based service or the year during which Allegiance expects to be
able to offer facilities-based service based on its current business plan.
(4) Data for New York City also includes Northern New Jersey and Long Island,
NY.
(5) Data for Dallas, TX also includes Fort Worth, TX.
(6) Data for Los Angeles, CA also includes Orange County, CA.
(7) Data for San Francisco, CA also includes San Jose, CA and Oakland, CA.
In the majority of its targeted markets, Allegiance will initially deploy
switches and collocate transmission equipment in ILEC central offices with heavy
concentrations of non-residential access lines. Over time, Allegiance plans to
expand its networks throughout the metropolitan areas to address the majority of
the business market in each area. In some markets, such as Northern New Jersey,
Allegiance will not initially deploy its own switch, but will deploy
transmission equipment in major central offices and route traffic to an existing
Allegiance switch until traffic growth warrants the addition of a switch to
service that market.
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NETWORK ARCHITECTURE
An important element of Allegiance's smart build strategy is the installation of
Lucent Series 5ESS(R)-2000 digital switches and related equipment at a central
location in each market. As of December 31, 1998, Allegiance had deployed seven
switches to serve nine markets: New York City, Dallas, Atlanta, Chicago, Los
Angeles, San Francisco, Fort Worth, Oakland and Boston.
Initially, Allegiance intends to lease local network trunking facilities from
the ILEC and/or one or more CLECs in order to connect Allegiance's switch to
major ILEC central offices serving the central business district and outlying
areas of business concentrations in each market. The switch will also be
connected to ILEC tandem switches and certain interexchange carrier
points-of-presence, the equivalent of a local phone company's central office. To
access the largest number of customers possible without having to lay fiber to
each of their premises, Allegiance will also locate access equipment such as
integrated digital loop carriers and related equipment in each of the ILEC
central offices in which it is connected.
As each customer is signed up, service will be provided by leasing unbundled
loops from the ILEC to connect Allegiance's integrated digital loop carriers
located in the serving central office to the customer premise equipment. For
large business, government, or other institutional customers or for numerous
customers located in large buildings, it may be more cost-effective for
Allegiance to use leased ILEC or CLEC capacity in the 1.5 to 150 megabit range,
or perhaps a wireless local loop leased from one of the emerging wireless CLECs,
to connect the customer(s) to the Allegiance network. In this case, Allegiance
will locate its integrated digital loop carriers or other equipment in the
customer's building.
Although Allegiance will initially lease its local network transmission
facilities, Allegiance plans to replace leased capacity with its own fiber optic
facilities as and when it experiences sufficient traffic volume growth between
its switch and specific ILEC central offices or as other factors make these
arrangements more attractive.
IMPLEMENTATION OF SERVICES
To offer services in a market, Allegiance generally must secure certification
from the state regulator and typically must file tariffs or price lists for the
services that it will offer. The certification process varies from state to
state; however, the fundamental requirements are largely the same. State
regulators require new entrants to demonstrate that they have secured adequate
financial resources to establish and maintain good customer service. New
entrants must also show that they possess the knowledge and ability required to
establish and operate a telecommunications network. Allegiance has made such
demonstrations in Texas, Georgia, California, Illinois, Maryland, New York, New
Jersey, Virginia, Massachusetts and Washington, D.C., where Allegiance has
obtained certificates to provide local exchange and intrastate toll services.
Applications for such authority are pending in Colorado, Michigan, Washington
and Pennsylvania, where Allegiance has obtained interim operating authority.
Allegiance intends to file similar applications in the near future in Ohio,
Missouri and Florida.
Before providing local service, a new entrant must negotiate and execute an
interconnection agreement with the ILEC. While such agreements can be voluminous
and may take months to negotiate, most of the key interconnection issues have
now been thoroughly addressed and commissions in most states have ruled on
arbitrations between the ILECs and new entrants. However, interconnection rates
and conditions may be subject to change as the result of future commission
actions or other changes in the regulatory environment. Under a recent United
States Supreme Court ruling, new entrants may adopt either all or portions of an
interconnection agreement already entered into by the ILEC and another carrier.
Such an approach will be selectively adopted by Allegiance to enable it to enter
markets quickly while at the same time preserving its right to replace the
adopted agreement with a customized interconnection agreement that can be
negotiated once service has already been established. For example, Allegiance
has adopted the interconnection agreement entered into between Southwestern Bell
and WinStar Wireless of Texas, Inc. in Texas and has begun to negotiate
enhancements to that agreement for ultimate inclusion in Allegiance's customized
agreement with Southwestern Bell.
While such interconnection agreements include key terms and prices for
interconnection, a significant joint implementation effort must be made with the
ILEC in order to establish operationally efficient and reliable traffic
interchange arrangements. Such interchange arrangements must include those
between the new entrant's network and the facilities of other service providers
as well as public service agencies. For example, Allegiance worked closely with
Southwestern Bell in order to devise and implement an efficient 911 call routing
plan that will meet the
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requirements of each individual 911 service bureau in Southwestern Bell areas
that Allegiance will serve using its own switches. Allegiance meets with key
personnel from 911 service bureaus to obtain their acceptance and to establish
dates for circuit establishment and joint testing. Other examples of traffic
interchange and interconnection arrangements utilizing the ILEC's network
include connectivity to its out-of-band signaling facilities, interconnectivity
to the ILEC's operator services and directory assistance personnel, and access
through the ILEC to the networks of wireless companies and interexchange
carriers.
Allegiance has entered into interconnection agreements with the ILECs in each of
the states in which its current eleven geographic markets are located. In
Georgia, New York and Texas, however, the original interconnection agreements
have expired. Allegiance is operating under the terms of these agreements while
negotiating new interconnection agreements. The new agreements will likely have
retroactive effective dates.
After the initial implementation activities are completed in a market,
Allegiance follows an on-going capacity management plan to ensure that adequate
quantities of network facilities, such as interconnection trunks are in place,
and a contingency plan must be devised to address spikes in demand caused by
events such as a larger-than-expected customer sale in a relatively small
geographic area.
REGULATION
Allegiance's telecommunications services business is subject to federal, state
and local regulation.
Federal Regulation
The FCC regulates interstate and international telecommunications services,
including the use of local telephone facilities to originate and terminate
interstate and international calls. Allegiance provides such services on a
common carrier basis. The FCC imposes certain regulations on common carriers
such as the ILECs that have some degree of market power. The FCC imposes less
regulation on common carriers without market power including, to date, CLECs
like Allegiance. The FCC requires common carriers to receive an authorization to
construct and operate telecommunications facilities, and to provide or resell
telecommunications services, between the United States and international points.
Under the Telecommunications Act, any entity, including cable television
companies and electric and gas utilities, may enter any telecommunications
market, subject to reasonable state regulation of safety, quality and consumer
protection. Because implementation of the Telecommunications Act is subject to
numerous federal and state policy rulemaking proceedings and judicial review
there is still uncertainty as to what impact such legislation will have on
Allegiance.
The Telecommunications Act is intended to increase competition. The act opens
the local services market by requiring ILECs to permit interconnection to their
networks and establishing ILEC obligations with respect to:
Reciprocal Compensation. Requires all local exchange carriers to
complete calls originated by competing local exchange carriers under
reciprocal arrangements at prices based on tariffs or negotiated prices.
Resale. Requires all ILECs and CLECs to permit resale of their
telecommunications services without unreasonable restrictions or conditions.
In addition, ILECs are required to offer wholesale versions of all retail
services to other telecommunications carriers for resale at discounted
rates, based on the costs avoided by the ILEC in the wholesale offering.
Interconnection. Requires all ILECs and CLECs to permit their
competitors to interconnect with their facilities. Requires all ILECs to
permit interconnection at any technically feasible point within their
networks, on nondiscriminatory terms, at prices based on cost, which may
include a reasonable profit. At the option of the carrier seeking
interconnection, collocation of the requesting carrier's equipment in the
ILECs' premises must be offered, except where an ILEC can demonstrate space
limitations or other technical impediments to collocation.
Unbundled Access. Requires all ILECs to provide nondiscriminatory access
to unbundled network elements including, network facilities, equipment,
features, functions, and capabilities, at any technically feasible point
within their networks, on nondiscriminatory terms, at prices based on cost,
which may include a reasonable profit.
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Number Portability. Requires all ILECs and CLECs to permit users of
telecommunications services to retain existing telephone numbers without
impairment of quality, reliability or convenience when switching from one
telecommunications carrier to another.
Dialing Parity. Requires all ILECs and CLECs to provide "1+" equal
access to competing providers of telephone exchange service and toll
service, and to provide nondiscriminatory access to telephone numbers,
operator services, directory assistance, and directory listing, with no
unreasonable dialing delays.
Access to Rights-of-Way. Requires all ILECs and CLECs to permit
competing carriers access to poles, ducts, conduits and rights-of-way at
regulated prices.
ILECs are required to negotiate in good faith with carriers requesting any or
all of the above arrangements. If the negotiating carriers cannot reach
agreement within a prescribed time, either carrier may request binding
arbitration of the disputed issues by the state regulatory commission. Where an
agreement has not been reached, ILECs remain subject to interconnection
obligations established by the FCC and state telecommunication regulatory
commissions.
In August 1996, the FCC released a decision establishing rules implementing the
ILEC interconnection obligations described above. On July 18, 1997, the Eighth
Circuit vacated certain portions of this decision and narrowly interpreted the
FCC's power to prescribe and enforce rules implementing the Telecommunications
Act. On January 25, 1999, the United States Supreme Court reversed the Eighth
Circuit decision and reaffirmed the FCC's broad authority to issue rules
implementing the Telecommunications Act, although it did vacate a rule
determining which network elements the incumbent local exchange carriers must
provide to competitors on an unbundled basis. Allegiance, however, leases only
the basic unbundled network elements from the ILEC and therefore does not expect
reconsideration of the unbundling rules to have an adverse effect on its smart
build strategy.
Nevertheless, the FCC likely will conduct additional rulemaking proceedings to
conform to the Supreme Court's interpretation of the law, and these proceedings
may result in further judicial review. While these court proceedings were
pending, Allegiance entered into interconnection agreements with a number of
ILECs through negotiations or, in some cases, adoption of another CLEC's
approved agreement. These agreements remain in effect, although in some cases
one or both parties may be entitled to demand renegotiation of particular
provisions based on intervening changes in the law. However, it is uncertain
whether Allegiance will be able to obtain renewal of these agreements on
favorable terms when they expire.
The Telecommunications Act codifies the ILECs' equal access and
nondiscrimination obligations and preempts inconsistent state regulation. The
Telecommunications Act also contains special provisions that replace prior
antitrust restrictions that prohibited the regional Bell operating companies
from providing long distance services and engaging in telecommunications
equipment manufacturing. The Telecommunications Act permitted the regional Bell
operating companies to enter the out-of-region long distance market immediately
upon its enactment. Further, provisions of the Telecommunications Act permit a
regional Bell operating company to enter the long distance market in its
in-region states if it satisfies several procedural and substantive
requirements, including:
o obtaining FCC approval upon a showing that the regional Bell operating
company has entered into interconnection agreements or, under some
circumstances, has offered to enter into such agreements in those states in
which it seeks long distance relief;
o the interconnection agreements satisfy a 14-point "checklist" of
competitive requirements; and
o the FCC is satisfied that the regional Bell operating company's entry into
long distance markets is in the public interest.
To date, several petitions by regional Bell operating companies for such entry
have been denied by the FCC, and none have been granted. However, it is likely
that additional petitions will be filed in 1999 and it is possible that regional
Bell operating companies may receive approval to offer long distance services in
one or more states. This may have an unfavorable effect on Allegiance's
business. Allegiance is legally able to offer its customers both long distance
and local exchange services, which the regional Bell operating companies
currently may not do. This ability to offer "one-stop shopping" gives Allegiance
a marketing advantage that it would no longer enjoy. See "-- Competition."
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On May 8, 1997, the FCC released an order establishing a significantly expanded
federal universal service subsidy regime. For example, the FCC established new
subsidies for telecommunications and information services provided to qualifying
schools and libraries with an annual cap of $2.25 billion and for services
provided to rural health care providers with an annual cap of $400 million. The
FCC also expanded the federal subsidies for local exchange telephone services
provided to low-income consumers. Providers of interstate telecommunications
service, such as Allegiance must pay for a portion of these programs.
Allegiance's share of these federal subsidy funds will be based on its share of
certain defined telecommunications end user revenues. Currently, the FCC is
assessing such payments on the basis of a provider's revenue for the previous
year. The FCC announced that it intends, effective July 1, 1999, to revise its
rules for subsidizing service provided to consumers in high cost areas, which
may result in further substantial increases in the overall cost of the subsidy
program. Several parties have appealed the May 8th order. Such appeals have been
consolidated and transferred to the United States Court of Appeals for the Fifth
Circuit where they are currently pending.
For the first half of 1999, Allegiance expects to incur a contribution liability
equal to approximately 1.5% of its 1998 operating revenues. With respect to
subsequent periods, however, Allegiance is currently unable to quantify the
amount of subsidy payments that it will be required to make or the effect that
these required payments will have on its financial condition.
Under authority granted by the FCC, Allegiance will resell the international
telecommunications services of other common carriers between the United States
and international points. In connection with such authority, Allegiance's
subsidiary, Allegiance Telecom International, Inc., has filed tariffs with the
FCC stating the rates, terms and conditions for its international services.
With respect to its domestic service offerings, various subsidiaries of
Allegiance have filed tariffs with the FCC stating the rates, terms and
conditions for their interstate services. Allegiance's tariffs are generally not
subject to pre-effective review by the FCC, and can be amended on one day's
notice. Allegiance's interstate services are provided in competition with
interexchange carriers and, with respect to access services, the ILECs. With
limited exceptions, the current policy of the FCC for most interstate access
services dictates that ILECs charge all customers the same price for the same
service. Thus, the ILECs generally cannot lower prices to those customers likely
to contract for their services without also lowering charges for the same
service to all customers in the same geographic area, including those whose
telecommunications requirements would not justify the use of such lower prices.
The FCC may, however, alleviate this constraint on the ILECs and permit them to
offer special rate packages to very large customers, as it has done in a few
cases, or permit other forms of rate flexibility. The FCC has adopted some
proposals that significantly lessen the regulation of ILECs that are subject to
competition in their service areas and provide such ILECs with additional
flexibility in pricing their interstate switched and special access on a central
office specific basis; and, as discussed in the following paragraph, is
considering expanding such flexibility.
In two orders released on December 24, 1996, and May 16, 1997, the FCC made
major changes in the interstate access charge structure. In the December 24th
order, the FCC removed restrictions on ILECs' ability to lower access prices and
relaxed the regulation of new switched access services in those markets where
there are other providers of access services. If this increased pricing
flexibility is not effectively monitored by federal regulators, it could have a
material adverse effect on Allegiance's ability to compete in providing
interstate access services. The May 16th order substantially increased the costs
that ILECs subject to the FCC's price cap rules recover through monthly,
non-traffic sensitive access charges and substantially decreased the costs that
these carriers recover through traffic sensitive access charges. In the May 16th
order, the FCC also announced its plan to bring interstate access rate levels
more in line with cost. The plan will include rules that may grant these
carriers increased pricing flexibility upon demonstrations of increased
competition or potential competition in relevant markets. The manner in which
the FCC implements this approach to lowering access charge levels could have a
material effect on Allegiance's ability to compete in providing interstate
access services. Several parties appealed the May 16th order. On August 19,
1998, the May 16th order was affirmed by the Eighth Circuit U.S. Court of
Appeals. The FCC is now considering public comments on pricing flexibility
proposals submitted by two regional Bell operating companies and on changing the
productivity factor (currently 6.5%), which is applied annually to reduce ILECs'
price cap indices.
ILECs around the country have been contesting whether the obligation to pay
reciprocal compensation to competitive local exchange carriers should apply to
local telephone calls from an ILEC's customers to Internet service providers
served by competitive local exchange carriers. The ILECs claim that this traffic
is interstate in nature and therefore should be exempt from compensation
arrangements applicable to local, intrastate calls. Competitive local exchange
carriers have contended that the interconnection agreements provide no exception
for
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local calls to Internet service providers and reciprocal compensation is
therefore applicable. Currently, over 25 state commissions and several federal
and state courts have ruled that reciprocal compensation arrangements do apply
to calls to Internet service providers, and no jurisdiction has ruled to the
contrary. Certain of these rulings are subject to appeal. Additional disputes
over the appropriate treatment of Internet service provider traffic are pending
in other states.
On February 26, 1999, the FCC released a Declaratory Ruling determining that
Internet service provider traffic is interstate for jurisdictional purposes, but
that its current rules neither require nor prohibit the payment of reciprocal
compensation for such calls. In the absence of a federal rule, the FCC
determined that state commissions have authority to interpret and enforce the
reciprocal compensation provisions of existing interconnection agreements, and
to determine the appropriate treatment of Internet service provider traffic in
arbitrating new agreements. The FCC also requested comment on alternative
federal rules to govern compensation for such calls in the future. In response
to the FCC ruling, some regional Bell operating companies have asked state
commissions to reopen previous decisions requiring the payment of reciprocal
compensation on Internet service provider calls.
Allegiance anticipates that Internet service providers will be among its target
customers, and adverse decisions in state proceedings could limit its ability to
service this group of customers profitably. Allegiance limits the switch
capacity used for Internet service provider lines to 20%. In addition, given the
uncertainty as to whether reciprocal compensation should be payable in
connection with calls to Internet service providers, Allegiance recognizes such
revenue only when realization of it is certain, which in most cases will be upon
receipt of cash.
State Regulation
The Telecommunications Act is intended to increase competition in the
telecommunications industry, especially in the local exchange market. With
respect to local services, ILECs are required to allow interconnection to their
networks and to provide unbundled access to network facilities, as well as a
number of other procompetitive measures. Because the implementation of the
Telecommunications Act is subject to numerous state rulemaking proceedings on
these issues, it is currently difficult to predict how quickly full competition
for local services, including local dial tone, will be introduced.
State regulatory agencies have regulatory jurisdiction when Allegiance
facilities and services are used to provide intrastate services. A portion of
Allegiance's current traffic may be classified as intrastate and therefore
subject to state regulation. Allegiance expects that it will offer more
intrastate services, including intrastate switched services, as its business and
product lines expand and state regulations are modified to allow increased local
services competition. To provide intrastate services, Allegiance generally must
obtain a certificate of public convenience and necessity from the state
regulatory agency and comply with state requirements for telecommunications
utilities, including state tariffing requirements.
State agencies, like the FCC, require Allegiance to file periodic reports, pay
various fees and assessments, and comply with rules governing quality of
service, consumer protection, and similar issues. Although the specific
requirements vary from state to state, they tend to be more detailed than the
FCC's regulation because of the strong public interest in the quality of basic
local exchange service. Allegiance intends to comply with all applicable state
regulations, and as a general matter does not expect that these requirements of
industry-wide applicability will have a material adverse effect on its business.
However, no assurance can be given that the imposition of new regulatory burdens
in a particular state will not affect the profitability of Allegiance's services
in that state.
Local Regulation
Allegiance's networks are subject to numerous local regulations such as building
codes and licensing. Such regulations vary on a city by city and county by
county basis. If Allegiance decides in the future to install its own fiber optic
transmission facilities, it will need to obtain rights-of-way over private and
publicly owned land. There can be no assurance that such rights-of-way will be
available to Allegiance on economically reasonable or advantageous terms.
COMPETITION
The telecommunications industry is highly competitive. Allegiance believes that
the principal competitive factors affecting its business will be pricing levels
and clear pricing policies, customer service, accurate billing and, to a
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lesser extent, variety of services. The ability of Allegiance to compete
effectively will depend upon its continued ability to maintain high quality,
market-driven services at prices generally equal to or below those charged by
its competitors. To maintain its competitive posture, Allegiance believes that
it must be in a position to reduce its prices in order to meet reductions in
rates, if any, by others. Any such reductions could adversely affect Allegiance.
Many of Allegiance's current and potential competitors have financial, personnel
and other resources, including brand name recognition, substantially greater
than those of Allegiance, as well as other competitive advantages over
Allegiance.
Local Exchange Carriers. In each of the markets targeted by Allegiance,
Allegiance will compete principally with the ILEC serving that area, such as
Ameritech, BellSouth, Southwestern Bell, Bell Atlantic or US WEST. Allegiance
believes the regional Bell operating companies' primary agenda is to be able to
offer long distance service in their service territories. The independent
telephone companies have already achieved this goal with good early returns.
Many experts expect the regional Bell operating companies to be successful in
entering the long distance market in a few states sometime in 1999. Allegiance
believes the regional Bell operating companies expect to offset share losses in
their local markets by capturing a significant percentage of the in-region long
distance market, especially in the residential segments where the regional Bell
operating companies' strong regional brand names and extensive advertising
campaigns may be very successful. See "-- Regulation."
As a recent entrant in the integrated telecommunications services industry,
Allegiance has not achieved and does not expect to achieve a significant market
share for any of its services. In particular, the ILECs have long-standing
relationships with their customers, have financial, technical and marketing
resources substantially greater than those of Allegiance, have the potential to
subsidize competitive services with revenues from a variety of businesses and
currently benefit from certain existing regulations that favor the ILECs over
Allegiance in certain respects. While recent regulatory initiatives, which allow
CLECs such as Allegiance to interconnect with ILEC facilities, provide increased
business opportunities for Allegiance, such interconnection opportunities have
been and likely will continue to be accompanied by increased pricing flexibility
for and relaxation of regulatory oversight of the ILECs.
ILECs have long-standing relationships with regulatory authorities at the
federal and state levels. While recent FCC administrative decisions and
initiatives provide increased business opportunities to telecommunications
providers such as Allegiance, they also provide the ILECs with increased pricing
flexibility for their private line and special access and switched access
services. In addition, with respect to competitive access services as opposed to
switched access services, the FCC recently proposed a rule that would provide
for increased ILEC pricing flexibility and deregulation for such access services
either automatically or after certain competitive levels are reached. If the
ILECs are allowed by regulators to offer discounts to large customers through
contract tariffs, engage in aggressive volume and term discount pricing
practices for their customers, and/or seek to charge competitors excessive fees
for interconnection to their networks, the income of competitors to the ILECs,
including Allegiance, could be materially adversely affected. If future
regulatory decisions afford the ILECs increased access services pricing
flexibility or other regulatory relief, such decisions could also have a
material adverse effect on competitors to the ILEC, including Allegiance.
Competitive Access Carriers/Competitive Local Exchange Carriers/Interexchange
Carriers/ Other Market Entrants. Allegiance also faces, and expects to continue
to face, competition from other current and potential market entrants, including
long distance carriers seeking to enter, reenter or expand entry into the local
exchange market such as AT&T, MCI WorldCom, and Sprint, and from other CLECs,
resellers of local exchange services, competitive access providers, cable
television companies, electric utilities, microwave carriers, wireless telephone
system operators and private networks built by large end users. In addition, a
continuing trend toward consolidation of telecommunications companies and the
formation of strategic alliances within the telecommunications industry, as well
as the development of new technologies, could give rise to significant new
competitors to Allegiance. For example, WorldCom acquired MFS Communications in
December 1996, acquired another CLEC, Brooks Fiber Properties, Inc. in 1997, and
recently merged with MCI. AT&T recently acquired Teleport Communications Group
Inc., a CLEC, and TeleCommunications, Inc., a cable, telecommunications and
high-speed Internet services provider. Ameritech Corporation has agreed to merge
with SBC Communications; and Bell Atlantic has agreed to merge with GTE
Corporation. These types of consolidations and strategic alliances could put
Allegiance at a competitive disadvantage.
The Telecommunications Act includes provisions which impose certain regulatory
requirements on all local exchange carriers, including competitors such as
Allegiance, while granting the FCC expanded authority to reduce the level of
regulation applicable to any or all telecommunications carriers, including
ILECs. The manner in which
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these provisions of the Telecommunications Act are implemented and enforced
could have a material adverse effect on Allegiance's ability to successfully
compete against ILECs and other telecommunications service providers. Allegiance
also competes with equipment vendors and installers, and telecommunications
management companies with respect to certain portions of its business.
The changes in the Telecommunications Act radically altered the market
opportunity for traditional competitive access providers and CLECs. Due to the
fact that most existing competitive access providers/ CLECs initially entered
the market providing dedicated access in the pre-1996 era, these companies had
to build a fiber infrastructure before offering services. Switches were added by
most competitive access providers/CLECs in the last year to take advantage of
the opening of the local market. With the Telecommunications Act requiring
unbundling of the local exchange carrier networks, competitive access
providers/CLECs will now be able to more rapidly enter the market by installing
switches and leasing trunk and loop capacity until traffic volume justifies
building facilities. New CLECs will not have to replicate existing facilities
and can be more opportunistic in designing and implementing networks.
A number of CLECs have entered or announced their intention to enter into one or
more of the same markets as Allegiance. Allegiance believes that not all CLECs
however, are pursuing the same target customers as Allegiance. Demographically,
business customers are divided into three categories: small, medium and large.
Targeted cities are divided into three groups by population: Tier 1, Tier 2
and Tier 3. As would be expected, each CLEC may focus on different combinations
of primary and secondary target customers.
Allegiance has chosen to focus primarily on small and medium-sized business
customers in large "Tier 1" markets. To help distinguish itself from other
competitors who have adopted a similar strategy, Allegiance uses a direct sales
approach to offer potential customers "one-stop shopping" services through a
single point of contact. In addition, Allegiance is actively pursuing
collocations throughout all of its target markets which, in combination with its
smart build strategy, is expected to allow Allegiance to access its markets and
provide a greater array of services more quickly than if it were able to use a
traditional build approach.
Allegiance believes the major interexchange carriers, such as AT&T, MCI WorldCom
and Sprint, have a two pronged strategy:
o keep the regional Bell operating companies out of in-region long distance
as long as possible, and
o develop facilities-based and unbundled local service, an approach already
being pursued by MCI WorldCom with the acquisition of MFS Communications,
and more recently by AT&T with its acquisitions of Teleport Communications
and TeleCommunications, Inc.
Competition for Provision of Long Distance Services. The long distance
telecommunications industry has numerous entities competing for the same
customers and a high average turnover rate, as customers frequently change long
distance providers in response to the offering of lower rates or promotional
incentives by competitors. Prices in the long distance market have declined
significantly in recent years and are expected to continue to decline.
Allegiance expects to increasingly face competition from companies offering long
distance data and voice services over the Internet. Such companies could enjoy a
significant cost advantage because they do not currently pay carrier access
charges or universal service fees.
Data/Internet Service Providers. The Internet services market is highly
competitive, and Allegiance expects that competition will continue to intensify.
Allegiance's competitors in this market will include Internet service providers,
other telecommunications companies, online services providers and Internet
software providers. Many of these competitors have greater financial,
technological and marketing resources than those available to Allegiance.
Competition from International Telecommunications Providers. Under the recent
World Trade Organization agreement on basic telecommunications services, the
United States and 72 other members of the World Trade Organization committed
themselves to opening their respective telecommunications markets and/or foreign
ownership and/or to adopting regulatory measures to protect competitors against
anticompetitive behavior by dominant telecommunications companies, effective in
some cases as early as January 1998. Although Allegiance believes that this
agreement could provide Allegiance with significant opportunities to compete in
markets that were not previously accessible and to provide more reliable
services at lower costs than Allegiance could have provided prior to
implementation of this agreement, it could also provide similar opportunities to
Allegiance's competitors and facilitate entry by foreign carriers into the U.S.
market. There can be no assurance that the pro-competitive effects of
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the World Trade Organization agreement will not have a material adverse effect
on Allegiance's business, financial condition and results of operations or that
members of the World Trade Organization will implement the terms of this
agreement.
EMPLOYEES
As of December 31, 1998, Allegiance had approximately 649 full-time employees.
Allegiance believes that its future success will depend on its continued ability
to attract and retain highly skilled and qualified employees. None of
Allegiance's employees are currently represented by a collective bargaining
agreement. Allegiance believes that it enjoys good relationships with its
employees.
RISK FACTORS
OUR FORWARD-LOOKING STATEMENTS MAY MATERIALLY DIFFER FROM ACTUAL EVENTS OR
RESULTS
This report, including the discussion under Item 7, "Management's Discussion and
Analysis of Financial Condition and Results of Operations," contains
"forward-looking statements," which you generally can identify by our use of
forward-looking words such as "believes," "expects," "may," "will," "should" or
"anticipates" or the negative or other variations of such terms or comparable
terminology, or by discussion of strategy that involve risks and uncertainties.
We often use these types of statements when discussing our plans and strategies,
our anticipation of revenues from designated markets, and statements regarding
the development of our businesses, the markets for our services and products,
our anticipated capital expenditures, operations support systems, changes in
regulatory requirements and other statements contained in this report regarding
matters that are not historical facts.
We caution you that these forward-looking statements are only predictions and
estimates regarding future events and circumstances. We cannot assure you that
we will achieve the future results reflected in these statements. The risks we
face that could cause us not to achieve these results include, but are not
limited to our ability to do the following in a timely manner, at reasonable
costs and on satisfactory terms and conditions:
o successfully market our services to current and new customers;
o connect with and develop cooperative working relationships with incumbent
local exchange carriers;
o develop efficient operations support systems and other back office systems;
o successfully and efficiently transfer new customers to our networks and
access new geographic markets;
o identify, finance and complete suitable acquisitions;
o borrow under our senior credit facility;
o install new switching facilities and other network equipment; and
o obtain leased fiber optic line capacity, rights-of-way, building access
rights and any required governmental authorizations, franchises and
permits.
Regulatory, legislative and judicial developments could also cause actual
results to differ materially from the future results reflected in such
forward-looking statements. You should consider all of our subsequent written
and oral forward-looking statements only in light of such cautionary statements.
You should not place undue reliance on these forward-looking statements and you
should understand that they speak only as of the dates we make them. Important
factors that could cause our actual results to be materially different from the
forward-looking statements are disclosed in this "Risk Factors" section and
throughout this report.
OUR LIMITED HISTORY OF OPERATIONS MAY NOT BE A RELIABLE BASIS FOR EVALUATING OUR
PROSPECTS
Because of our short operating history, you have limited operating and financial
data which you can use to evaluate our performance. From our inception on April
22, 1997 through December 16, 1997, we were in the development stage of
operations.
IF WE DO NOT EFFECTIVELY MANAGE RAPID EXPANSION OF OUR BUSINESS, OUR FINANCIAL
CONDITION WILL SUFFER
We are in the early stages of our operations and have only recently begun to
deploy networks in our first 17 target markets. If we are successful in the
implementation of our business plan, we will be rapidly expanding our operations
and providing bundled telecommunications services on a widespread basis. This
rapid expansion may
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place a significant strain on our management, financial and other resources. If
we fail to manage our growth effectively, we may not be able to expand our
customer base and service offerings as we have planned.
OUR SUCCESS DEPENDS ON OUR KEY PERSONNEL AND WE MAY NOT BE ABLE TO REPLACE KEY
EXECUTIVES WHO LEAVE
We are managed by a small number of key executive officers, most notably Royce
J. Holland, our Chairman and Chief Executive Officer. The loss of services of
one or more of these key individuals, particularly Mr. Holland, could materially
and adversely affect our business and our prospects. Most of our executive
officers do not have employment agreements, and we do not maintain key person
life insurance for any of our executive officers. The competition for qualified
personnel in the telecommunications industry is intense. For this reason, we
cannot assure you that we will be able to hire or retain necessary personnel in
the future.
WE ARE DEPENDENT ON EFFECTIVE BILLING, CUSTOMER SERVICE AND INFORMATION SYSTEMS
AND WE MAY HAVE DIFFICULTIES IN DEVELOPING THESE SYSTEMS
Sophisticated back office information and processing systems are vital to our
growth and our ability to monitor costs, bill customers, initiate, implement and
track customer orders and achieve operating efficiencies. We cannot assure you
that these systems will be successfully implemented on a timely basis or at all
or will perform as expected because:
o our vendors may fail to deliver proposed products and services in a timely
and effective manner and at acceptable costs;
o we may fail to adequately identify all of our information and processing
needs;
o our processing or information systems may fail or be inadequate;
o we may be unable to effectively integrate such products or services;
o we may fail to upgrade systems as necessary; and
o third party vendors may cancel or fail to renew license agreements that
relate to these systems.
WE MAY BE ADVERSELY IMPACTED BY YEAR 2000 ISSUES, MANY OF WHICH ARE BEYOND OUR
CONTROL
The "year 2000" issue generally describes the various problems that may result
from the improper processing of dates and date-sensitive transactions by
computers and other equipment as a result of computer hardware and software
using two digits to identify the year in a date. The failure to process dates
could result in network and 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. A failure of our customers or vendors, including other
telecommunications operators, to cause their software and systems to be year
2000 compliant could have a material adverse effect on us and on our ability to
meet our obligations. Until the year 2000 occurs, we will not know for sure that
all systems will then function adequately. In addition, we are dependent upon
third-party suppliers, including other telecommunications operators, for the
delivery of interconnection and other services and on third-party customers for
the purchase of our services. In many cases, our services and operations require
electronic interfacing with the systems and networks of third-party
telecommunication operators such as the incumbent local exchange carriers.
WE FACE POTENTIAL CONFLICTS OF INTEREST CAUSED BY FUND INVESTOR CONTROL WHICH
COULD BE DETRIMENTAL TO HOLDERS OF OUR SECURITIES
You should be aware that the investment funds that provided our initial equity
hold a majority of our board seats and a significant amount of our common stock
and that as a result, our direction and future operations may be controlled by
these funds. For a discussion of the voting agreement among our original fund
and management investors regarding the election of nominees to the board of
directors, see the discussion under Item 13, "Certain Relationships and Related
Transactions" of this report. In addition, decisions concerning our operations
or financial structure may present conflicts of interest between these investors
and our management and other holders of our securities, including our notes. In
addition to their investments in us, these investors or their affiliates
currently have significant investments in other telecommunications companies and
may in the future invest in other entities engaged in the telecommunications
business or in related businesses, including entities that compete with us.
Conflicts may also arise in the negotiation or enforcement of arrangements
entered into by us and entities in which these investors have an interest.
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UNDER CERTAIN CIRCUMSTANCES WE MAY NEED ADDITIONAL CAPITAL TO EXPAND OUR
BUSINESS AND INCREASE REVENUE
We may need additional capital to fund capital expenditures, working capital,
debt service and cash flow deficits during the period in which we are expanding
and developing our business and deploying our networks, services and systems. We
estimate, based on our current business plan, that approximately $750 to $850
million of capital will be necessary to fund the deployment and operation of our
networks in all of our initial 24 markets to the point at which operating cash
flow from a market will be sufficient to fund such market's operating and
capital expenditures. This amount includes capital expenditures, working capital
and cash flow deficits, but excludes debt service. We have raised approximately
$554 million of capital to date. The actual amount and timing of our future
capital requirements may differ materially from our estimates as a result of
financial, business and other factors many of which are beyond our control, as
well as prevailing economic conditions.
We believe that the proceeds from our anticipated common stock offering and
borrowings expected to be available under a senior credit facility, together
with our cash on hand, will be sufficient to pre-fund market deployment in all
24 targeted markets. However, we have not yet entered into the credit facility
and if established, we will only be able to borrow under the credit facility if
we are in compliance with certain financial covenants. In the event we cannot
borrow under the credit facility we may need to access alternative sources of
capital. If we are unable to do so we may not be able to expand as we expect,
which may have an adverse effect on us.
OUR SUBSTANTIAL INDEBTEDNESS COULD MAKE US UNABLE TO SERVICE INDEBTEDNESS AND
MEET OUR OTHER REQUIREMENTS AND COULD ADVERSELY AFFECT OUR FINANCIAL HEALTH
We have a significant amount of debt outstanding and plan to access additional
debt financing to fund our business plan. On December 31, 1998, we had $471.7
million of outstanding indebtedness and $110.4 million of stockholders' equity.
We anticipate incurring additional indebtedness in the future, including a
senior secured revolving credit facility that we expect to close in April 1999.
See the discussion of this credit facility in the section titled "Recent
Developments."
This level of debt could:
o impair our ability to obtain additional financing for working capital,
capital expenditures, acquisitions or general corporate purposes;
o require us to dedicate a substantial portion of our cash flow from
operations to the payment of principal and interest on our indebtedness,
thereby reducing the funds available for the growth of our networks;
o place us at a competitive disadvantage with those of our competitors who do
not have as much debt as we do;
o impair our ability to adjust rapidly to changing market conditions; and
o make us more vulnerable if there is a downturn in general economic
conditions or in our business.
The successful implementation of our business plan is essential for us to meet
our working capital, capital expenditure and debt service requirements.
Allegiance's earnings for the year ended December 31, 1998 were insufficient to
cover fixed charges by approximately $249.3 million. We cannot assure you that
we will be able to meet our working capital, capital expenditure and debt
service requirements.
LIMITATIONS IMPOSED BY RESTRICTIVE COVENANTS COULD LIMIT HOW WE CONDUCT BUSINESS
AND A DEFAULT UNDER OUR INDENTURES AND FINANCING AGREEMENTS COULD SIGNIFICANTLY
IMPACT OUR ABILITY TO REPAY OUR INDEBTEDNESS
Our indentures and the agreements entered into in connection with our initial
equity funding contain covenants that restrict our ability to:
o incur additional indebtedness;
o pay dividends and make other distributions;
o prepay subordinated indebtedness;
o make investments and other restricted payments;
o enter into sale and leaseback transactions;
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<PAGE> 19
o create liens;
o sell assets; and
o engage in certain transactions with affiliates.
Our future financing arrangements, including the senior secured revolving credit
facility discussed in the section titled "Recent Developments" will most likely
contain similar or more restrictive covenants, as well as other covenants that
will require us to maintain specified financial ratios and satisfy financial
tests. As a result of these restrictions, we are limited in how we conduct
business and we may be unable to raise additional debt or equity financing to
operate during general economic or business downturns, to compete effectively or
to take advantage of new business opportunities. This may affect our ability to
generate revenues and make profits. Without sufficient revenues and cash, we may
not be able to pay interest and principal on our indebtedness.
Our failure to comply with the covenants and restrictions contained in our
indentures and other financing agreements could lead to a default under the
terms of these agreements. If such a default occurs, the other parties to such
agreements could declare all amounts borrowed and all amounts due under other
instruments that contain provisions for cross-acceleration or cross-default due
and payable. In addition, lenders under our future financing arrangements could
terminate their commitments to lend to us. If that occurs, we cannot assure you
that we would be able to make payments on our indebtedness, meet our working
capital and capital expenditure requirements, or that we would be able to find
additional alternative financing. Even if we could obtain additional alternative
financing, we cannot assure you that it would be on terms that are favorable or
acceptable to us.
WE MAY NOT HAVE THE FUNDS NECESSARY TO FINANCE THE CHANGE OF CONTROL OFFER WHICH
MAY BE REQUIRED BY OUR INDENTURES
Our indentures provide that upon a change of control, each note holder will have
the right to require us to purchase all or a portion of such holder's notes. We
would be required to purchase the notes at a purchase price of 101% of the
accreted value of the 11 3/4% notes and 101% of the principal amount of the
12 7/8% notes, plus any accrued and unpaid interest to the date of repurchase.
It is possible that we will not have sufficient funds at that time to repurchase
our notes.
IF WE DO NOT INTERCONNECT WITH OUR PRIMARY COMPETITORS, THE INCUMBENT LOCAL
EXCHANGE CARRIERS, OUR BUSINESS WILL BE ADVERSELY AFFECTED
Many new carriers, including Allegiance, have experienced difficulties in
working with the incumbent local exchange carriers with respect to initiating,
interconnecting, and implementing the systems used by these new carriers to
order and receive unbundled network elements and wholesale services and locating
the new carriers' equipment in the offices of the incumbent local exchange
carriers. As a new carrier, we must coordinate with incumbent local exchange
carriers so that we can provide local service to customers on a timely and
competitive basis. The Telecommunications Act created incentives for regional
Bell operating companies to cooperate with new carriers and permit access to
their facilities by denying such companies the ability to provide in-region long
distance services until they have satisfied statutory conditions designed to
open their local markets to competition. The regional Bell operating companies
in our markets are not yet permitted by the FCC to offer long distance services.
These companies may not be accommodating to us once they are permitted to offer
long distance service. If we cannot obtain the cooperation of a regional Bell
operating company in a region, whether or not it has been authorized to offer
long distance service, our ability to offer local services in such region on a
timely and cost-effective basis will be adversely affected.
IF WE DO NOT OBTAIN PEERING ARRANGEMENTS WITH INTERNET SERVICE PROVIDERS, THE
PROFITABILITY OF OUR INTERNET ACCESS SERVICES WILL SUFFER
The profitability of our Internet access services, and related services such as
Web site hosting, may be adversely affected if we are unable to obtain "peering"
arrangements with Internet service providers. In the past, major Internet
service providers routinely exchanged traffic with other Internet service
providers that met technical criteria on a "peering" basis, meaning that each
Internet service provider accepted traffic routed to Internet addresses on their
system from their "peers" on a reciprocal basis, without payment of
compensation. However, since 1997 UUNET Technologies, Inc., the largest Internet
service provider, has been greatly restricting the use of peering arrangements
with other providers and has been imposing charges for accepting traffic from
providers other than its "peers." Other major Internet service providers have
adopted similar policies. We do not currently have any peering arrangements
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<PAGE> 20
and cannot assure you that we will be able to negotiate "peer" status with any
of the major nationwide Internet service providers in the future, or that we
will be able to terminate traffic on Internet service providers' networks at
favorable prices.
OUR OFFERING OF LONG DISTANCE SERVICES IS AFFECTED BY OUR ABILITY TO ESTABLISH
EFFECTIVE RESALE AGREEMENTS
As part of our "one-stop shopping" offering of bundled telecommunications
services to our customers, we offer long distance services. We have relied and
will continue to rely on other carriers to provide transmission and termination
services for all of our long distance traffic. We will continue to enter into
resale agreements with long distance carriers to provide us with transmission
services. Such agreements typically provide for the resale of long distance
services on a per-minute basis and may contain minimum volume commitments.
Negotiation of these agreements involves estimates of future supply and demand
for transmission capacity as well as estimates of the calling pattern and
traffic levels of our future customers. If we fail to meet our minimum volume
commitments, we may be obligated to pay underutilization charges and if we
underestimate our need for transmission capacity, we may be required to obtain
capacity through more expensive means.
OUR PRINCIPAL COMPETITORS FOR LOCAL SERVICES, THE INCUMBENT LOCAL EXCHANGE
CARRIERS, AND POTENTIAL ADDITIONAL COMPETITORS, HAVE ADVANTAGES THAT MAY
ADVERSELY AFFECT OUR ABILITY TO COMPETE WITH THEM
The telecommunications industry is highly competitive. Many of our current and
potential competitors in the local market have financial, technical, marketing,
personnel and other resources, including brand name recognition, substantially
greater than ours, as well as other competitive advantages over us. In each of
the markets targeted by us, we will compete principally with the incumbent local
exchange carrier serving that area and they enjoy advantages that may adversely
affect our ability to compete with them. Incumbent local exchange carriers are
established providers of local telephone services to all or virtually all
telephone subscribers within their respective service areas. Incumbent local
exchange carriers also have long-standing relationships with federal and state
regulatory authorities. FCC and state administrative decisions and initiatives
provide the incumbent local exchange carriers with pricing flexibility for
their:
o private lines, which are private, dedicated telecommunications connections
between customers;
o special access services, which are dedicated lines from a customer to a
long distance company provided by the local phone company; and
o switched access services, which refers to the call connection provided by
the local phone company's switch between a customer's phone and the long
distance company's switch.
In addition, with respect to competitive access services, such as special access
services as opposed to switched access services, the FCC is considering allowing
incumbent local exchange carriers increased pricing flexibility and deregulation
for such access services either automatically or after certain competitive
levels are reached. If the incumbent local exchange carriers are allowed by
regulators to offer discounts to large customers through contract tariffs,
engage in aggressive volume and term discount pricing practices for their
customers, and/or seek to charge competitors excessive fees for interconnection
to their networks, competitors such as us could be materially adversely
affected. If future regulatory decisions afford the incumbent local exchange
carriers increased pricing flexibility or other regulatory relief, such
decisions could also have a material adverse effect on competitors such as us.
We also face, and expect to continue to face, competition in the local market
from other current and potential market entrants, including long distance
carriers seeking to enter, reenter or expand entry into the local exchange
marketplace such as AT&T, MCI WorldCom and Sprint, and from other competitive
local exchange carriers, resellers, competitive access providers, cable
television companies, electric utilities, microwave carriers, wireless telephone
system operators and private networks built by large end users. In addition, the
development of new technologies could give rise to significant new competitors
in the local market.
SIGNIFICANT COMPETITION IN PROVIDING LONG DISTANCE AND INTERNET SERVICES COULD
REDUCE THE DEMAND FOR AND PROFITABILITY OF OUR SERVICES
We also face significant competition in providing long distance and Internet
services. Many of these competitors have greater financial, technological,
marketing, personnel and other resources than those available to us.
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<PAGE> 21
The long distance telecommunications market has numerous entities competing for
the same customers and a high average turnover rate, as customers frequently
change long distance providers in response to the offering of lower rates or
promotional incentives. Prices in the long distance market have declined
significantly in recent years and are expected to continue to decline. We face
competition from large carriers such as AT&T, MCI WorldCom and Sprint and many
smaller long distance carriers. Other competitors are likely to include regional
Bell operating companies providing long distance services outside of their local
service area and, with the removal of regulatory barriers, long distance
services within such local service areas, other competitive local exchange
carriers, microwave and satellite carriers and private networks owned by large
end users. We may also increasingly face competition from companies offering
local and long distance data and voice services over the Internet. Such
companies could enjoy a significant cost advantage because they do not currently
pay many of the charges or fees that we have to pay. In addition, in June 1998,
Sprint announced its intention to offer voice, data and video services over its
nationwide asynchronous transfer mode network, which Sprint anticipates will
significantly reduce its cost to provide such services. Sprint plans to bill its
customers based upon the amount of traffic carried, irrespective of the time
required to send the traffic or the traffic's destination.
The Internet services market is highly competitive and we expect that
competition will continue to intensify. Our competitors in this market include
Internet service providers, other telecommunications companies, online services
providers and Internet software providers.
OUR NEED TO COMPLY WITH EXTENSIVE GOVERNMENT REGULATION CAN INCREASE OUR COSTS
AND SLOW OUR GROWTH
Our networks and the provision 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 slow our growth and have a material
adverse effect upon us.
The FCC exercises jurisdiction over us with respect to interstate and
international services. We must obtain, and have obtained through our
subsidiary, Allegiance Telecom International, Inc., prior FCC authorization for
installation and operation of international facilities and the provision,
including by resale, of international long distance services. Additionally, we
file publicly available documents detailing our services, equipment and pricing,
also known as "tariffs," with the FCC for both international and domestic
long-distance services.
State regulatory commissions exercise jurisdiction over us because we provide
intrastate services. We are required to obtain regulatory authorization and/or
file tariffs at state agencies in most of the states in which we operate. If and
when we seek to build our own network segments, local authorities regulate our
access to municipal rights-of-way. Constructing a network is also subject to
numerous local regulations such as building codes and licensing. Such
regulations vary on a city by city and county by county basis.
Regulators at both the federal and state level require us to pay various fees
and assessments, file periodic reports, and comply with various rules regarding
the contents of our bills, protection of subscriber privacy, and similar matters
on an on-going basis.
We cannot assure you that the FCC or state commissions will grant required
authority or refrain from taking action against us if we are found to have
provided services without obtaining the necessary authorizations, or to have
violated other requirements of their rules and orders. Regulators or others
could challenge our compliance with applicable rules and orders. Such challenges
could cause us to incur substantial legal and administrative expenses.
DEREGULATION OF THE TELECOMMUNICATIONS INDUSTRY INVOLVES UNCERTAINTIES, AND THE
RESOLUTION OF THESE UNCERTAINTIES COULD ADVERSELY AFFECT OUR BUSINESS
The Telecommunications Act provides for a significant deregulation of the
domestic telecommunications industry, including the local exchange, long
distance and cable television industries. The Telecommunications Act remains
subject to judicial review and additional FCC rulemaking, and thus it is
difficult to predict what effect the legislation will have on us and our
operations. There are currently many regulatory actions underway and being
contemplated by federal and state authorities regarding interconnection pricing
and other issues that could result in significant changes to the business
conditions in the telecommunications industry. We cannot assure you that these
changes will not have a material adverse effect upon us.
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<PAGE> 22
THE REGULATION OF INTERCONNECTION WITH INCUMBENT LOCAL EXCHANGE CARRIERS
INVOLVES UNCERTAINTIES, AND THE RESOLUTION OF THESE UNCERTAINTIES COULD
ADVERSELY AFFECT OUR BUSINESS
Although the incumbent local exchange carriers are required under the
Telecommunications Act to unbundle and make available elements of their network
and permit us to purchase only the origination and termination services that we
need, thereby decreasing our operating expenses, such unbundling may not be done
as quickly as we require and may be priced higher than we expect. This is
important because we rely on the facilities of these other carriers to connect
to our high capacity digital switches so that we can provide services to our
customers. Our ability to obtain these interconnection agreements on favorable
terms, and the time and expense involved in negotiating them, can be adversely
affected by legal developments.
A recent Supreme Court decision vacated a FCC rule determining which network
elements the incumbent local exchange carriers must provide to competitors on an
unbundled basis. We expect that the FCC will conduct a rulemaking to adopt new
standards for unbundling of network elements in conformance with this decision.
The implementation of these and other FCC rules may lead to further litigation.
This may complicate our interconnection negotiations, and may adversely affect
our existing agreements and operations.
WE COULD LOSE REVENUE IF CALLS TO INTERNET SERVICE PROVIDERS ARE TREATED AS LONG
DISTANCE INTERSTATE CALLS
We believe that other local exchange carriers should have to compensate us when
their customers place calls to Internet service providers who are our customers.
Most incumbent local exchange carriers disagree. Internet service providers are
among our target customers, and decisions providing that other carriers do not
have to compensate us for these calls could limit our ability to service this
group of customers profitably.
For all other local calls, it is clear that the telecommunications company whose
customer calls a customer of a second telecommunications company must compensate
the second company. This is known as reciprocal compensation. This rule does not
apply to long distance interstate calls and the FCC in its Declaratory Ruling of
February 26, 1999, determined that Internet service provider traffic is
interstate for jurisdictional purposes, but that its current rules neither
require nor prohibit the payment of reciprocal compensation for such calls. In
the absence of a federal rule, the FCC determined that state commissions have
authority to interpret and enforce the reciprocal compensation provisions of
existing interconnection agreements, and to determine the appropriate treatment
of Internet service provider traffic in arbitrating new agreements.
THE REGULATION OF ACCESS CHARGES INVOLVES UNCERTAINTIES, AND THE RESOLUTION OF
THESE UNCERTAINTIES COULD ADVERSELY AFFECT OUR BUSINESS
To the extent we provide long-distance, often referred to as "interexchange,"
telecommunications service, we are required to pay access charges to other local
exchange carriers when we use the facilities of those companies to originate or
terminate interexchange calls. As a competitive local exchange carrier, we also
provide access services to other long distance service providers. The interstate
access charges of incumbent local exchange carriers are subject to extensive
regulation by the FCC, while those of competitive local exchange carriers are
subject to a lesser degree of FCC regulation, but remain subject to the
requirement that all charges be just, reasonable, and not unreasonably
discriminatory. Disputes have arisen regarding the regulation of access charges
and these may be resolved adversely to us.
The FCC has made major changes in the interstate access charge structure. The
manner in which the FCC implements and monitors these increased pricing
flexibility changes could have a material adverse effect on our ability to
compete in providing interstate access services.
Some interexchange carriers, including AT&T, have also asked the FCC to take
regulatory action to prevent competitive local exchange carriers from charging
allegedly "excessive" access charges. Although no complaints have been filed
against us, we do provide access service to interexchange carriers and we could
be subject in the future to allegations that our charges for this service are
unjust and unreasonable. In that event, we would have to provide the FCC with an
explanation of how we set our rates and justify them as reasonable. We can give
no assurance that the FCC will accept our rates as reasonable. If our rates are
reduced by regulatory order, this could have a material adverse effect on our
profitability.
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IF WE DO NOT CONTINUALLY ADAPT TO TECHNOLOGICAL CHANGE, WE COULD LOSE CUSTOMERS
AND MARKET SHARE
The telecommunications industry is subject to rapid and significant changes in
technology, and we rely on outside vendors for the development of and access to
new technology. The effect of technological changes on our business cannot be
predicted. We believe our future success will depend, in part, on our ability to
anticipate or adapt to such changes and to offer, on a timely basis, services
that meet customer demands. We cannot assure you that we will obtain access to
new technology on a timely basis or on satisfactory terms. Any failure by us to
obtain new technology could cause us to lose customers and market share.
WE HAVE APPLIED FOR, BUT NOT YET RECEIVED, ASSURANCE FROM THE SEC REGARDING OUR
STATUS UNDER THE INVESTMENT COMPANY ACT AND IF WE ARE SUBJECT TO THE INVESTMENT
COMPANY ACT, IT COULD ADVERSELY AFFECT OUR FINANCING ACTIVITIES AND FINANCIAL
RESULTS
Allegiance currently has substantial short-term investments, pending the
deployment of our capital in the pursuit of building our business. This may
result in Allegiance being deemed as an "investment company" under the
Investment Company Act of 1940. This statute requires the registration of, and
imposes various substantive restrictions on, certain companies that are, or hold
themselves out as being, engaged primarily, or propose to engage primarily in,
the business of investing, reinvesting or trading in securities, or that fail
certain statistical tests regarding composition of assets and sources of income
even though they do not intend to be primarily engaged in the businesses of
investing, reinvesting, owning, holding or trading securities.
Allegiance is primarily engaged in a business other than investing, reinvesting,
owning, holding or trading securities and, therefore, is not an investment
company within the meaning of this statute. While we believe this means we are
not an investment company within the meaning of that law, we have been able to
also rely on a safe harbor in that law for certain transient or temporary
investment companies. However, this exemption is only available to companies for
a one-year period and that one-year period terminated in January 1999. We have
applied to the SEC for a one-year exemptive order declaring that Allegiance is
not an investment company and not required to register under this statute. We
have not yet received such an order, and it is possible that we will not
ultimately be successful in receiving such an order. We believe that if we are
granted the exemption, under our current business plan we will have deployed a
sufficient amount of capital by the end of the one-year period such that we
would not then be deemed to be an investment company.
If we were required to register as an investment company under the Investment
Company Act, we would become subject to substantial regulation with respect to
our capital structure, management, operations, transactions with affiliated
persons and other matters. To avoid having to register as an investment company,
we may have to invest a portion of our liquid assets in cash and demand deposits
instead of short-term securities. The extent to which we will have to do so will
depend on the composition and value of our total assets at that time. Having to
register as an investment company or having to invest a material portion of our
liquid assets in cash and demand deposits to avoid such registration, could have
a material adverse effect on our business, financial condition and results of
operations.
FUTURE SALES OF OUR STOCK BY EXISTING STOCKHOLDERS MAY ADVERSELY AFFECT OUR
STOCK PRICE
We currently have 50,360,866 shares of common stock outstanding. While certain
of these shares are "restricted securities" under the federal securities laws,
such shares are or will be eligible for sale subject to restrictions as to
timing, manner, volume, notice and the availability of current public
information regarding Allegiance. Sales of substantial amounts of stock in the
public market, or the perception that sales could occur, could depress the
prevailing market price for our stock. Sales may also make it more difficult for
us to sell equity securities or equity-related securities in the future at a
time and price that we deem appropriate.
ANTI-TAKEOVER PROVISIONS IN ALLEGIANCE'S CHARTER AND BYLAWS COULD LIMIT OUR
SHARE PRICE AND DELAY A CHANGE OF MANAGEMENT
Our certificate of incorporation and by-laws contain provisions that could make
it more difficult or even prevent a third party from acquiring Allegiance
without the approval of our incumbent board of directors.
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ITEM 2. PROPERTIES
Allegiance owns or leases, in its operating territories, telephone property
which includes:
o owning switches
o leasing high capacity digital lines that interconnect Allegiance's network
with ILEC networks;
o leasing high capacity digital lines that connect Allegiance's switching
equipment to Allegiance transmission equipment located in ILEC central
offices;
o leasing local loop lines which connect Allegiance's customers to
Allegiance's network; and
o leasing space in ILEC central offices for collocating Allegiance
transmission equipment.
Allegiance is headquartered in Dallas, Texas and leases offices and space in a
number of locations, primarily for sales offices and network equipment
installations. The table below lists Allegiance's current leased facilities:
<TABLE>
<CAPTION>
LEASE APPROXIMATE
LOCATION EXPIRATION SQUARE FOOTAGE
--------- ---------- --------------
<S> <C> <C>
Dallas, TX............ February 2008 76,000
Atlanta, GA........... February 2003 7,400
Atlanta, GA........... November 2001 7,300
Boston, MA............ September 2003 12,000
Boston, MA............ September 2008 18,000
Chicago, IL........... March 2009 11,000
Chicago, IL........... July 2008 14,000
Fort Worth, TX........ June 2003 3,900
Houston, TX........... December 2005 11,700
Houston, TX........... November 2008 18,000
Los Angeles, CA....... June 2008 11,700
Los Angeles, CA....... June 2008 14,585
Newport, CA........... April 2006 7,800
New York, NY.......... August 2006 8,700
New York, NY.......... March 2008 19,500
New York, NY.......... June 2008 12,400
Oakland, CA........... December 2006 2,000
Philadelphia, PA...... April 2002 8,900
Philadelphia, PA...... October 2008 18,000
San Diego, CA......... March 2008 14,000
San Francisco, CA..... April 2002 8,100
San Francisco, CA..... June 2008 16,000
San Jose, CA.......... February 2004 4,500
Washington, DC........ November 2008 15,000
Washington, DC........ November 2006 8,200
Westchester, IL....... January 2001 10,700
Westchester, IL....... April 2001 5,700
</TABLE>
Allegiance believes that its leased facilities are adequate to meet its current
needs in the markets in which it has begun to deploy networks, and that
additional facilities are available to meet its development and expansion needs
in existing and projected target markets for the foreseeable future.
ITEM 3. LEGAL PROCEEDINGS
Allegiance is not party to any legal proceeding that Allegiance believes would,
individually or in the aggregate, have a material adverse effect on Allegiance's
financial condition or results of operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Allegiance did not submit any matter to a vote of its stockholders during the
fourth quarter of 1998.
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ITEM 4A. EXECUTIVE OFFICERS OF ALLEGIANCE
The following sets forth certain information regarding Allegiance's executive
officers. Allegiance's executive officers are elected annually by the board of
directors at its first meeting held after each annual meeting of stockholders or
as soon thereafter as convenient.
<TABLE>
<CAPTION>
NAME AGE POSITION(S)
----------------------------- ------ -------------------------------------------------------
<S> <C> <C>
Royce J. Holland 50 Chairman of the Board and Chief Executive Officer
C. Daniel Yost 50 President and Chief Operating Officer and Director
Thomas M. Lord 42 Executive Vice President of Corporate Development,
Chief Financial Officer, and Director
John J. Callahan 49 Senior Vice President of Sales and Marketing and
Director
Dana A. Crowne 38 Senior Vice President and Chief Engineer
Stephen N. Holland 47 Senior Vice President and Chief Information Officer
Patricia E. Koide 50 Senior Vice President of Human Resources, Real
Estate, Training, Facilities and Administration
Gregg A. Long 45 Senior Vice President of Development and Regulatory
Mark B. Tresnowski 39 Senior Vice President, General Counsel and Secretary
Anthony J. Parella 39 National Vice President of Field Sales
</TABLE>
Royce J. Holland, Allegiance's Chairman of the Board and Chief Executive
Officer, has more than 25 years of experience in the telecommunications,
independent power and engineering/construction industries. Prior to founding
Allegiance in April 1997, Mr. Holland was one of several co-founders of MFS
Communications, where he served as President and Chief Operating Officer from
April 1990 until September 1996 and as Vice Chairman from September 1996 to
February 1997. In January 1993, Mr. Holland was appointed by President George
Bush to the National Security Telecommunications Advisory Committee. Mr. Holland
was recently named Chairman of the Association for Local Telecommunications
Services, the industry trade organization for the competitive telephone sector.
Mr. Holland also presently serves on the board of directors of CSG Systems, a
publicly held billing services company. Mr. Holland's brother, Stephen N.
Holland, is employed as Allegiance's Senior Vice President and Chief Information
Officer.
C. Daniel Yost, who joined Allegiance as President and Chief Operating Officer
in February 1998, was elected to Allegiance's board of directors in March 1998.
Mr. Yost has more than 26 years of experience in the telecommunications
industry. From July 1997 until he joined Allegiance, Mr. Yost was the President
and Chief Operating Officer for U.S. Operations of Netcom On-Line Communications
Services, Inc., a leading Internet service provider. Mr. Yost served as the
President, Southwest Region of AT&T Wireless Services, Inc. from June 1994 to
July 1997. Prior to that, from July 1991 to June 1994, Mr. Yost was the
President, Southwest Region of McCaw Cellular Communications/LIN Broadcasting.
Thomas M. Lord, a co-founder and director of Allegiance and its Executive Vice
President of Corporate Development and Chief Financial Officer, is responsible
for overseeing Allegiance's mergers and acquisitions, corporate finance and
investor relations functions. Mr. Lord is an 18-year veteran in investment
banking, securities research and portfolio management, including serving as a
managing director of Bear, Stearns & Co. Inc. from January 1986 to December
1996. In the five-year period ending December 1996, Mr. Lord oversaw 43
different transactions valued in excess of $6.2 billion for the
telecommunications, information services and technology industries.
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John J. Callahan, who joined Allegiance as Senior Vice President of Sales and
Marketing in December 1997, has more than 18 years of experience in the
telecommunications industry. Most recently, Mr. Callahan was President of the
Western Division for MFS Communications from December 1991 to November 1997,
where he was responsible for the company's sales and operations in Arizona,
California, Georgia, Florida, Illinois, Michigan, Missouri, Ohio, Oregon, Texas
and Washington. Prior to joining MFS Communications, Mr. Callahan was Vice
President and General Manager, Southwest Division for Sprint. Mr. Callahan also
held sales positions with Data Switch and North American Telecom. Mr. Callahan
was elected to Allegiance's board of directors in March 1998.
Dana A. Crowne became Allegiance's Senior Vice President and Chief Engineer in
August 1997. Prior to joining Allegiance, Mr. Crowne held various management
positions at MFS Communications from the time of its founding in 1988, where his
responsibilities included providing engineering support and overseeing budgets
for the construction of MFS Communications' networks. Mr. Crowne ultimately
became Vice President, Network Optimization for MFS Communications from January
1996 to May 1997 and managed the company's network expenses and planning and its
domestic engineering functions. Prior to joining MFS Communications, Mr. Crowne
designed and installed fiber optic transmission systems for Morrison-Knudsen and
served as a consultant on the construction of private telecommunications
networks with JW Reed and Associates.
Stephen N. Holland joined Allegiance as its Senior Vice President and Chief
Information Officer in September 1997. Prior to that time, Mr. Holland held
several senior level positions involving management of or consulting on
information systems, accounting, taxation and finance. Mr. Holland's experience
includes serving as Practice Manager and Information Technology Consultant for
Oracle Corporation from June 1995 to September 1997, as Chief Financial Officer
of Petrosurance Casualty Co. from September 1992 to June 1995, as Manager of
Business Development for Electronic Data Systems, and as a partner of Price
Waterhouse. Mr. Holland's brother, Royce J. Holland, presently serves as
Allegiance's Chairman of the Board and Chief Executive Officer.
Patricia E. Koide has been Allegiance's Senior Vice President of Human
Resources, Real Estate, Training Facilities and Administration since August
1997. Before then, Ms. Koide was Vice President of Corporate Services,
Facilities and Administration for WorldCom from March 1997 to August 1997. Ms.
Koide also held various management positions within MFS Communications and its
subsidiaries since 1989, including Senior Vice President of Facilities,
Administration and Purchasing for MFS Communications North America from 1996 to
1997, Senior Vice President of Human Resources, Facilities and Administration
for MFS Communications Telecom from 1994 to 1996, and Vice President of Human
Resources and Administration for MFS Communications North America from 1989 to
1993. Prior to MFS Communications, Ms. Koide was with Sprint for eight years
where she managed the company's human resources, real estate and facilities for
the Midwest.
Gregg A. Long, who became Allegiance's Senior Vice President of Regulatory and
Development in September 1997, spent 11 years at Destec Energy, Inc. as Project
Development Manager C Partnership Vice President and Director. In that position,
he was responsible for the development of gas-fired power plants from conceptual
stages through project financing. Prior to joining Destec, Mr. Long was Manager
of Project Finance at Morrison-Knudsen, where he was responsible for analyzing
and arranging finance packages for various industrial, mining and civil projects
and also served as financial consultant and analyst.
Mark B. Tresnowski became Allegiance's Senior Vice President and General Counsel
in February 1999. Mr. Tresnowski has been Allegiance's Secretary since September
1997. Mr. Tresnowski practiced law at Kirkland & Ellis for 13 years and was a
partner of that firm from October 1992 to January 1999. In private practice, Mr.
Tresnowski specialized in private and public financings, mergers and
acquisitions and securities law.
Anthony J. Parella, who joined Allegiance as its Regional Vice President --
Central Division in August 1997 and became its National Vice President of Field
Sales in August 1998, has more than 10 years of experience in the
telecommunications industry. Prior to joining Allegiance, Mr. Parella was Vice
President and General Manager for MFS Intelenet, Inc., an operating unit of MFS
Communications, from February 1994 to January 1997, where he was responsible for
the company's sales and operations in Texas. Mr. Parella also served as Director
of Commercial Sales for Sprint from 1991 to January 1994.
24
<PAGE> 27
PART II
ITEM 5. MARKET FOR ALLEGIANCE'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
MARKET INFORMATION
Allegiance's common stock is listed on the Nasdaq National Market. Allegiance's
ticker symbol is "ALGX." Allegiance completed the initial public offering of its
common stock in July 1998. Prior to July 1, 1998, no established public trading
market for the common stock existed.
The following table sets forth on a per share basis, the high and low sale
prices per share for our common stock as reported on the Nasdaq National Market
for the periods indicated:
<TABLE>
<CAPTION>
HIGH LOW
---- ---
<S> <C> <C>
Year ended December 31, 1998:
Third quarter (from July 1, 1998).......................................... $15.688 $ 6.250
Fourth quarter............................................................ $13.375 $ 5.000
Year ended December 31, 1999:
First quarter (through March 24, 1999).................................... $31.000 $11.563
</TABLE>
STOCKHOLDERS
There were approximately 128 owners of record of Allegiance common stock as of
March 24, 1999. This number excludes stockholders whose stock is held in nominee
or street name by brokers and Allegiance believes that it has a significantly
larger number of beneficial holders of common stock. A recent reported last sale
price of our common stock on the Nasdaq National Market is set forth on the
front cover of this report.
DIVIDENDS
We do not anticipate paying any cash dividends in the foreseeable future. Any
future determination to pay dividends will be at the discretion of our board of
directors and will be dependent upon then existing conditions, including our
financial condition, results of operations, contractual restrictions, capital
requirements, business prospects, and other factors our board of directors deems
relevant. In addition, our current financing arrangements effectively prohibit
us from paying cash dividends for the foreseeable future.
RECENT SALES OF UNREGISTERED SECURITIES
On February 25, 1998, Allegiance issued:
(a) 71.25 shares of redeemable convertible preferred stock to Richard
Fields for an aggregate initial purchase price of $37,500; these shares
now represent 30,374 shares of common stock after giving effect to the
conversion of such preferred stock into common stock and stock split in
connection with the initial public offering;
(b) 95 shares of redeemable convertible preferred stock to Roger Curry for
an aggregate initial purchase price of $50,000; these shares now
represent 40,498 shares of common stock after giving effect to the
conversion of such preferred stock into common stock and stock split in
connection with the initial public offering;
(c) 23.75 shares of redeemable convertible preferred stock to Northwestern
University for an aggregate initial purchase price of $12,500; these
shares now represent 10,125 shares of common stock after giving effect
to the conversion of such preferred stock into common stock and stock
split in connection with the initial public offering;
(d) 237.5 shares of redeemable convertible preferred stock to MKW Partners,
L.P. for an aggregate initial purchase price of $125,001; these shares
now represent 101,245 shares of common stock after giving effect to the
conversion of such preferred stock into common stock and stock split in
connection with the initial public offering;
(e) 47.5 shares of redeemable convertible preferred stock to Tom Shattan
for an aggregate initial purchase price of $25,000; these shares now
represent 20,249 shares of common stock after giving effect to the
conversion of such preferred stock into common stock and stock split in
connection with the initial public offering;
25
<PAGE> 28
(f) 28.5 shares of redeemable convertible preferred stock to Greg Mendel
for an aggregate initial purchase price of $15,000; these shares now
represent 12,149 shares of common stock after giving effect to the
conversion of such preferred stock into common stock and stock split in
connection with the initial public offering; and
(g) 19 shares of redeemable convertible preferred stock to Kevin Fechtmeyer
for an aggregate initial purchase price of $10,000; these shares now
represent 8,100 shares of common stock after giving effect to the
conversion of such preferred stock into common stock and stock split in
connection with the initial public offering.
On March 13, 1998, Allegiance issued 118.75 shares of redeemable convertible
preferred stock to Charles Ross Partners, LLC for an aggregate initial purchase
price of $62,500. These shares now represent 50,623 shares of common stock after
giving effect to the conversion of such preferred stock into common stock and
stock split in connection with the initial public offering.
The above-described transactions were exempt from registration under the
Securities Act under Section 4(2) of the Securities Act, as transactions not
involving any public offering.
On February 3, 1998, Allegiance issued 445,000 units, with each unit consisting
of one 11 3/4% Senior Discount Note due 2008 and one redeemable warrant to
purchase .0034224719 shares of Allegiance's common stock. Allegiance received
approximately $240.7 million of net proceeds, after deducting underwriting
discounts and commissions of approximately $8.75 million and other expenses
payable by Allegiance of approximately $1.0 million, from the issuance of the
units. Such units were issued to:
(a) "qualified institutional buyers" (as defined in Rule 144A of the
Securities Act),
(b) other institutional "accredited investors" (as defined in Rule 501(a)
of the Securities Act), and
(c) outside the United States in compliance with Regulation S under the
Securities Act,
and therefore, the issuance of such units was exempt from registration under the
Securities Act. Morgan Stanley & Co. Incorporated, Salomon Brothers Inc, Bear,
Stearns & Co. Inc. and Donaldson, Lufkin & Jenrette Securities Corporation were
the initial purchasers of the units. As a result of Allegiance's
426.2953905-for-one stock split in connection with its initial public offering,
each warrant is exercisable to purchase 1.45898399509 shares of common stock at
an exercise price of $.01 per share, subject to anti-dilution adjustments set
forth in the warrant agreement governing the warrants. All of these warrants are
currently exercisable.
ITEM 6. SELECTED FINANCIAL DATA
The information required by this Item 6 is incorporated in this report by
reference from the section titled "Selected Financial Data" of our annual report
to stockholders for the fiscal year ended December 31, 1998 (the "annual
report").
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The information required by this Item 7 is incorporated in this report by
reference from the section titled "Management's Discussion and Analysis of
Financial Condition and Results of Operations" of our annual report.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Allegiance's investment policy is limited by its existing bond indentures.
Allegiance is restricted to investing in financial instruments with a maturity
of one year or less. The indentures require investments in high quality
instruments, such as obligations of the U.S. Government or any agency thereof
guaranteed by the United States of America, money market deposits, and
commercial paper with a rating of A1/P1.
Allegiance is thus exposed to market risk related to changes in short-term U.S.
interest rates. Allegiance manages these risks by closely monitoring market
rates and the duration of its investments. Allegiance does not enter into
financial or commodity investments for speculation or trading purposes and is
not a party to any financial or commodity derivatives.
26
<PAGE> 29
Interest income earned on Allegiance's investment portfolio is affected by
changes in short-term U.S. interest rates. Allegiance believes that it is not
exposed to significant changes in fair value because of its conservative
investment strategy. However, the estimated interest income for the calendar
year 1999, based on the average 1998 earned rate on investments, is $13.6
million and assuming a 100 basis point drop in the average rate, Allegiance
would be exposed to a $2.5 million reduction in interest income for the year.
The following table illustrates this impact on a quarterly basis:
<TABLE>
<CAPTION>
QUARTER ENDING
--------------
MARCH JUNE SEPTEMBER DECEMBER
1999 1999 1999 1999 TOTAL
----- ---- ---- ---- -----
($S IN MILLIONS)
<S> <C> <C> <C> <C> <C>
Estimated Average Outstanding Balance............ $ 367.4 $ 290.7 $ 213.9 $ 131.8
Estimated Interest Earned at Estimated Rate
of 5.4% at December 31, 1998..................... $ 5.0 $ 3.9 $ 2.9 $ 1.8 $ 13.6
Estimated Impact of Interest Rate drop........... $ 0.9 $ 0.7 $ 0.5 $ 0.3 $ 2.5
</TABLE>
Allegiance has outstanding long term, fixed rate notes, not subject to
interest rate fluctuations.
ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The information required by this Item 8 is incorporated in this report by
reference from the financial statements contained in our annual report, except
for the financial statement schedules which are included in Item 14 of this
report. For a list of financial statements filed as part of this report, see
Item 14 of this report.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF ALLEGIANCE
The information required by this Item 10 regarding Allegiance's directors is
incorporated in this report by reference from certain sections of our definitive
proxy statement for the annual meeting of stockholders for the fiscal year ended
December 31, 1998, which will be filed with the SEC no later than April 30, 1999
(the "proxy statement"). You will find our response to this Item 10 in the
sections titled "Who Are Allegiance's Directors and Officers?" and "About the
Board of Directors and its Committees" of our proxy statement.
Information required by this Item 10 regarding the executive officers of
Allegiance is included in Item 4A of Part I of this report as permitted by
Instruction 3 to Item 401(b) of Regulation S-K.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this Item 11 is incorporated in this report by
reference from the sections titled "Compensation of Directors and Executive
Officers," "Compensation Committee Interlocks and Insider Participation" and
"Executive Agreements" of our proxy statement.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this Item 12 is incorporated in this report by
reference from the section titled "Security Ownership of Certain Beneficial
Owners and Management" of our proxy statement.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this Item 13 is incorporated in this report by
reference from the section titled "Certain Relationships and Related
Transactions" of our proxy statement.
27
<PAGE> 30
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a)(1) Financial Statements (the following financial information from our
annual report is incorporated by reference into Part II of this
report):
Report of Independent Public Accountants
Consolidated Balance Sheets as of December 31, 1998, and December
31, 1997
Consolidated Statements of Operations for the year ended December
31, 1998, and for the Period from Inception (April 22, 1997)
through December 31, 1997
Consolidated Statements of Stockholders' Equity (Deficit) for the
year ended December 31, 1998, and for the Period from Inception
(April 22, 1997) through December 31, 1997
Consolidated Statements of Cash Flows for the year ended December
31, 1998, and for the Period from Inception (April 22, 1997)
through December 31, 1997
Notes to Consolidated Financial Statements
(a)(2) Financial Statement Schedules:
S-I Report of Independent Public Accountants on Financial
Statement Schedule
S-II Valuation and Qualifying Accounts for the years ended
December 31, 1997 and 1998
(a)(3) The exhibits filed in response to Item 601 of Regulation S-K are listed
in the Exhibit Index starting on page E-1 of this report.
(b) Reports on Form 8-K
There were no reports filed during the three months ended December 31,
1998.
28
<PAGE> 31
SIGNATURES
According to the requirements of the Securities Exchange act of 1934, Allegiance
Telecom, Inc. has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized on March 29, 1999.
ALLEGIANCE TELECOM, INC.
By /s/ ROYCE J. HOLLAND
----------------------------------------------
Royce J. Holland, Chairman of the Board
and Chief Executive Officer
According to the requirements of the Securities Exchange Act of 1934, this
report has been signed by the following persons in the capacities indicated on
March 29, 1999.
<TABLE>
<S> <C>
/s/ ROYCE J. HOLLAND Chairman of the Board and Chief Executive Officer
- ------------------------------------------ (Principal Executive Officer)
Royce J. Holland
/s/ C. DANIEL YOST
- ------------------------------------------ President, Chief Operating Officer, and Director
C. Daniel Yost
/s/ THOMAS M. LORD Executive Vice President, Chief Financial Officer,
- ------------------------------------------ and Director (Principal Financial Officer)
Thomas M. Lord
/s/ DENNIS M. MAUNDER Vice President and Controller (Principal Accounting
- ------------------------------------------ Officer)
Dennis M. Maunder
/s/ JOHN J. CALLAHAN Senior Vice President of Sales and Marketing, and
- ------------------------------------------ Director
John J. Callahan
/s/ PAUL D. CARBERY
- ------------------------------------------ Director
Paul D. Carbery
/s/ JAMES E. CRAWFORD, III
- ------------------------------------------ Director
James E. Crawford, III
/s/ JOHN B. EHRENKRANZ
- ------------------------------------------ Director
John B. Ehrenkranz
/s/ PAUL J. FINNEGAN
- ------------------------------------------ Director
Paul J. Finnegan
/s/ RICHARD D. FRISBIE
- ------------------------------------------ Director
Richard D. Frisbie
/s/ ALAN E. GOLDBERG
- ------------------------------------------ Director
Alan E. Goldberg
/s/ REED E. HUNDT
- ------------------------------------------ Director
Reed E. Hundt
/s/ JAMES N. PERRY, JR.
- ------------------------------------------ Director
James N. Perry, Jr.
</TABLE>
<PAGE> 32
ALLEGIANCE TELECOM, INC.
SCHEDULE I -- REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
ON FINANCIAL STATEMENT SCHEDULE
To the Board of Directors and Stockholders of Allegiance Telecom, Inc.:
We have audited, in accordance with generally accepted auditing standards,
the consolidated balance sheets of Allegiance Telecom, Inc. and subsidiaries as
of December 31, 1998 and 1997, and the related consolidated statements of
operations, stockholders' equity (deficit) and cash flows for the year ended
December 31, 1998, and for the period from inception (April 22, 1997), to
December 31, 1997, incorporated by reference in this Form 10-K and have issued
our report thereon dated February 3, 1999. These consolidated financial
statements and the schedule referred to below are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
consolidated financial statements and schedule based on our audits.
Our audits were made for the purpose of forming an opinion on the basic
consolidated financial statements taken as a whole. Schedule II -- Valuation and
Qualifying Accounts is not a required part of the basic consolidated financial
statements but is supplementary information required by the Securities and
Exchange Commission. This information has been subjected to the auditing
procedures applied in our audit of the basic financial statements and, in our
opinion, is fairly stated in all material respects in relation to the basic
consolidated financial statements taken as a whole.
ARTHUR ANDERSEN LLP
Dallas, Texas,
February 3, 1999
S-I
<PAGE> 33
ALLEGIANCE TELECOM, INC.
SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS
FOR THE YEARS ENDED DECEMBER 31, 1997 AND 1998
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
ADDITIONS
---------------------
BALANCE AT CHARGED TO CHARGED
BEGINNING OF COSTS AND TO OTHER BALANCE AT
DESCRIPTION PERIOD EXPENSES ACCOUNTS DEDUCTIONS END OF PERIOD
----------- ------------ ---------- -------- ---------- -------------
<S> <C> <C> <C> <C> <C>
ALLOWANCE FOR DOUBTFUL ACCOUNTS
Year Ended December 31, 1998............. $ -- $649.8 $ -- $(72.6) $577.2
From period of inception (April 22, 1997)
to December 31, 1997.................. $ -- $ -- $ -- $ -- $ --
</TABLE>
S-II
<PAGE> 34
EXHIBIT INDEX
<TABLE>
<CAPTION>
EXHIBIT
NO. DESCRIPTION
------------ -------------------------------------------------------------------------------------------------
<S> <C>
1.1 Form of Underwriting Agreement (Exhibit 1.1 to Allegiance's Registration Statement on Form S-1,
Registration No. 333-53479 (the "Form S-1 Registration Statement")).
3.1 Amended and Restated Certificate of Incorporation (Exhibit 3.1 to Allegiance's Form 10-Q for the
period ended June 30, 1998).
*3.2 Certificate of Correction to Amended and Restated Certificate of Incorporation.
3.3 Amended and Restated By-Laws (Exhibit 3.2 to Allegiance's Form 10-Q for the period ended June 30,
1998).
4.1 Indenture, dated as of July 7, 1998, by and between Allegiance and The Bank of New York, as
trustee (including the Form of Notes) (Exhibit 4.1 to Allegiance's Registration Statement on Form
S-1, Registration No. 333-69543).
4.2 Indenture, dated as of February 3, 1998, by and between Allegiance and The Bank of New York, as
trustee (Exhibit 4.2 to Allegiance's Registration Statement on Form S-4, Registration No.
333-49013 (the "Form S-4 Registration Statement")).
4.3 Form of 11 3/4% Senior Discount Notes (Exhibit 4.3 to the Form S-4 Registration Statement).
4.4 Collateral Pledge and Security Agreement, dated as of July 7, 1998, by and between Allegiance and
The Bank of New York, as trustee (Exhibit 4.4 to Allegiance Telecom, Inc.'s Registration
Statement on Form S-1, Registration No. 333-69543).
10.1 Stock Purchase Agreement, dated August 13, 1997, between Allegiance LLC and Allegiance (Exhibit
10.1 to the Form S-4 Registration Statement).
10.2 Securityholders Agreement, dated August 13, 1997, among Allegiance LLC, the Fund Investors, the
Management Investors and Allegiance (Exhibit 10.2 to the Form S-4 Registration Statement).
10.3 Registration Agreement, dated August 13, 1997, among the Fund Investors, the Management Investors
and Allegiance (Exhibit 10.3 to the Form S-4 Registration Statement).
10.4 Warrant Registration Rights Agreement, dated as of January 29, 1998, by and among Allegiance and
Morgan Stanley & Co. Incorporated, Salomon Brothers Inc, Bear, Stearns & Co. Inc. and Donaldson,
Lufkin & Jenrette Securities Corporation, as initial purchasers of the 11 3/4% Senior Discount
Notes (Exhibit 10.11 to the Form S-4 Registration Statement).
+10.5 Allegiance Telecom, Inc. 1997 Nonqualified Stock Option Plan (Exhibit 10.4 to the Form S-4
Registration Statement).
+10.6 Allegiance Telecom, Inc. 1998 Stock Incentive Plan (Exhibit 10.6 to the Form S-1 Registration
Statement).
*+10.7 First Amendment to the Allegiance Telecom, Inc. 1998 Stock Incentive Plan.
+10.8 Executive Purchase Agreement, dated August 13, 1997, among Allegiance LLC, Allegiance and Royce
J. Holland (Exhibit 10.5 to the Form S-4 Registration Statement).
+10.9 Executive Purchase Agreement, dated August 13, 1997, among Allegiance LLC, Allegiance and Thomas
M. Lord (Exhibit 10.6 to the Form S-4 Registration Statement).
+10.10 Executive Purchase Agreement, dated January 28, 1998, among Allegiance LLC, Allegiance and C.
Daniel Yost (Exhibit 10.7 to the Form S-4 Registration Statement).
+10.11 Form of Executive Purchase Agreement among Allegiance LLC, Allegiance and each of the other
Management Investors (Exhibit 10.8 to the Form S-4 Registration Statement).
10.12 Warrant Agreement, dated February 3, 1998, by and between Allegiance and The Bank of New York, as
Warrant Agent (including the form of the Warrant Certificate) (Exhibit 10.9 to the Form S-4
Registration Statement).
10.13 General Agreement, dated October 16, 1997, as amended, between Allegiance and Lucent
Technologies Inc. (Exhibit 10.10 to the Form S-4 Registration Statement).
10.14 Form of Indemnification Agreement by and between Allegiance and its directors and officers
(Exhibit 10.13 to the Form S-1 Registration Statement).
*11.1 Statement Regarding Computation of Per Share Earnings (Loss) for the year ended December 31,
1998.
*11.2 Statement Regarding Computation of Per Share Earnings (Loss) for the period from inception (April
22, 1997) through December 31, 1997.
*13.1 Portions of Allegiance's Annual Report to Stockholders for the year ended December 31, 1998.
*21.1 Subsidiaries of Allegiance.
</TABLE>
E-1
<PAGE> 35
<TABLE>
<S> <C>
*23.1 Consent of Arthur Andersen LLP.
*27.1 Financial Data Schedule for the year ended December 31, 1998.
27.2 Financial Data Schedule for the period from inception
(April 22, 1997) through December 31, 1997 (incorporated
by reference to Exhibit 27.2 to the Form S-4 Registration
Statement).
</TABLE>
- ------------------
* Filed as part of this report.
+ Management contract or compensatory plan or arrangement filed as an
exhibit to this report pursuant to Items 14(a) and 14(c) of Form 10-K.
E-2
<PAGE> 1
EXHIBIT 3.2
CERTIFICATE OF CORRECTION
TO
AMENDED AND RESTATED
CERTIFICATE OF INCORPORATION
OF
ALLEGIANCE TELECOM, INC.
* * * *
Adopted in accordance with the provisions of '103 (f) of the
General Corporation Law of the State of Delaware
* * * *
Mark B. Tresnowski, being the Secretary of Allegiance Telecom, Inc., a
corporation duly organized and existing under and by virtue of the General
Corporation Law of the State of Delaware (the "Corporation"), DOES HEREBY
CERTIFY as follows:
FIRST: The name of the corporation is Allegiance Telecom, Inc.
SECOND: The Amended and Restated Certificate of Incorporation of the
Corporation which was filed with the Secretary of State of Delaware on July 2,
1998 inadvertently deleted provisions from Part C of ARTICLE IV of the
Corporation=s Certificate of Incorporation.
THIRD: ARTICLE IV of the Amended and Restated Certificate of
Incorporation is hereby corrected to add at the end of Part C thereof, the
following:
"(4) Notwithstanding any provision herein to the contrary, in
connection with an acquisition of Common Stock as to which the
Hart-Scott-Rodino Antitrust Improvements Act of 1976 (the AHSR Act") is
applicable, until such time as the applicable waiting period (and
extensions thereof) under the HSR Act relating to any holder making such
acquisition have expired or otherwise terminated, such holder shall have no
right to vote the Common Stock (except for votes concerning proposed
amendments or waivers to this Certificate of Incorporation).@
IN WITNESS WHEREOF, the undersigned, being the Secretary hereinabove
named, for the purpose of correcting the Amended and Restated Certificate of
<PAGE> 2
Incorporation of the Corporation pursuant to the General Corporation Law of the
State of Delaware, under penalties of perjury does hereby declare and certify
that this is the act and deed of the Corporation and the facts stated herein are
true, and accordingly has hereunto signed this Certificate of Correction to
Amended and Restated Certificate of Incorporation this 1st day of February,
1999.
Allegiance Telecom, Inc.,
a Delaware corporation
By: /s/ Mark B. Tresnowski
-------------------------------
Mark B. Tresnowski
Secretary
-2-
<PAGE> 1
EXHIBIT 10.7
FIRST AMENDMENT
TO THE
ALLEGIANCE TELECOM, INC.
1998 STOCK INCENTIVE PLAN
WHEREAS, the Allegiance Telecom, Inc. 1998 Stock Incentive Plan was adopted by
the board of directors and stockholders of Allegiance Telecom, Inc.
("Allegiance").
WHEREAS, Allegiance's board of directors is correcting and amending the
Allegiance Telecom, Inc. 1998 Stock Incentive Plan in accordance with Section
16 of such plan.
RESOLVED, that the number of shares of common stock available under the
Allegiance Telecom, Inc. 1998 Stock Incentive Plan be corrected by substituting
the number "3,655,778" for the number "3,806,658" in Section 4 of this plan.
Such correction shall be effective as of December 31, 1998.
FURTHER RESOLVED, that the number of shares of common stock available under the
Allegiance Telecom, Inc. 1998 Stock Incentive Plan be increased by substituting
the number "6,155,778" for the number "3,655,778" in Section 4 of this plan.
Such amendment shall be effective as of March 2, 1999.
FURTHER RESOLVED, that the officers of Allegiance be, and hereby are,
authorized to take whatever actions are necessary to carry out the intent and
purpose of the foregoing amendment.
<PAGE> 1
EXHIBIT 11.1
ALLEGIANCE TELECOM, INC.
COMPUTATION OF PER SHARE EARNINGS (LOSS)
Year Ended December 31, 1998
(In thousands, except share and per share amounts)
<TABLE>
<CAPTION>
Number of Shares Percent Outstanding Equivalent Shares
---------------- ------------------- -----------------
<S> <C> <C> <C>
Prior to Initial Public Offering
1997 Common Stock Offering 426 51.23% 218
After Initial Public Offering
1997 Common Stock Offering 426 48.77% 208
1998 Common Stock Offering 10,000,000 48.77% 4,876,712
Preferred Stock Converted to Common Stock 40,341,128 48.77% 19,673,208
--------------
24,550,346
WEIGHTED AVERAGE SHARES OUTSTANDING 24,550,346
NET LOSS APPLICABLE TO COMMON STOCK $ (258,459.6)
NET LOSS PER SHARE, BASIC AND DILUTED $ (10.53)
==============
</TABLE>
<PAGE> 1
EXHIBIT 11.2
ALLEGIANCE TELECOM, INC.
COMPUTATION OF PER SHARE EARNINGS (LOSS)
Period From Inception (April 22, 1997) to December 31, 1997
(In thousands, except share and per share amounts)
<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 $ (7,502.1)
NET LOSS PER SHARE, BASIC AND DILUTED $ (17,610.68)
=============
</TABLE>
<PAGE> 1
EXHIBIT 13.1
ALLEGIANCE TELECOM, INC.
PORTIONS OF ANNUAL REPORT TO STOCKHOLDERS
FOR THE YEAR ENDED DECEMBER 31, 1998
Selected Financial Data
(dollars in thousands, except share and per share information)
The selected consolidated financial data presented below as of and for the year
ended December 31, 1998, and as of and for the period from inception (April 22,
1997) through December 31, 1997, were derived from the audited consolidated
financial statements of the Company and should be read in conjunction with
"Management's Discussion & Analysis of Financial Condition & Results of
Operations" and the Company's audited financial statements and the notes thereto
contained elsewhere in this annual report.
<TABLE>
<CAPTION>
Period from
Inception
(April 22, 1997),
Year Ended through
December 31, December 31,
1998 1997
-------------- --------------
<S> <C> <C>
Statement of Operations Data:
Revenue $ 9,786.2 $ 0.4
Network 9,528.8 151.2
Selling, general and administrative 46,089.4 3,425.9
Management ownership allocation charge 167,311.9 --
Noncash deferred compensation 5,307.2 209.9
Depreciation and amortization 9,002.8 12.7
-------------- --------------
Loss from operations (227,453.9) (3,799.3)
Interest income 19,917.4 111.4
Interest expense (38,951.7) --
-------------- --------------
Net loss (246,488.2) (3,687.9)
Accretion of redeemable preferred stock and warrant values (11,971.4) (3,814.2)
-------------- --------------
Net loss applicable to common stock $ (258,459.6) $ (7,502.1)
============== ==============
Net loss per share, basic and diluted $ (10.53) $ (17,610.68)
============== ==============
Weighted average number of shares outstanding, basic and diluted 24,550,346 426
============== ==============
</TABLE>
<PAGE> 2
<<p33
<TABLE>
<CAPTION>
As of December 31,
----------------------------
1998 1997
------------ ------------
<S> <C> <C>
Balance Sheet Data:
------------ ------------
Cash and cash equivalents $ 262,501.7 $ 5,726.4
Short-term investments 143,389.7 --
Short-term investments, restricted(1) 25,542.8 --
Working capital(2) 366,162.7 2,046.2
Property and equipment, net of accumulated depreciation and amortization 144,860.0 23,899.9
Long-term investments, restricted(1) 36,699.2 --
Total assets 637,874.3 30,047.0
Long-term debt 471,652.1 --
Redeemable cumulative convertible preferred stock -- 33,409.4
Redeemable warrants 8,634.1 --
Stockholders' equity (deficit) 110,429.6 (7,292.1)
------------ ------------
Other Financial Data:
------------ ------------
EBITDA(3) $ (45,832.0) $ (3,576.7)
Net cash used in operating activities (17,269.8) (1,942.9)
Net cash used in investing activities (319,170.4) (21,926.0)
Net cash provided by financing activities 593,215.5 29,595.3
Capital expenditures (113,538.7) (21,926.0)
------------ ------------
</TABLE>
(1) Reflects the purchase of U.S. government securities, which have been placed
in a pledge account, to fund the first three years' interest payments on
the 12 7/8% Senior Notes due 2008, the first semiannual installment of
which was paid in November 1998. The securities are stated at their
accreted value, which approximates fair value, and are classified as
short-term and long-term based upon the maturity dates of each of the
securities at the balance sheet date.
(2) Working capital was calculated as total current assets, less restricted
short-term investments, less total current liabilities.
(3) EBITDA consists of earnings before interest, income taxes, depreciation and
amortization, management ownership allocation charge and non-cash deferred
compensation. While not a measure under generally accepted accounting
principles, EBITDA is a measure commonly used in the telecommunications
industry and is presented to assist in understanding the Company's
operating results. Although EBITDA should not be construed as a substitute
for operating income (loss) determined in accordance with generally
accepted accounting principles, it is included herein to provide additional
information with respect to the ability of the Company to meet future debt
service, capital expenditure and working capital requirements. The
calculation of EBITDA does not include the commitments of the Company for
capital expenditures and payment of debt and should not be deemed to
represent funds available to the Company. See "Management's Discussion &
Analysis of Financial Condition & Results of Operations" for a discussion
of the financial operations and liquidity of the Company as determined in
accordance with generally accepted accounting principles.
<PAGE> 3
p34>>
Management's Discussion & Analysis of Financial Condition & Results of
Operations
Overview
Allegiance is a competitive local exchange carrier (CLEC), seeking to be a
premier provider of telecommunications services to business, government and
other institutional users in major metropolitan areas across the United States.
Allegiance offers an integrated set of telecommunications products and services
including local exchange, local access, domestic and international long
distance, data and a full suite of Internet services. Its principal competitors
are incumbent local exchange carriers (ILECs), such as the regional Bell
operating companies and GTE Corporation operating units.
Allegiance is developing its networks throughout the U.S., using what it refers
to as a "Smart Build" approach. In contrast to the traditional network build-out
strategy under which carriers install their own telecommunications switch in
each market and then construct their own fiber optic networks to reach
customers, Allegiance installs its own switch in each market but then leases
other elements of the network from the ILECs. The Smart Build strategy
specifically involves:
o leasing existing ILEC copper wire connections throughout a local market
area, also called the "local loop," which connect customers to the central
offices, or "hubs," of an ILEC network; and
o installing, or physically locating, transmission equipment in these central
offices to route customer traffic through them to Allegiance's own switch.
Locating equipment at ILEC facilities, also known as "collocation," is central
to the success of the Smart Build strategy. By collocating, Allegiance has the
ability to lease, on a monthly or long-term basis, local loop and other network
elements owned by the ILEC. This enables Allegiance to reach a wide range of
customers without having to build network connections to each one of them.
Management believes that the Smart Build approach offers a number of competitive
advantages over the traditional build-out strategy by allowing Allegiance to:
o accelerate market entry by nine to 18 months by eliminating or at least
deferring the need for city franchises, rights-of-way and building access;
o reduce initial capital expenditures in each market, allowing Allegiance to
focus its initial capital resources on the critical areas of sales,
marketing, and operations support systems, instead of on constructing
extensive fiber optic networks to each customer;
o improve return on capital by generating revenue with a smaller capital
investment;
o defer capital expenditures for network assets to the time when revenue
generated by customer demand is available to finance such expenditures; and
o address attractive service areas selectively throughout target markets and
not just in those areas where Allegiance owns network transmission
facilities.
<PAGE> 4
<<p35
Once traffic volume justifies further investment, Allegiance may then construct
its own fiber network or lease unused fiber to which Allegiance adds its own
electronic transmission equipment. This unused fiber is known as "dark fiber,"
because no light is transmitted through it while it is unused. Allegiance
believes that dark fiber is readily available in most major markets.
Allegiance has rapidly deployed its networks since commencing service in
December 1997 and was operating in nine markets across the U.S. as of the end
of 1998, and 11 as of March 15, 1999. Allegiance has had significant success in
selling its services to customers, with approximately 86,500 lines sold during
1998. The table below provides selected key operational data:
<TABLE>
<CAPTION>
As of December 31,
--------------------
1998 1997
----------- ------
<S> <C> <C>
Markets served 9 --
Number of switches deployed 7 --
Central office collocations 101 --
Addressable market (business lines) 3.6 million --
Lines sold 86,500 20
Lines installed 47,700 9
Sales force employees 295 --
Total employees 649 40
----------- ------
</TABLE>
Allegiance does not begin to develop a new market until it has raised the
capital that it projects to be necessary to build its network and operate that
market to the point at which operating cash flow from the market is sufficient
to fund such market's operating costs and capital expenditures.
Results of Operations
Allegiance commenced operations in August 1997. During the period from August to
December 1997, Allegiance did not sell any services or open any markets.
Instead, substantial effort was devoted to developing business plans, initiating
applications for governmental authorizations, hiring management and other key
personnel, working on the design and development of local exchange telephone
networks and operations support systems, acquiring equipment and facilities, and
negotiating interconnection agreements. Allegiance initiated service by buying
phone lines at wholesale prices and then reselling them to nine "beta" customers
in Dallas during December 1997, generating only $400 of revenue for that period.
Given that Allegiance has significantly increased its customer base and
geographic markets from the commencement of operations in Dallas during 1997,
comparisons of 1998 results with those of 1997 are not meaningful.
Allegiance first provided service using its own switch and transmission
equipment in April 1998 to customers in New York City. Throughout the remainder
of 1998, it initiated facilities-based services in Atlanta, Boston, Chicago,
Dallas, Fort Worth, Los Angeles, Oakland and San Francisco. In January 1999,
Allegiance announced that it was operational in Philadelphia. In March 1999,
Allegiance announced that it was operational in Washington, D.C., including
suburban Maryland and Virginia. Allegiance expects to become operational in San
Jose during the first quarter of 1999. Allegiance plans to open five additional
markets during 1999 for which it has already raised the necessary capital.
<PAGE> 5
p36>>
Although Allegiance initiated resale services in Dallas in 1997, Allegiance
sales teams have focused their efforts almost exclusively on selling services
that require the use of Allegiance facilities. Allegiance earns significantly
higher margins by providing facilities-based services instead of resale
services. During the fourth quarter of 1998, facilities-based lines represented
91% of all lines sold and 83% of all lines installed, as compared to 86% and 73%
for the third quarter of 1998 and 51% and 17% for the second quarter of 1998,
respectively. For the full year, 67,100 facilities-based lines were sold, and
30,500 of those were installed. Resale lines sold during 1998 totaled 19,400, of
which 17,200 were installed. Allegiance continues to emphasize the sale of
facilities-based services and lines. We estimate that the proportion of customer
lines for which we simply resell service provided by other carriers will
continue to decline to the point that, eventually, no more than 5% of all lines
Allegiance sells will be resale lines.
During 1998, Allegiance generated $9.8 million of revenue. The majority, $6.9
million, was local service revenue consisting of:
o the monthly recurring charge for basic service;
o usage-based charges for local calls in certain markets;
o charges for vertical services, such as call waiting and call forwarding;
and
o to a lesser extent, non-recurring charges, such as charges for additional
lines for an existing customer.
Access charges, which we earn by connecting Allegiance local service customers
to their selected long distance carriers for outbound calls or by delivering
inbound long distance traffic to Allegiance local service customers, accounted
for $2.2 million of Allegiance's 1998 revenues. Approximately 20% of
Allegiance's local service customers have chosen Allegiance as their long
distance carrier. Long distance revenues during 1998 amounted to $.7 million.
All other sources of revenue accounted for approximately $10,000 during 1998.
During 1998, Allegiance recognized an insignificant amount of revenue from
"reciprocal compensation" generated by having customers of other local exchange
carriers calling Internet service providers that are Allegiance customers.
Allegiance had no revenue from reciprocal compensation during 1997. Given the
uncertainty as to whether reciprocal compensation should be payable in
connection with calls to Internet service providers, Allegiance recognizes such
revenue only when realization of it is certain, which in most cases will be 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 an
ILEC's customers to Internet service providers served by 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. Currently, over 25 state commissions and several federal and state
courts have ruled that reciprocal compensation arrangements do apply to calls to
Internet service providers, and no jurisdiction has ruled to the contrary.
Certain of these rulings are subject to appeal. Additional disputes over the
appropriate treatment of Internet service provider traffic are pending in other
states. On February 26, 1999, the FCC released a Declaratory Ruling determining
that Internet service provider traffic is interstate for jurisdictional
purposes, but that its current rules neither require nor prohibit the payment of
reciprocal compensation for such calls. In the absence of a federal rule, the
FCC determined that state commissions have authority to interpret and enforce
the reciprocal compensation provisions of existing interconnection agreements,
and to determine the appropriate treatment of Internet service provider traffic
in arbitrating new agreements. The FCC also requested comment on alternative
federal rules to govern compensation for such calls in the future. In response
to the FCC ruling, some regional Bell operating companies have asked state
commissions to reopen previous decisions requiring the payment of reciprocal
compensation on Internet service provider calls. Allegiance anticipates that
Internet service providers will be among its target customers, and adverse
decisions in state proceedings could limit its ability to service this group of
customers profitably.
<PAGE> 6
<<p37
The revenue yield, or revenue generated per line per month, was approximately
$56.00 for all of 1998. Allegiance received orders for lines from certain
Internet service providers during the fourth quarter of 1998. As these lines are
installed, the current mix between end-user retail lines and Internet service
provider wholesale lines will change. However, the switch capacity used for the
Internet service provider lines will be well below Allegiance's policy limit of
20%. Internet service provider wholesale lines typically generate approximately
half the revenue yield, excluding the reciprocal compensation component of
revenue, of that provided by an end-user retail line. The revenue yield may
decline during the first half of 1999 as a result of the change in the mix.
However, data and Internet services such as frame relay (a high speed data
service used to transmit data between computers), dedicated and dial-up access
to the Internet, web page design, e-mail and domain name service, which we
introduced in December 1998, may partially, or perhaps completely, offset the
reduction anticipated from the receipt of those orders.
Although our primary focus is on serving higher-margin, higher
revenue-generating end-user lines, significant Internet wholesale line orders,
such as those received during the fourth quarter of 1998, contribute positively
to gross margin (even excluding the reciprocal compensation component of
revenue). For this reason, we will accept such orders in the future but do not
plan to allow the installation of such lines to constitute more than 20% of our
switch capacity.
During 1998, Allegiance did not have sales of or revenue from installation of
customer premise equipment. Allegiance did not have revenue from system
integration activities, wireless, data or Internet services. Allegiance does not
plan to sell customer premise equipment or wireless services in the foreseeable
future.
Acquisitions during 1999 may increase revenues and revenue yield. Allegiance has
had discussions and will continue to have discussions in the foreseeable future,
concerning potential acquisitions of Internet service providers and other
providers of telecommunications services.
In January 1999, Allegiance announced that it had successfully achieved
"electronic bonding" between certain aspects of its operations support systems
and those of Bell Atlantic relating to the New York City market. The systems
that we currently use to switch customers from their existing carrier to
Allegiance and to begin providing them service generally require multiple
entries of customer information by hand and are exchanged by fax with the ILEC.
Electronic bonding is a method in which manual processing and faxing of
information is replaced with electronic processing, where our computer systems
and those of other carriers communicate directly. The manual approach that we
must use in the absence of electronic bonding not only is labor intensive but
also creates numerous opportunities for:
o errors in providing new service and billing;
o service interruptions;
o poor customer service; and
o increased customer turnover.
These problems create added expenses and decrease customer satisfaction.
Without electronic bonding, confirmation of receipt and installation of orders
has taken from two business days to one month. Electronic bonding is expected to
improve productivity by decreasing the period between the time of sale and the
time a customer's line is installed. During 1999, Allegiance expects to
electronically bond with Bell Atlantic in other markets and with other ILECs and
extend the functionality of the electronic bonding to pre-ordering, billing and
certain customer service processes. Currently, Allegiance and Bell Atlantic are
testing electronic bonding in Boston. Allegiance and Southwestern Bell are now
in the process of testing electronic bonding in the Dallas market. The early
results of these efforts have been encouraging. For example, electronic bonding
with Southwestern Bell so far has not required a significant change to the
software coding written on behalf of Allegiance for the Bell Atlantic electronic
bonding. Allegiance and Pacific Bell are discussing the possibility of using
this same template to pass service requests between these parties. Ameritech has
also contacted us regarding the initiation of a project to electronically bond.
<PAGE> 7
p38>>
Network expenses increased from $.2 million in 1997 to $9.5 million in 1998.
This sharp increase is consistent with the deployment of our networks and
initiation and growth of our services during 1998. Network expenses represent:
o the cost of leasing high-capacity digital lines that interconnect
Allegiance's network with ILEC networks;
o the cost of leasing high-capacity digital lines that connect Allegiance's
switching equipment to Allegiance transmission equipment located in ILEC
central offices;
o the cost of leasing local loop lines, that connect Allegiance's customers
to Allegiance's network;
o the cost of leasing space in ILEC central offices for collocating
Allegiance transmission equipment; and
o the cost of leasing Allegiance's nationwide Internet network.
The costs to lease local loop lines and high-capacity digital lines from the
ILECs vary by ILEC and are regulated by state authorities under the
Telecommunications Act of 1996. Allegiance believes that, in many instances,
there are multiple carriers in addition to the ILEC from which it can lease high
capacity lines and that Allegiance can generally lease those lines at lower
prices than are charged by the ILEC. Allegiance expects that the costs
associated with these leases will increase with customer volume and will be a
significant part of its ongoing cost of services. The cost of leasing switch
sites is also a significant part of Allegiance's ongoing cost of services.
On January 25, 1999, the United States Supreme Court reaffirmed the FCC's broad
authority to issue rules implementing the Telecommunications Act of 1996,
although it did vacate a rule determining which network elements the ILECs must
provide to competitors on an unbundled basis. Allegiance, however, leases only
the basic unbundled network elements from the ILEC and therefore does not expect
reconsideration of the unbundling rules to have an adverse effect on its Smart
Build strategy.
Nevertheless, the FCC likely will conduct additional rulemaking proceedings to
conform to the Supreme Court's interpretation of the law and these proceedings
may result in further judicial review.
In constructing its initial switching and transmission equipment for a new
market, Allegiance capitalizes only the non-recurring charges associated with
its initial network facilities and the monthly recurring costs of those network
facilities until the switching equipment begins to carry revenue-producing
traffic. Typically, the charges for just one to two months are capitalized. We
expense the monthly recurring and non-recurring costs resulting from the growth
of existing collocation sites, and the costs related to expansion of the network
to additional collocation sites in operational markets as we incur these
charges.
In an effort to reduce network expenses, Allegiance is moving to the next stage
of its Smart Build strategy in New York City and Dallas by entering into leases
for dark fiber to which Allegiance is installing its own electronic equipment.
These leases are accounted for as capital leases. In New York City, Allegiance
has entered into an agreement to lease three rings of dark fiber in Manhattan,
with an extension into Brooklyn. In the Dallas market, Allegiance has reached an
agreement to lease one ring of dark fiber in Dallas County. Allegiance
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.
We expect "reciprocal compensation" costs to be a major portion of our cost of
services. Allegiance must enter into an interconnection agreement with the ILEC
in each market to make widespread calling available to Allegiance's customers.
These agreements typically set the cost per minute to be charged by each party
for the calls that are exchanged between the two carriers' networks. Generally,
a carrier must compensate another carrier when a local call by the first
carrier's customer terminates on the second carrier's network. These reciprocal
compensation costs will grow for Allegiance as its customers' outbound call
volume grows. We expect, however, to generate increased revenue from the ILECs
as inbound calling volume to our customers increases. If our customers' outbound
call volume is equivalent to their inbound call volume, our interconnection
costs paid to the ILECs will be substantially offset by the interconnection
revenues we receive from them.
<PAGE> 8
<<p39
The cost of securing long distance service capacity will increase as
Allegiance's customers' long distance calling volume increases. Allegiance
expects that these costs will be a significant portion of its cost of long
distance services. Allegiance has entered into one resale agreement with a long
distance carrier to provide Allegiance with the ability to provide our customers
with long distance service. Allegiance expects to enter into resale agreements
for long distance service 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. Allegiance's existing resale
agreement, however, does not contain a minimum volume commitment. If Allegiance
agrees to minimum volume commitments and fails to meet them, it may be obligated
to pay underutilization charges. Under most of these agreements, if a company
underestimates its need for transmission capacity and exceeds the maximum amount
agreed to under such agreements, it may be required to obtain capacity through
more expensive means.
Allegiance leases high-capacity digital lines which comprise its Internet
network, which currently has servers in New York, Dallas and San Francisco. The
costs of these lines will increase as Allegiance opens new markets and connects
the additional markets to its Internet network.
Selling, general and administrative expenses increased to $46.1 million in 1998
from just $3.4 million in 1997, which is primarily due to the growth of our
business. Selling, general and administrative expenses include salaries and
related personnel costs, facilities costs and legal and consulting fees. The
number of employees increased to 649 as of December 31, 1998, from 40 as of
December 31, 1997. As of December 31, 1998, the sales force, including sales
managers and sales administrators, had grown to 295. Allegiance did not employ
any account executives, major account managers or sales engineers prior to
January 1998. During 1999, Allegiance expects the number of its sales personnel
to grow significantly. Allegiance currently does not use agents to sell its
services, nor does it currently use any print or other media advertising
campaigns. As Allegiance continues to grow in terms of number of customers and
call volume, we expect that ongoing expenses for customer care and billing will
increase.
The magnitude of our net loss for 1998 is principally due to the management
ownership allocation charge, a non-cash charge to income. Allegiance's original
private equity fund investors and its original management team investors owned
95.0% and 5.0%, respectively, of the ownership interests of Allegiance Telecom,
LLC, an entity that owned substantially all of Allegiance's outstanding capital
stock prior to Allegiance's initial public offering of its common stock. As a
result of this offering, the assets of Allegiance Telecom, LLC, which consisted
almost entirely of such capital stock, were distributed to the original fund
investors and management investors in accordance with the Allegiance Telecom,
LLC limited liability company agreement. This agreement provided that the equity
allocation between the fund investors and management investors be 66.7% and
33.3%, respectively, based upon the valuation implied by the initial public
offering. Under generally accepted accounting principles, Allegiance recorded
the increase in the assets of Allegiance Telecom, LLC allocated to the
management investors as a $193.5 million increase in additional paid-in capital.
Of this charge, we recorded $122.5 million as a non-cash, non-recurring charge
to operating expense and $71.0 million as a deferred management ownership
allocation charge. We amortized $44.8 million of the deferred charge in 1998. We
will further amortize this deferred charge at $18.8 million, $7.2 million and
$.2 million during 1999, 2000, and 2001, respectively. This period is the
timeframe over which Allegiance 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 Allegiance is terminated.
In addition to the above expenses, Allegiance recognized $5.3 million and $.2
million amortization of deferred stock compensation expense for the years ended
December 31, 1998 and 1997, respectively, also non-cash charges. Such deferred
compensation was recorded in connection with membership units of Allegiance
Telecom, LLC sold to certain management employees and grants to employees under
Allegiance's 1997 Stock Option Plan made prior to Allegiance's initial public
offering of common stock.
Depreciation expense increased from approximately $13,000 in 1997 to $9.0
million in 1998, consistent with the completion of Allegiance's networks and
initiation of services in nine markets by December 31, 1998.
<PAGE> 9
p40>>
Interest expense for the year ended December 31, 1998, was $39.0 million. There
was no interest expense incurred during 1997. Interest expense recorded during
1998 reflects: the issuance on February 3, 1998, of 11 3/4% Senior Discount
Notes due 2008, and the issuance on July 7, 1998, of 12 7/8% Senior Notes due
2008. See "Liquidity and Capital Resources" on page 41 for a discussion of these
note offerings. Allegiance capitalizes a portion of its interest costs as part
of the construction cost of its networks, in accordance with Statement of
Financial Accounting Standards No. 34. The amount of interest capitalized during
1998 was $2.8 million. No interest was capitalized during 1997. Interest income
during 1998 and 1997 was $19.9 million and $.1 million, respectively, resulting
from the investment of excess cash and from U.S. government securities that we
purchased and placed in a pledge account to secure the semiannual payments of
interest through May 2001 on the 12 7/8% Senior Notes due 2008.
Allegiance has recorded the potential redemption value of its redeemable
warrants in the 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 such warrants when redemption is
first permitted. Amounts accreted increase the recorded value of such warrants
on the balance sheet and result in a non-cash charge to increase the net loss
applicable to Allegiance's common stock. Accretion of $.5 million related to the
redeemable warrants has been recorded for the year ending December 31, 1998.
Until the consummation of Allegiance's initial public offering of common stock,
Allegiance also recorded the potential redemption values of its redeemable
convertible preferred stock, in the 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 related to the redeemable convertible preferred stock of $11.5 million
was recorded for the year ending December 31, 1998, and $3.8 million was
recorded for the period from inception to December 31, 1997.
Our net loss for 1998, after the non-cash, one-time management allocation charge
and amortization of deferred compensation and a portion of the deferred
management allocation charge, but before the accretion of the redeemable
convertible preferred stock and redeemable warrants, was $246.5 million and was
$3.7 million for the period from inception to December 31, 1997. After deducting
accretion of preferred stock and warrant values, the net loss applicable to
common stock was $258.5 million and $7.5 million for the year ended December 31,
1998, and for the period from inception to December 31, 1997, respectively.
Many securities analysts use the measure of earnings before deducting interest,
taxes, depreciation and amortization, also commonly referred to as "EBITDA," as
a way of evaluating a company. Allegiance had negative EBITDA of $45.8 million
and $3.6 million for the year ended December 31, 1998, and for the period from
inception to December 31, 1997, respectively. In calculating EBITDA, Allegiance
also excludes the non-cash charges to operations for management ownership
allocation charge and deferred stock compensation expense totaling $172.6
million and $.2 million for the year ended December 31, 1998 and for the period
from inception to December 31, 1997, respectively.
Allegiance expects to continue to experience increasing operating losses and
negative EBITDA as a result of its development activities and as it expands its
operations. Allegiance does not expect to achieve positive EBITDA in any market
until at least its second year of operation in such market.
<PAGE> 10
<<p41
Liquidity and Capital Resources
Allegiance's financing plan is predicated on the prefunding of each market's
expansion to positive free cash flow. By using this approach, Allegiance avoids
being in the position of seeking additional capital to fund a market after
Allegiance has already made significant capital investment in that market. We
believe that by raising all required capital prior to making any commitments in
a market, we can raise capital on more favorable terms and conditions.
Allegiance plans to establish networks in the 24 largest U.S. metropolitan
markets. We estimate that we will need approximately $750 million to $850
million to construct these networks and fund our operating losses in these
markets to the point of positive free cash flow. We have raised approximately
$553.7 million in total capital since our inception. We believe that the
proceeds from our current capital raising efforts, together with existing
capital resources, will be sufficient to prefund market deployment in all of our
24 targeted markets.
We may decide to seek additional capital in the future to expand our business
and sources of additional financing may include vendor financing and/or the
private or public sale of Allegiance's equity or debt securities. We cannot
ensure, however, that such financing will be available at all or on terms
acceptable to Allegiance, or that Allegiance's estimate of additional funds
required is accurate.
The actual amount and timing of Allegiance's future capital requirements may
differ materially from its estimates as a result of, among other things:
o the cost of the development of its networks in each of its markets;
o a change in or inaccuracy of its development plans or projections that
leads to an alteration in the schedule or targets of its rollout plan;
o the extent of price and service competition for telecommunications services
in its markets;
o the demand for its services;
o regulatory and technological developments, including additional market
developments and new opportunities, in Allegiance's industry; and
o the consummation of acquisitions.
Allegiance's cost of rolling out its networks and operating its business, as
well as its revenues, will depend on a variety of factors, including:
o its ability to meet its rollout schedules;
o its ability to negotiate favorable prices for purchases of equipment;
o its ability to develop, acquire and integrate the necessary operations
support systems and other back office systems;
o the number of customers and the services for which they subscribe;
o the nature and penetration of new services that Allegiance may offer; and
o the impact of changes in technology and telecommunication regulations.
As such, actual costs and revenues may vary from expected amounts, possibly to a
material degree and such variations are likely to affect Allegiance's future
capital requirements.
Allegiance initially raised approximately $50.1 million from certain members of
the Allegiance management team and from affiliates of four private equity
investment funds with extensive experience in financing telecommunications
companies: Madison Dearborn Capital Partners, Morgan Stanley Capital Partners,
Frontenac Company and Battery Ventures.
<PAGE> 11
p42>>
On February 3, 1998, Allegiance raised gross proceeds of approximately $250.5
million in an offering of 445,000 units, each unit consisting of one 11 3/4%
note and one redeemable warrant to purchase .0034224719 shares of common stock
at an exercise price of $.01 per share, subject to certain antidilution
provisions. Net proceeds of approximately $240.7 million were received from this
offering. Of the gross proceeds, $242.3 million was allocated to the value of
the 11 3/4% notes, and $8.2 million was allocated to the redeemable warrants.
The 11 3/4% notes have a principal amount at maturity of $445.0 million and an
effective interest rate of 12.45%. The 11 3/4% notes mature on February 15,
2008. From and after February 15, 2003, interest on such notes will be payable
semi-annually in cash at the rate of 11 3/4% per annum. The accretion of
original issue discount will cause an increase in indebtedness from December 31,
1998, to February 15, 2008, of $174.5 million.
Allegiance completed the initial public offering of its common stock and the
offering of the 12 7/8% notes early in the third quarter of 1998. Allegiance
raised net proceeds of approximately $124.8 million from the offering of these
notes and approximately $137.8 million from its initial public offering of
common stock.
The 12 7/8% notes mature on May 15, 2008. Interest on these notes is payable in
cash semi-annually, commencing November 15, 1998. The 12 7/8% notes were sold at
less than par, resulting in an effective rate of 13.24%, and the value of the 12
7/8% notes is being accreted, using the effective interest method, 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, Allegiance purchased U.S.
government securities for approximately $69.0 million and placed them in a
pledge account to fund interest payments for the first three years the 12 7/8%
notes are outstanding. The first interest payment was made in November 1998.
Such U.S. government securities are reflected in the balance sheet as of
December 31, 1998, at accreted value of approximately $62.2 million, $25.5
million of which we classified as current assets and $36.7 million of which we
classified in other non-current assets.
Allegiance expended $21.9 million and $113.5 million during 1997 and 1998,
respectively, for property, plant, equipment, software and hardware necessary in
deploying its networks in nine markets and providing operations and other
support systems necessary in conducting its business. Allegiance also used
capital during 1998 to fund its operations; excess cash was used to purchase
short-term investments and money market investments.
On December 31, 1998, Allegiance transmission equipment was collocated in 101
ILEC central offices. Allegiance anticipates that it will more than double the
number of collocations during 1999. As of December 31, 1998, Allegiance had
committed $17.1 million of its capital for switching equipment and switch
facilities and $3.2 million for dark fiber leases. Under Allegiance's current
business plans, it plans to make approximately $250 million in capital
expenditures in 1999, including approximately $227 million for switching
equipment, switch and sales facilities, transmission equipment and collocation
facilities.
As of December 31, 1998, Allegiance had approximately $405.9 million of cash and
short-term investments. This amount excludes the restricted U.S. government
securities that have been placed in a pledge account. Allegiance believes, based
on its business plan, that the net proceeds from its current capital raising
efforts and previous capital raising activities will be sufficient to prefund
its market deployment in all of its 24 targeted markets to the point of positive
free cash flow in each of these markets.
On March 19, 1999, Allegiance announced that it intends to offer shares of its
common stock in an underwritten primary offering. On that date, Allegiance also
announced that it had entered into a letter agreement with Goldman Sachs Credit
Partners L.P., TD Securities (USA) Inc. and Morgan Stanley Senior Funding, Inc.
to arrange a seven year senior secured revolving credit facility for a
subsidiary of Allegiance Telecom, Inc. These banks have received commitments for
this facility aggregating in excess of $200.0 million from various lenders.
These commitments remain subject to various conditions, including the
negotiation and execution of a definitive credit agreement. This revolving
facility would be available, subject to satisfaction of certain terms and
conditions, to provide purchase money financing for the acquisition,
construction and improvement of telecommunications assets by Allegiance's
operating subsidiaries. Borrowings under the facility will not be available to
us until we reach certain financial and operating objectives, and then will only
be available to the extent we have achieved certain further objectives and have
maintained certain financial ratios and covenants. Based on Allegiance's current
business plan, we do not expect to draw on the facility until year 2000.
<PAGE> 12
<<p43
The facility will be structurally senior to all of Allegiance's 12 7/8% notes
and 11 3/4% notes issued in 1998. The lenders will have a first priority
security interest in all of the assets of the Allegiance operating subsidiaries
and the stock of the Allegiance borrowing subsidiary. Interest rates under the
facility will be tied to the level of debt compared to consolidated EBITDA and
is initially expected to be the London Interbank Offering Rate + 3.75%. The
commitment fee on the undrawn portion of the facility is initially expected to
be 1.50% of the total amount of the facility, with step-downs based on
utilization. The facility will also be subject to certain representations,
warranties, covenants and events of default customary for credits of this nature
and otherwise agreed upon by the parties. We expect that this facility will
close in April 1999.
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 transactions 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 network and 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.
The Alliance for Telecommunications Industry Solutions recently tested the U.S.
phone system and found no year 2000-related anomalies in the interconnected
networks. AT&T and Sprint joined Ameritech, GTE and US West in the Network
Testing Committee year 2000 efforts recently completed. The tests focused
specifically on the Signaling System 7 and local number portability systems and
possible disruptions on December 31, 1999. The Network Testing Committee said it
tested call processing, mass calling events and potential network congestion,
cross network service call completion and credit card and calling card
validation. The Alliance plans to analyze the test in more detail in April 1999.
State of Readiness > Generally, Allegiance has identified two areas for year
2000 review: internal systems and operations, and external systems and services.
As a new enterprise, Allegiance does not have older systems that are not year
2000 ready. As it develops its network and support systems, Allegiance intends
to ensure that all systems will be year 2000 ready. Allegiance is purchasing its
operations support systems with express specifications, warranties and remedies
that all systems be year 2000 ready. In addition, Allegiance requires all
vendors supplying third-party software and hardware to warrant year 2000
readiness. However, there can be no assurance, until the year 2000, that all
systems will then function adequately. Also, Allegiance 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 could expose Allegiance to year 2000 problems.
Allegiance is in the process of conducting a company-wide inventory of all
computer systems on which the company relies, both within and outside of
Allegiance. This inventory is scheduled to be completed by the end of May 1999.
Allegiance will use this inventory to contact its external suppliers, vendors
and providers to obtain information about their year 2000 readiness and, based
on that information, will assess the extent to which these external information
technology and noninformation technology systems, including embedded technology,
could cause a material adverse effect on Allegiance's operations in the event
that the systems fail to properly process date-sensitive transactions after
December 31, 1999.
Allegiance's assessment of its year 2000 readiness will be ongoing as it
continues to develop its own operations support systems 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, Allegiance may in the
future identify a significant internal or external year 2000 issue that, if not
remedied in a timely manner, could have a material adverse effect on
Allegiance's business, financial condition and results of operations.
<PAGE> 13
p44>>
COSTS TO ADDRESS YEAR 2000 ISSUES > Allegiance has used its internal information
technology and other personnel in identifying year 2000 issues. Allegiance does
not anticipate any significant costs to make its internal systems year 2000
compliant because it does not expect any remediation to be required and does not
expect to make material expenditures for outside consultants to assist
Allegiance in its effort to address year 2000 issues. Because no material year
2000 issues have yet been identified in connection with external sources,
Allegiance cannot reasonably estimate costs that may be required for remediation
or for implementation of contingency plans. As Allegiance gathers information
relating to external sources of year 2000 issues, Allegiance 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, Allegiance's costs
to remediate such issues will be consistent with its historical costs.
RISKS OF YEAR 2000 ISSUES > Allegiance cannot reasonably ascertain the extent of
the risks involved in the event that any one system fails to process
date-sensitive calculations accurately because it has not identified any
material year 2000 issues. Potential risks include:
o the inability to process customer billing accurately or in a timely manner;
o the inability to provide accurate financial reporting to management,
auditors, investors and others;
o litigation costs associated with potential suits from customers and
investors;
o delays in implementing other information technology projects, as a result
of work by internal personnel on year 2000 issues;
o delays in receiving payment or equipment from customers or suppliers, as a
result of their systems' failure; and
o the inability to occupy and operate in a facility.
Any one of these risks, if it materializes, could have a material adverse effect
on Allegiance's business, financial condition or results of operations.
All of Allegiance's information technology and noninformation technology systems
and products relating to Allegiance's external issues are manufactured or
supplied by other companies outside of Allegiance's control. As a result, we
cannot assure you that the systems of any of those companies will be year 2000
ready. In particular, Allegiance will be dependent upon other ILECs, long
distance carriers and other companies for interconnection and completion of
off-network calls. These interconnection arrangements are material to
Allegiance'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
Allegiance's business in the affected market. Moreover, although Allegiance 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 Allegiance's internal and external
systems fail or are not year 2000 ready in a timely manner, there could be a
material adverse effect on Allegiance's business, financial condition or results
of operations.
CONTINGENCY PLANS > Even though Allegiance has not identified any specific year
2000 issues, Allegiance believes that the design of its networks and support
systems could provide Allegiance with certain operating contingencies in the
event material external systems fail. In all of its markets, however, Allegiance
has or intends to establish interconnection agreements with the ILECs and other
regional and international carriers. If one of these carriers fails for any
reason, including year 2000 problems, there may be little Allegiance can do to
mitigate the impact of such a failure on Allegiance's operations. Allegiance has
attempted to ensure that its own operating facilities and systems are fully
backed up with auxiliary power generators capable of operating all equipment and
systems for indeterminate periods should power supplies fail, subject to the
availability of fuel to run these generators. Allegiance also has the ability to
relocate headquarters and administrative personnel to other Allegiance
facilities should power and other services at its Dallas headquarters fail.
Because of the inability of Allegiance'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 Allegiance will not
experience numerous disruptions that could have a material effect on
Allegiance's operations.
<PAGE> 14
<<p45
Report of Independent Public Accountants
To the Board of Directors and Stockholders of Allegiance Telecom, Inc.:
We have audited the accompanying consolidated balance sheets of Allegiance
Telecom, Inc. (a Delaware corporation) and subsidiaries (the "Company") as of
December 31, 1998 and 1997, and the related consolidated statements of
operations, stockholders' equity (deficit), and cash flows for the year ended
December 31, 1998, and for the period from inception (April 22, 1997), to
December 31, 1997. These financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Allegiance Telecom, Inc. and
subsidiaries as of December 31, 1998 and 1997, and the results of their
operations and their cash flows for the year ended December 31, 1998, and for
the period from inception (April 22, 1997), to December 31, 1997, in conformity
with generally accepted accounting principles.
ARTHUR ANDERSEN LLP
Dallas, Texas,
February 3, 1999
<PAGE> 15
Allegiance Telecom, Inc. and Subsidiaries
Consolidated Balance Sheets
December 31, 1998 and 1997 (in thousands, except share and per share data)
<TABLE>
<CAPTION>
1998 1997
------------ ------------
<S> <C> <C>
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 262,501.7 $ 5,726.4
Short-term investments 143,389.7 --
Short-term investments, restricted 25,542.8 --
Accounts receivable (net of allowance for doubtful accounts of
$577.2 and $0, at December 31, 1998 and 1997, respectively) 6,186.6 4.3
Prepaid expenses and other current assets 1,243.2 245.2
------------ ------------
Total current assets 438,864.0 5,975.9
PROPERTY AND EQUIPMENT (net of accumulated depreciation and amortization
of $9,015.4 and $12.7 at December 31, 1998 and 1997,respectively) 144,860.0 23,899.9
OTHER NONCURRENT ASSETS:
Deferred debt issuance costs (net of accumulated amortization of
$733.7 and $0, at December 31, 1998 and 1997, respectively) 16,078.4 --
Long-term investments, restricted 36,699.2 --
Other assets 1,372.7 171.2
------------ ------------
Total other noncurrent assets 54,150.3 171.2
------------ ------------
Total assets $ 637,874.3 $ 30,047.0
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
CURRENT LIABILITIES:
Accounts payable $ 20,981.7 $ 2,261.7
Accrued liabilities and other current liabilities 26,176.8 1,668.0
------------ ------------
Total current liabilities 47,158.5 3,929.7
LONG-TERM DEBT 471,652.1 --
REDEEMABLE CUMULATIVE CONVERTIBLE PREFERRED STOCK, $.01 par value,
0 and 40,498,062 shares authorized, 0 and 40,498,062 shares issued
and outstanding at December 31, 1998 and 1997, respectively -- 33,409.4
REDEEMABLE WARRANTS 8,634.1 --
COMMITMENTS AND CONTINGENCIES (see Notes 6 and 8)
STOCKHOLDERS' EQUITY (DEFICIT):
Preferred stock, $.01 par value, 1,000,000 and 0 shares authorized, no shares issued
or outstanding at December 31, 1998 and 1997, respectively -- --
Common stock, $.01 par value, 150,000,000 and 42,629,965 shares authorized, 50,341,554
and 426 shares issued and outstanding at December 31, 1998 and 1997, respectively 503.4 --
Additional paid-in capital 416,729.9 3,008.4
Deferred compensation (14,617.3) (2,798.4)
Deferred management ownership allocation charge (26,224.7) --
Accumulated deficit (265,961.7) (7,502.1)
------------ ------------
Total stockholders' equity (deficit) 110,429.6 (7,292.1)
------------ ------------
Total liabilities and stockholders' equity (deficit) $ 637,874.3 $ 30,047.0
============ ============
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
<PAGE> 16
<<p47
Allegiance Telecom, Inc. and Subsidiaries
Consolidated Statements of Operations
(in thousands, except share and per share data)
<TABLE>
<CAPTION>
Period from
Inception
(April 22, 1997),
Year Ended through
December 31, December 31,
1998 1997
-------------- --------------
<S> <C> <C>
REVENUE $ 9,786.2 $ 0.4
OPERATING EXPENSES:
Network 9,528.8 151.2
Selling, general and administrative 46,089.4 3,425.9
Management ownership allocation charge 167,311.9 --
Noncash deferred compensation 5,307.2 209.9
Depreciation and amortization 9,002.8 12.7
-------------- --------------
Total operating expenses 237,240.1 3,799.7
-------------- --------------
Loss from operations (227,453.9) (3,799.3)
OTHER (EXPENSE) INCOME:
Interest income 19,917.4 111.4
Interest expense (38,951.7) --
-------------- --------------
Total other (expense) income (19,034.3) 111.4
-------------- --------------
NET LOSS (246,488.2) (3,687.9)
ACCRETION OF REDEEMABLE PREFERRED STOCK AND WARRANT VALUES (11,971.4) (3,814.2)
-------------- --------------
NET LOSS APPLICABLE TO COMMON STOCK $ (258,459.6) $ (7,502.1)
============== ==============
NET LOSS PER SHARE, basic and diluted $ (10.53) $ (17,610.68)
============== ==============
WEIGHTED AVERAGE NUMBER OF SHARES OUTSTANDING, basic and diluted 24,550,346 426
============== ==============
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
<PAGE> 17
Allegiance Telecom, Inc. and Subsidiaries
Consolidated Statements of Stockholders' Equity (Deficit)
For the year ended December 31, 1998, and for the period from inception (April
22, 1997), through December 31, 1997 (in thousands, except share and per share
data)
<TABLE>
<CAPTION>
Preferred Stock Common Stock
---------------------- ----------------------
Number Number
of of
Shares Amount Shares Amount
---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Balance, April 22, 1997 (date of inception) -- $ -- -- $ --
Issuance of common stock at $.23 per share -- -- 426 --
Accretion of redeemable preferred stock and warrant values -- -- -- --
Deferred compensation -- -- -- --
Amortization of deferred compensation -- -- -- --
Net loss -- -- -- --
---------- ---------- ---------- ----------
Balance, December 31, 1997 -- -- 426 --
Accretion of redeemable preferred stock and warrant values -- -- -- --
Initial public offering -- -- 10,000,000 100.0
Conversion of redeemable preferred stock -- -- 40,341,128 403.4
Deferred compensation -- -- -- --
Amortization of deferred compensation -- -- -- --
Net loss -- -- -- --
---------- ---------- ---------- ----------
Balance, December 31, 1998 -- $ -- 50,341,554 $ 503.4
========== ========== ========== ==========
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
<PAGE> 18
<TABLE>
<CAPTION>
Deferred
Management
Additional Ownership
Paid-In Deferred Allocation Accumulated
Capital Compensation Charge Deficit Total
---------- ----------- ---------- ----------- ----------
<S> <C> <C> <C> <C> <C>
Balance, April 22, 1997 (date of inception) $ -- $ -- $ -- $ -- $ --
Issuance of common stock at $.23 per share 0.1 -- -- -- 0.1
Accretion of redeemable preferred stock and warrant values -- -- -- (3,814.2) (3,814.2)
Deferred compensation 3,008.3 (3,008.3) -- -- --
Amortization of deferred compensation -- 209.9 -- -- 209.9
Net loss -- -- -- (3,687.9) (3,687.9)
---------- ---------- ---------- ----------- ----------
Balance, December 31, 1997 3,008.4 (2,798.4) -- (7,502.1) (7,292.1)
Accretion of redeemable preferred stock and warrant values -- -- -- (11,971.4) (11,971.4)
Initial public offering 137,656.8 -- -- -- 137,756.8
Conversion of redeemable preferred stock 65,402.0 -- -- -- 65,805.4
Deferred compensation 210,662.7 (17,126.1) (193,536.6) -- --
Amortization of deferred compensation -- 5,307.2 167,311.9 -- 172,619.1
Net loss -- -- -- (246,488.2) (246,488.2)
---------- ---------- ---------- ----------- ----------
Balance, December 31, 1998 $416,729.9 $(14,617.3) $(26,224.7) $(265,961.7) $110,429.6
========== ========== ========== =========== ==========
</TABLE>
<PAGE> 19
Allegiance Telecom, Inc. and Subsidiaries
Consolidated Statements of Cash Flows
For the year ended December 31, 1998, and for the period from inception (April
22, 1997), through December 31, 1997 (in thousands)
<TABLE>
<CAPTION>
1998 1997
------------ ------------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss $ (246,488.2) $ (3,687.9)
Adjustments to reconcile net loss to cash used in operating activities--
Depreciation and amortization 9,002.8 12.7
Provision for uncollectible accounts receivable 577.2 --
Accretion of senior discount notes 27,762.7 --
Amortization of original issue discount 569.9 --
Amortization of deferred debt issuance costs 733.7 --
Amortization of management ownership allocation charge and deferred compensation 172,619.1 209.9
Changes in assets and liabilities--
Accounts receivable (6,759.5) (4.3)
Prepaid expenses and other current assets (998.0) (245.2)
Other assets (1,201.5) (171.2)
Accounts payable 4,703.9 275.1
Accrued liabilities and other current liabilities 22,208.1 1,668.0
------------ ------------
Net cash used in operating activities (17,269.8) (1,942.9)
------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment (113,538.7) (21,926.0)
Purchases of investments (294,688.8) --
Proceeds from redemption of investments 89,057.1 --
------------ ------------
Net cash used in investing activities (319,170.4) (21,926.0)
------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from senior notes 443,212.1 --
Proceeds from issuance of redeemable warrants 8,183.5 --
Deferred debt issuance costs (16,812.1) --
Proceeds from issuance of redeemable preferred stock -- 5,000.0
Proceeds from redeemable capital contributions 20,875.2 24,595.2
Proceeds from issuance of common stock -- 0.1
Proceeds from initial public offering 137,756.8 --
------------ ------------
Net cash provided by financing activities 593,215.5 29,595.3
------------ ------------
INCREASE IN CASH AND CASH EQUIVALENTS 256,775.3 5,726.4
CASH AND CASH EQUIVALENTS, beginning of period 5,726.4 --
------------ ------------
CASH AND CASH EQUIVALENTS, end of period $ 262,501.7 $ 5,726.4
============ ============
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid during the period for interest $ 9,384.4 $ --
============ ============
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
<PAGE> 20
<<p51
Allegiance Telecom, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
December 31, 1998 and 1997 (in thousands, except share and per share data)
1. General:
Allegiance Telecom, Inc., a competitive local exchange carrier (CLEC), was
incorporated on April 22, 1997, as a Delaware corporation, for the purpose of
providing 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 business plan is focused on offering services in 24 of the largest
metropolitan areas in the United States. As of December 31, 1998, the Company
was operational in nine markets: Atlanta, Boston, Chicago, Dallas, Fort Worth,
Los Angeles, New York City, Oakland and San Francisco and is in the process of
deploying networks in seven other markets: Houston, Northern New Jersey, Orange
County, Philadelphia, San Diego, San Jose and Washington, D.C.
Until December 16, 1997, the Company was in the development stage. From its
inception on April 22, 1997, through December 31, 1997, the Company's principal
activities included developing its 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 (OSS), acquiring equipment and facilities, and
negotiating interconnection agreements. Also, the Company initiated resale
services to customers in the Dallas market in December 1997. During 1998, the
Company began providing facilities-based services to customers in its markets.
During 1998, the Company concentrated on building out the markets it is
currently operating in, as well as developing its future markets. Accordingly,
the Company has incurred substantial 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 by the
competitive environment in which the Company operates. 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 incumbent local exchange carrier (ILEC) facilities, lease
adequate trunking capacity from ILECs or other CLECs, purchase and install
switches in additional markets, implement efficient OSS and other back office
systems, develop a sufficient customer base, and attract, retain, and motivate
qualified personnel. The Company's networks and the provisions 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 market 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. Summary of Significant Accounting Policies:
CONSOLIDATION > The accompanying financial statements include the accounts of
Allegiance Telecom, Inc. and its wholly owned subsidiaries. All significant
intercompany balances and transactions have been eliminated.
CASH AND CASH EQUIVALENTS > For purposes of reporting cash flows, the Company
includes as cash and cash equivalents, cash, marketable securities, and
commercial paper with original maturities of three months or less at date of
purchase.
<PAGE> 21
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.
RESTRICTED INVESTMENTS > Restricted investments consist primarily of U.S.
government securities purchased in connection with the Company's outstanding
12 7/8% Notes (see Note 4) to secure the first three years' (six semiannual)
interest payments on the 12 7/8% Notes. Such investments are stated at their
accreted value, which approximates fair value, and are shown in both current and
other noncurrent assets, based upon the maturity dates of each of the securities
at the balance sheet date.
Restricted investments also includes $787.2 in certificates of deposit held as
collateral for letters of credit issued on behalf of the Company. These
investments are classified as other noncurrent assets.
ACCOUNTS RECEIVABLE > Accounts receivable consist of end-user receivables,
interest receivable, and at December 31, 1997, a receivable from an employee.
PREPAID EXPENSES AND OTHER CURRENT ASSETS > Prepaid expenses and other current
assets consist of prepaid rent, prepaid insurance, and refundable deposits.
Prepayments are expensed on a straight-line basis over the life of the
underlying agreements.
PROPERTY AND EQUIPMENT > Property and equipment includes network equipment,
leasehold improvements, software, office equipment, furniture and fixtures,
construction-in-progress, 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 year ended
December 31, 1998, was $41,749.9 before the capitalization of $2,798.2 of
interest related to construction-in-progress. No interest expense was incurred
during the period ended December 31, 1997. Repair and maintenance costs are
expensed as incurred.
Property and equipment at December 31, 1998 and 1997, consist of the following:
<TABLE>
<CAPTION>
Useful
Lives
1998 1997 (in years)
---------- ---------- ----------
<S> <C> <C> <C>
Network equipment $ 67,303.8 $ -- 5-7
Leasehold improvements 24,483.2 37.5 5-10
Software 7,840.0 -- 3
Office equipment and other 4,384.3 89.9 2
Furniture and fixtures 2,419.6 150.2 5
---------- ----------
Property and equipment, in service 106,430.9 277.6
Less-accumulated depreciation (9,015.4) (12.7)
---------- ----------
Property and equipment, in service, net 97,415.5 264.9
Construction-in-progress 47,444.5 23,635.0
---------- ----------
Property and equipment, net $144,860.0 $ 23,899.9
========== ==========
</TABLE>
REVENUE RECOGNITION > Revenue is recognized in the month in which the service is
provided, except for reciprocal compensation generated by calls placed to
Internet service providers connected to the Company's network. The propriety of
CLECs (such as the Company) to earn local reciprocal compensation is the subject
of numerous regulatory and legal challenges. Until this issue is ultimately
resolved, the Company has determined to recognize this revenue only when
realization of it is certain, which in most cases will be upon receipt of cash.
COMPREHENSIVE INCOME > In June 1997, the Financial Accounting Standards Board
(FASB) issued Statement of Financial Accounting Standards (SFAS) No. 130 (SFAS
130), "Reporting Comprehensive Income." SFAS 130 established reporting and
disclosure requirements for comprehensive income and its components within the
financial statements. The Company's comprehensive income components were
immaterial as of December 31, 1998, and the Company had no comprehensive income
components as of December 31, 1997; therefore, comprehensive income/loss is the
same as net income/loss for both periods.
<PAGE> 22
LOSS PER SHARE > The Company calculates net loss per share under the provisions
of SFAS No. 128, "Earnings 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 (see Note 3). The net loss
applicable to common stock includes the accretion of redeemable cumulative
convertible preferred stock and warrant values of $11,971.4 for the year ended
December 31, 1998, and $3,814.2 for the period from inception (April 22, 1997),
through December 31, 1997.
The securities listed below were not included in the computation of diluted loss
per share, since the effect from the conversion would be antidilutive.
<TABLE>
<CAPTION>
December 31,
--------------------------
1998 1997
------------ ------------
<S> <C> <C>
Redeemable Cumulative Convertible Preferred Stock -- 40,498,062
Redeemable Warrants 649,248 --
1997 Nonqualified Stock Option Plan 886,127 189,127
1998 Stock Incentive Plan 365,526 --
Employee Stock Discount Purchase Plan 44,624 --
------------ ------------
</TABLE>
RECOGNITION OF THE COST OF START-UP ACTIVITIES > On April 3, 1998, the American
Institute of Certified Public Accountants issued Statement of Position No. 98-5
(SOP 98-5), "Reporting on the Costs of Start-up Activities." SOP 98-5 requires
that start-up activities and organization costs be expensed as incurred and that
start-up costs capitalized prior to the adoption of SOP 98-5 be reported as a
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
effect on the Company, inasmuch as the Company had previously expensed all such
costs.
ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES > In June 1998, the
FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging
Activities" (SFAS 133). SFAS 133 requires that all derivatives be recognized at
fair value as either assets or liabilities. SFAS 133 also requires an entity
that elects to apply hedge accounting to establish the method to be used in
assessing the effectiveness of the hedging derivatives and the measurement
approach for determining the ineffectiveness of the hedge at the inception of
the hedge. The methods chosen must be consistent with the entity's approach to
managing risk. The Company adopted SFAS 133 at the beginning of the fourth
quarter of 1998. Adoption of SFAS 133 did not have an effect on the Company,
inasmuch as the Company has historically not invested in derivatives or
participated in hedging activities.
USE OF ESTIMATES IN FINANCIAL STATEMENTS > The preparation of financial
statements in conformity with generally accepted accounting principles requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of expenses during
the reporting period. Actual results could differ from those estimates.
RECLASSIFICATIONS > Certain amounts in the prior period's consolidated financial
statements have been reclassified to conform with the current period
presentation.
3. Capitalization:
In connection with its initial public offering of common stock (the "IPO") on
July 7, 1998 (see below), the Company effected a 426.2953905-for-one stock
split, which is retroactively reflected within these financial statements.
STOCK PURCHASE AGREEMENT AND SECURITY HOLDERS AGREEMENT > On August 13, 1997,
the Company entered into a stock purchase agreement with Allegiance Telecom, LLC
("Allegiance LLC") (see Note 7). Allegiance LLC purchased 40,498,062 shares of
12% redeemable cumulative convertible preferred stock ("Redeemable Preferred
Stock"), par value $.01 per share, for aggregate consideration of $5,000.0 (the
"Initial Closing"). Allegiance LLC agreed to make additional contributions as
necessary to fund expansion into new markets ("Subsequent Closings"). In order
to obtain funds through Subsequent Closings, the Company submitted a proposal
<PAGE> 23
p54>>
to Allegiance LLC detailing the funds necessary to build out the Company's
business in a new market. Allegiance LLC was not required to make any
contributions until it approved the proposal. The maximum commitment of
Allegiance LLC was $100,000.0. No capital contributions were required to be made
after the Company consummated an initial public offering of its stock (which
occurred on July 7, 1998).
Allegiance LLC contributed a total of $50,132.9 and $29,595.2 prior to the
Company's initial public offering and as of December 31, 1997, respectively.
Each security holder in Allegiance LLC had the right to require Allegiance LLC
to repurchase all of the outstanding securities held by such security holder at
the greater of the original cost (including interest at 12% per annum) for such
security or the fair market value, as defined in the security holders agreement,
at any time and from time to time after August 13, 2004, but not after the
consummation of a public offering or sale of the Company. If repurchase
provisions had been exercised, the Company had agreed, at the request and
direction of Allegiance LLC, to take any and all actions necessary, including
declaring and paying dividends and repurchasing preferred or common stock, to
enable Allegiance LLC to satisfy its repurchase obligations.
Because of the redemption provisions, the Company has recognized the accretion
of the value of the Redeemable Preferred Stock to reflect management's estimate
of the potential future fair market value of the Redeemable Preferred Stock
payable in the event the repurchase provisions were exercised. Amounts were
accreted using the effective interest method, assuming the Redeemable Preferred
Stock is redeemed at a redemption price based on the estimated potential future
fair market value of the equity of the Company in August 2004. The accretion was
recorded each period as an increase in the balance of Redeemable Preferred Stock
outstanding and a noncash increase in the net loss applicable to common stock.
In connection with the IPO, the Redeemable Preferred Stock was converted into
common stock, and the amounts accreted were reclassified as a component of
additional paid-in capital. In addition, the redemption provisions and the
obligation of Allegiance LLC to make additional contributions to the Company
(and the obligation of the members of Allegiance LLC to make capital
contributions) have terminated.
REDEEMABLE CUMULATIVE CONVERTIBLE PREFERRED STOCK > Each share of the Company's
Redeemable Preferred Stock was convertible into shares of the Company's common
stock (the "Common Stock") on a one-for-one basis, subject to certain
antidilution provisions. No dividends were declared in 1998 or 1997.
In 1998, prior to the conversion of the Redeemable Preferred Stock, the Company
recorded accretion of $11,520.8. Accretion recorded in the period ended December
31, 1997, was $3,814.2.
Capital contributed in the Subsequent Closings occurring in October 1997 and
January 1998 and other capital contributions totaled approximately $45,132.9.
In February and March 1998, the Company issued 273,361.92 shares of Redeemable
Preferred Stock for aggregate consideration of $337.5.
In connection with the consummation of the IPO, the outstanding shares of the
Redeemable Preferred Stock were converted into 40,341,128 shares of Common
Stock. Upon the conversion of the Redeemable Preferred Stock, the obligation of
the Company to redeem the Redeemable Preferred Stock also terminated and,
therefore, the accretion of the Redeemable Preferred Stock value recorded to the
date of the IPO, $15,335.0, was reclassified to additional paid-in capital along
with $50,470.4 proceeds from the issuance of the Redeemable Preferred Stock and
redeemable capital contributions.
PREFERRED STOCK > In connection with the IPO, the Company authorized 1,000,000
shares of preferred stock ("Preferred Stock") with a $.01 par value. At December
31, 1998, no shares of Preferred Stock were issued and outstanding.
COMMON STOCK > On July 7, 1998, the Company raised $150,000.0 of gross proceeds
in the Company's IPO. The Company sold 10,000,000 shares of its Common Stock at
a price of $15 per share. In connection with the IPO, the outstanding shares of
Redeemable Preferred Stock were converted into 40,341,128 shares of Common
Stock, and the Company increased the number of authorized Common Stock to
150,000,000. At December 31, 1998, 50,341,554 shares were issued and
outstanding. Of the authorized but unissued Common Stock, 6,998,970 shares are
reserved for issuance upon exercise of options issued under the Company's stock
option, stock incentive, and stock purchase plans (see Note 10) and 649,248
shares are reserved for issuance, sale, and delivery upon the exercise of
warrants (see Note 4).
<PAGE> 24
DEFERRED COMPENSATION > Allegiance LLC sold to certain management investors (the
"Management Investors") membership units of Allegiance LLC at amounts less than
their estimated fair market value; therefore, the Company has recognized
deferred compensation of $10,090.2 and $977.6 at December 31, 1998 and 1997,
respectively, of which $2,726.1 and $40.7 have been amortized to expense at
December 31, 1998 and 1997, respectively. In connection with the IPO, the
Redeemable Preferred Stock was converted into Common Stock, and Allegiance LLC
was dissolved. The deferred compensation charge is amortized based upon 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.
DEFERRED MANAGEMENT OWNERSHIP ALLOCATION CHARGE > On July 7, 1998, in connection
with the IPO, certain venture capital investors (the "Fund Investors") and
certain Management Investors owned 95.0% and 5.0%, respectively, of the
ownership interests of Allegiance LLC, which owned substantially all of the
Company's outstanding capital stock. As a result of the successful IPO,
Allegiance LLC was dissolved, and its assets (which consisted almost entirely of
such capital stock) have been distributed to the Fund Investors and 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 IPO. 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 noncash, nonrecurring charge to operating expense and $71,061.1
was recorded as a deferred management ownership allocation charge. The deferred
charge was amortized at $44,836.4 as of December 31, 1998, and will be further
amortized at $18,870.2, $7,175.7, and $178.8 during 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.
4. Long-Term Debt:
Long-term debt consisted of the following:
<TABLE>
<CAPTION>
December 31,
--------------------------
1998 1997
------------ ------------
<S> <C> <C>
Series B 11 3/4% Notes, face amount $445,000.0 due February 15, 2008,
effective interest rate of 12.45%, at accreted value $ 270,526.1 $ --
12 7/8% Senior Notes, face amount $205,000.0 due May 15, 2008,
effective interest rate of 13.24%, at accreted value 201,018.6 --
Other 107.4 --
------------ ------------
Total long-term debt $ 471,652.1 $ --
============ ============
</TABLE>
On February 3,1998, the Company raised gross proceeds of approximately
$250,477.1 in an offering of 445,000 Units (the "Unit Offering"), each of which
consists of one 11 3/4% Senior Discount Note due 2008 of the Company (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 $8,183.5 was allocated to the Redeemable
Warrants. The Redeemable Warrants became exercisable in connection with the IPO
(see Note 3) in July 1998, and each warrant may now purchase 1.45898399509
shares of Common Stock as a result of the stock split (see Note 3).
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 after 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.
<PAGE> 25
p56>>
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 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 a result of the warrant
redemption provisions, 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 year ended
December 31, 1998, was $450.6.
The Series B Notes are redeemable by the Company, in whole or in part, anytime
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 at 111.750% of the
accreted value on the redemption date, provided that at least $289,250.0
aggregate principal amount at maturity of the Series B Notes remains outstanding
after such redemption.
On July 7, 1998, the Company raised approximately $200,918.5 of gross proceeds
from the sale of its 12 7/8% Senior Notes due 2008 (the "12 7/8% Notes"), of
which approximately $69,033.4 was used to purchase U.S. government securities,
which were placed in a pledge account to secure and fund the first six scheduled
payments of interest on the notes (see Note 2).
The 12 7/8% Notes have a principal amount at maturity of $205,000.0 and an
effective interest rate of 13.24%. The 12 7/8% Notes mature on May 15, 2008.
Interest on the 12 7/8% Notes is payable semi-annually in cash at the rate of
12 7/8% on May 15 and November 15 of each year. As of December 31, 1998, the
Company has recorded accrued interest associated with the 12 7/8% Notes of
$3,470.2, which is included in other current liabilities.
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, 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 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 remains outstanding.
The Series B 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 to their capital stock, redeem capital stock, make
investments or certain other restricted payments, sell assets, issue or sell
stock of restricted subsidiaries (as defined in the indentures relating to the
Series B Notes and the 12 7/8% Notes), 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 each series of notes at a purchase price
of 101% of the accreted value thereof (in the case of the Series B Notes) and
101% of the principal amount thereof (in the case of the 12 7/8% Notes),
together with accrued interest, if any. However, these limitations are subject
to a number of qualifications and exceptions (as defined in the indentures
relating to each series of notes). The Company was in compliance with all such
restrictive covenants of each series of notes at December 31, 1998.
<PAGE> 26
<<p57
5. Capital Leases:
On May 29, 1998, the Company signed a capital lease agreement for three,
four-fiber rings, with a term of 10 years and a renewal term of 10 years, at an
expected total cost of $3,485.0; $871.3 was paid as of December 31, 1998. The
remainder is expected to be paid in 1999 and is not reflected in the financial
statements, since the payment is contingent upon the timing of completion of
network segments.
On December 4, 1998, the Company signed a capital lease agreement for 12 optical
fibers configured in two separate rings, with a term of 15 years and two renewal
terms of five years each. Total cost associated with the capital lease is
dependent upon the timing of completion of connectivity of the optical fibers
with the Company's network, which is to be completed in two phases. The Company
will incur recurring monthly charges of $29.4 after the completion of phase one.
After completion of phase two, the Company will pay a one-time fee of $76.5, and
the recurring monthly charge will increase to $76.5. This capital lease is not
reflected in the financial statements, since the total cost and timing of
payments are contingent upon the timing of completion of the phases.
6. 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. 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
moved to dismiss the abuse of process and unfair competition claims. The court
dismissed the unfair competition claim on March 4, 1998. Thus, the Company's
counterclaim for attempted monopolization and abuse of power are still being
litigated.
7. Related Parties:
From inception (April 22, 1997) through July 7, 1998, the Company was a wholly
owned subsidiary of Allegiance LLC. On July 7, 1998, the Fund Investors and the
Management Investors owned 95.0% and 5.0%, respectively, of the ownership
interest of Allegiance LLC, which owned substantially all of the Company's
outstanding capital stock. As a result of the successful IPO (see Note 3),
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 the LLC Agreement (see Note 3).
As of July 7, 1998 and 1997, Allegiance LLC had made aggregate capital
contributions to the Company of approximately $50,132.9 and $29,595.2,
respectively.
During 1998 and 1997, the Company paid all organizational and legal fees of
Allegiance LLC, the amount of which was not material. No amounts are due from
Allegiance LLC at December 31, 1998, or December 31, 1997.
In connection with the Unit Offering (see Note 4), the IPO (see Note 3), and the
sale of the 12 7/8% Notes (see Note 4), the Company incurred approximately
$11,331.5 in fees to an affiliate of an investor in the Company.
<PAGE> 27
p58>>
8. Commitments and Contingencies:
The Company has entered into various operating lease agreements, with
expirations through 2009, for network facilities, office space, and equipment.
Future minimum lease obligations related to the Company's operating leases as of
December 31, 1998, are as follows:
<TABLE>
-------------
<S> <C>
1999 $ 10,984.8
2000 11,201.6
2001 10,436.7
2002 8,600.8
2003 7,940.7
Thereafter 30,083.5
=============
</TABLE>
Total rent expense for the year ended December 31, 1998, was $2,991.8 and for
the period from inception (April 22, 1997) through December 31, 1997, was
$212.1.
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.
9. Federal Income Taxes:
The Company accounts for income tax under the provisions of SFAS No. 109,
"Accounting for Income Taxes" (SFAS 109). SFAS 109 requires an asset and
liability approach that requires the recognition of deferred tax assets and
liabilities for the expected future tax consequences of events that have been
recognized in the Company's financial statements. The Company had approximately
$53,572.5 and $460.5 of net operating loss carryforwards for federal income tax
purposes at December 31, 1998 and 1997, respectively. The net operating loss
carryforwards will expire in the years 2012 and 2018 if not previously utilized.
The Company has recorded a valuation allowance equal to the net deferred tax
assets at December 31, 1998 and 1997, due to the uncertainty of future operating
results. The valuation allowance will be reduced at such time as management
believes it is more likely than not that the net deferred tax assets will be
realized. Any reductions in the valuation allowance will reduce future
provisions for income tax expense.
The Company's deferred tax assets and liabilities and the changes in those
assets are:
<TABLE>
<CAPTION>
1997 Change 1998
------------ ------------ ------------
<S> <C> <C> <C>
Start-up costs capitalized for tax purposes $ 1,025.9 $ (213.7) $ 812.2
Net operating loss carryforward 156.6 18,058.1 18,214.7
Amortization of original issue discount -- 9,663.6 9,663.6
Depreciation -- (2,392.4) (2,392.4)
Valuation allowance (1,182.5) (25,115.6) (26,298.1)
------------ ------------ ------------
$ -- $ -- $ --
============ ============ ============
</TABLE>
Amortization of the original issue discount on the Series B Notes and 12 7/8%
Notes as interest expense is not deductible in the income tax return until paid.
Under existing income tax law, all operating expenses incurred prior to a
company commencing its principal operations are capitalized and amortized over a
five-year period for tax purposes.
<PAGE> 28
<<p59
10. Stock Options/Stock Incentive/Stock Purchase Plans:
At December 31, 1998, the Company had three stock-based compensation plans: the
1997 Nonqualified Stock Option Plan (the "1997 Option Plan"), the 1998 Stock
Incentive Plan, and the Employee Stock Discount Purchase Plan (the "Stock
Purchase Plan"). The Company applies the provisions of Accounting Principles
Board Opinion No. 25, "Accounting for Stock Issued to Employees," and the
related interpretations in accounting for the Company's plans. Had compensation
cost for the Company's plans been determined based on the fair value of the
options as of the grant dates for awards under the plans, consistent with the
method prescribed in SFAS No. 123, "Accounting for Stock-Based Compensation,"
the Company's net loss applicable to Common Stock and net loss per share would
have increased to the pro forma amounts indicated below. The Company utilized
the following assumptions in calculating the estimated fair value of each option
on the date of grant, using the Black-Scholes option-pricing model with the
following weighted-average assumptions for grants in 1998 and 1997: dividend
yield of 0%, expected volatility of 89.1%, and expected lives of six years for
both years: risk-free interest rates of 5.63% in 1998 and 6.06% in 1997 for the
1997 Option Plan and 4.70% in 1998 for the 1998 Stock Incentive Plan.
<TABLE>
<CAPTION>
1998 1997
------------ ------------
<S> <C> <C>
Net loss applicable to common stock - as reported $ 258,459.6 $ 7,502.1
Net loss applicable to common stock - pro forma 259,796.6 7,512.2
Net loss per share, basic and diluted - as reported 10.53 17,610.68
Net loss per share, basic and diluted - pro forma 10.58 17,634.27
------------ ------------
</TABLE>
As the 1998 Stock Incentive Plan and the Stock Purchase Plan were adopted in
1998, the December 31, 1997, pro forma balances do not include expenses for
these plans.
1997 OPTION PLAN AND 1998 STOCK INCENTIVE PLAN > Under the 1997 Option Plan, the
Company granted options to key employees, a director, and a consultant of the
Company for an aggregate of 1,037,474 shares of the Company's Common Stock. The
Company will not grant options for any additional shares under the 1997 Option
Plan.
Under the 1998 Stock Incentive Plan, the Company may grant options to certain
employees, directors, advisors, and consultants of the Company. The 1998 Stock
Incentive Plan provides for issuance of the following types of incentive awards:
stock options, stock appreciation rights, restricted stock, performance grants,
and other types of awards that the Compensation Committee of the Board of
Directors (the "Compensation Committee") deems consistent with the purposes of
the 1998 Stock Incentive Plan. The Company has reserved 3,655,778 shares of
Common Stock for issuance under the 1998 Stock Incentive Plan.
Options granted under both plans have a term of six years and vest over a
three-year period, and the Compensation Committee administers both option plans.
A summary of the status of the 1997 Option Plan as of December 31, 1998 and
1997, is presented in the table below:
<TABLE>
<CAPTION>
December 31, 1998 December 31, 1997
------------------------------- ----------------------------
Weighted Weighted
Average Average
Shares Exercise Price Shares Exercise Price
------------ -------------- ------------ --------------
<S> <C> <C> <C> <C>
Outstanding, beginning of period 189,127 $ 2.47 -- $ --
Granted 848,347 2.76 189,127 2.47
Exercised -- -- -- --
Forfeited (151,347) 2.60 -- --
------------ ------------
Outstanding, end of period 886,127 2.73 189,127 2.47
============ ============
Options exercisable at period-end 44,481 --
============ ============
Weighted average fair value of options granted $ 2.82 $ 0.68
============ ============
</TABLE>
As of December 31, 1998 and 1997, options outstanding under the 1997 Option Plan
have a weighted average remaining contractual life of 5.2 and 5.8 years,
respectively.
<PAGE> 29
p60>>
A summary of the status of the 1998 Stock Incentive Plan as of December 31,
1998, is presented in the table below:
<TABLE>
<CAPTION>
December 31,1998
---------------------------
Weighted Average
Shares Exercise Price
--------- ----------------
<S> <C> <C>
Outstanding, beginning of period -- $ --
Granted 399,974 10.21
Exercised -- --
Forfeited (34,448) 10.47
--------- ---------
Outstanding, end of period 365,526 10.19
=========
Options exercisable at period-end --
=========
Weighted average fair value of options granted $ 10.22
=========
</TABLE>
As of December 31, 1998, options outstanding under the 1998 Stock Incentive Plan
have a weighted average remaining contractual life of 5.7 years.
As the estimated fair market value of the Company's Common Stock (as implied by
the IPO price) exceeded the exercise price of the options granted, the Company
has recognized deferred compensation of $7,635.0 and $2,030.7 at December 31,
1998 and 1997, respectively, of which $2,581.1 and $169.2 have been amortized to
expense at December 31, 1998 and 1997, respectively, over the vesting period of
the options. As of December 31, 1998, the Company has reversed $599.1 of
unamortized deferred compensation related to options forfeited.
STOCK PURCHASE PLAN > The Company's Stock Purchase Plan is intended to give
employees a convenient means of purchasing shares of Common Stock through
payroll deductions. Each participating employee's contributions will be used to
purchase shares for the employee's share account as promptly as practicable
after each calendar quarter. The cost per share will be 85% of the lower of the
closing price of the Company's Common Stock on the Nasdaq National Market on the
first or the last day of the calendar quarter. The Company has reserved
2,305,718 shares of Common Stock for issuance under the Stock Purchase Plan. As
of December 31, 1998, no shares have been issued under the Stock Purchase Plan;
however, participants have contributed $303.4 and will be issued 44,624 shares
of Common Stock in January 1999. The Compensation Committee administers the
Stock Purchase Plan.
<PAGE> 1
EXHIBIT 21.1
Subsidiaries of Allegiance Telecom, Inc.
Allegiance Telecom International, Inc., Delaware corporation
Allegiance Telecom Service Corporation, Delaware corporation
Allegiance Internet, Inc., Delaware corporation
Allegiance Telecom of California, Inc., Delaware corporation
Allegiance Telecom of Colorado, Inc., Delaware corporation
Allegiance Telecom of the District of Columbia, Inc., Delaware corporation
Allegiance Telecom of Florida, Inc., Delaware corporation
Allegiance Telecom of Georgia, Inc., Delaware corporation
Allegiance Telecom of Illinois, Inc., Delaware corporation
Allegiance Telecom of Maryland, Inc., Delaware corporation
Allegiance Telecom of Massachusetts, Inc., Delaware corporation
Allegiance Telecom of Michigan, Inc., Delaware corporation
Allegiance Telecom of New Jersey, Inc., Delaware corporation
Allegiance Telecom of New York, Inc., Delaware corporation
Allegiance Telecom of Pennsylvania, Inc., Delaware corporation
Allegiance Telecom of Texas, Inc., Delaware corporation
Allegiance Telecom of Virginia, Inc., Delaware corporation
Allegiance Telecom of Washington, Inc., Delaware corporation
Allegiance Finance Company, Inc., Delaware corporation
<PAGE> 1
EXHIBIT 23.1
CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS
As independent public accountants, we hereby consent to the incorporation of our
report incorporated by reference in this Form 10-K, into the Company's
previously filed Registration Statements on Form S-8 File No. 333-70769 and
333-73453.
ARTHUR ANDERSEN LLP
Dallas, Texas
March 29, 1999
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
CONDENSED CONSOLIDATED BALANCE SHEET AT DECEMBER 31, 1998 AND FROM THE
CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS FOR THE YEAR ENDED
DECEMBER 31, 1998 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH
CONSOLIDATED FINANCIAL STATEMENT.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> DEC-31-1998
<CASH> 262,502
<SECURITIES> 143,390
<RECEIVABLES> 6,764
<ALLOWANCES> 577
<INVENTORY> 0
<CURRENT-ASSETS> 438,864
<PP&E> 153,875
<DEPRECIATION> 9,015
<TOTAL-ASSETS> 637,874
<CURRENT-LIABILITIES> 47,159
<BONDS> 471,545
0
0
<COMMON> 503
<OTHER-SE> 109,926
<TOTAL-LIABILITY-AND-EQUITY> 637,874
<SALES> 0
<TOTAL-REVENUES> 9,786
<CGS> 0
<TOTAL-COSTS> 9,529
<OTHER-EXPENSES> 181,622
<LOSS-PROVISION> 577
<INTEREST-EXPENSE> 38,952
<INCOME-PRETAX> (258,460)
<INCOME-TAX> 0
<INCOME-CONTINUING> (258,460)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (258,460)
<EPS-PRIMARY> (10.53)
<EPS-DILUTED> (10.53)
</TABLE>
