<PAGE> 1
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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
---------------------
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2000.
[ ] 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)
<TABLE>
<S> <C>
DELAWARE 75-2721491
(State or other jurisdiction (IRS Employer
of incorporation or organization) Identification No.)
</TABLE>
1950 STEMMONS FREEWAY
SUITE 3026
DALLAS, TEXAS 75207
(Address of principal executive offices) (Zip Code)
(214) 261-7100
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports) and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
As of August 4, 2000, the registrant had 108,864,633 shares of common stock
outstanding.
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<PAGE> 2
ALLEGIANCE TELECOM, INC. AND SUBSIDIARIES
FORM 10-Q INDEX
<TABLE>
<CAPTION>
PAGE
NO.
----
<S> <C>
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements.............................. 2
Condensed Consolidated Balance Sheets as of June 30,
2000 and December 31, 1999............................ 2
Condensed Consolidated Statements of Operations for the
three and six months ended June 30, 2000 and 1999..... 3
Condensed Consolidated Statements of Cash Flows for the
six months ended June 30, 2000 and 1999............... 4
Notes to Condensed Consolidated Financial Statements... 5
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations.................... 11
Item 3. Quantitative and Qualitative Disclosures about
Market Risk............................................ 31
PART II. OTHER INFORMATION
Item 1. Legal Proceedings................................. 32
Item 2. Changes in Securities and Use of Proceeds......... 32
Item 3. Defaults Upon Senior Securities................... 32
Item 4. Submission of Matters to a Vote of Security
Holders................................................ 32
Item 5. Other Information................................. 32
Item 6. Exhibits and Reports on Form 8-K.................. 32
Signatures................................................ 33
</TABLE>
1
<PAGE> 3
PART I. FINANCIAL INFORMATION
ALLEGIANCE TELECOM, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
JUNE 30, DECEMBER 31,
2000 1999
------------ ------------
(UNAUDITED)
<S> <C> <C>
ASSETS
CURRENT ASSETS:
Cash and cash equivalents................................. $ 936,465 $ 502,234
Short-term investments.................................... 26,050 23,783
Short-term investments, restricted........................ 25,598 25,518
Accounts receivable, net.................................. 61,830 29,857
Prepaid expenses and other current assets................. 5,213 2,257
---------- ----------
Total current assets.............................. 1,055,156 583,649
PROPERTY AND EQUIPMENT, net................................. 549,369 377,413
DEFERRED DEBT ISSUANCE COSTS, net........................... 26,057 21,668
LONG-TERM INVESTMENTS, RESTRICTED........................... 829 13,232
OTHER ASSETS, net........................................... 77,737 37,913
---------- ----------
Total assets...................................... $1,709,148 $1,033,875
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable.......................................... $ 40,522 $ 44,805
Accrued liabilities and other current liabilities......... 44,691 28,868
---------- ----------
Total current liabilities......................... 85,213 73,673
LONG-TERM DEBT.............................................. 536,109 514,432
LONG-TERM LIABILITIES....................................... 2,498 2,154
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' EQUITY:
Preferred stock -- $.01 par value, 1,000,000 shares
Authorized, no shares issued or outstanding at June 30,
2000 and December 31, 1999............................. -- --
Common stock -- 109,114,012 and 97,459,677 shares issued
and 108,786,517 and 97,421,709 outstanding at June 30,
2000 and December 31, 1999, respectively............... 1,091 975
Common stock in treasury, at cost, 327,495 and 37,968
shares at June 30, 2000 and December 31, 1999,
respectively........................................... (45) (5)
Common stock warrants..................................... 3,132 3,719
Additional paid-in capital................................ 1,691,596 940,120
Deferred compensation..................................... (9,553) (13,573)
Deferred management ownership allocation charge........... (2,063) (6,790)
Accumulated deficit....................................... (598,830) (480,830)
---------- ----------
Total stockholders' equity........................ 1,085,328 443,616
---------- ----------
Total liabilities and stockholders' equity........ $1,709,148 $1,033,875
========== ==========
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
financial statements.
2
<PAGE> 4
ALLEGIANCE TELECOM, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
---------------------------- --------------------------
2000 1999 2000 1999
------------- ------------ ------------ -----------
<S> <C> <C> <C> <C>
REVENUES............................... $ 63,006 $ 17,746 $ 110,167 $ 27,722
OPERATING EXPENSES:
Network.............................. 34,550 12,717 61,670 20,342
Selling, general and
administrative.................... 56,743 30,652 104,734 58,236
Depreciation and amortization........ 25,351 9,920 46,705 17,137
Management ownership allocation
charge............................ 2,176 5,475 4,592 11,255
Non-cash deferred compensation....... 2,010 2,010 4,020 3,831
------------ ----------- ------------ -----------
Total operating expenses..... 120,830 60,774 221,721 110,801
------------ ----------- ------------ -----------
Loss from operations......... (57,824) (43,028) (111,554) (83,079)
OTHER INCOME (EXPENSE):
Interest income...................... 16,441 8,962 29,895 14,283
Interest expense..................... (15,347) (15,190) (36,341) (29,456)
------------ ----------- ------------ -----------
Total other income
(expense).................. 1,094 (6,228) (6,446) (15,173)
NET LOSS............................... (56,730) (49,256) (118,000) (98,252)
ACCRETION OF REDEEMABLE PREFERRED STOCK
AND WARRANT VALUES................... -- -- -- (130)
------------ ----------- ------------ -----------
NET LOSS APPLICABLE TO COMMON STOCK.... $ (56,730) $ (49,256) $ (118,000) $ (98,382)
============ =========== ============ ===========
NET LOSS PER SHARE, basic and
diluted.............................. $ (0.52) $ (0.53) $ (1.11) $ (1.17)
============ =========== ============ ===========
WEIGHTED AVERAGE NUMBER OF SHARES
OUTSTANDING, basic and diluted....... 108,377,432 92,397,731 106,235,098 83,979,789
============ =========== ============ ===========
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
financial statements.
3
<PAGE> 5
ALLEGIANCE TELECOM, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(DOLLARS IN THOUSANDS)
(UNAUDITED)
<TABLE>
<CAPTION>
SIX MONTHS ENDED
JUNE 30,
---------------------
2000 1999
--------- ---------
<S> <C> <C>
Cash Flows from Operating Activities:
Net loss.................................................. $(118,000) $ (98,252)
Adjustments to reconcile net loss to cash used in
operating activities --
Depreciation and amortization........................... 46,705 17,137
Provision for bad debt.................................. 8,245 1,603
Accretion of investments................................ (1,369) (2,479)
Accretion of Senior Discount Notes...................... 18,773 16,839
Amortization of deferred debt issuance costs............ 7,945 1,146
Amortization of management ownership allocation charge
and deferred compensation.............................. 8,612 15,086
Changes in assets and liabilities, net of affects of
acquisitions --
Increase in accounts receivable......................... (39,201) (12,309)
Increase in prepaid expenses and other current assets... (2,058) (1,473)
Decrease (increase) in other assets..................... 1,527 (165)
(Decrease) increase in accounts payable................. (6,093) 19,436
Increase in accrued liabilities and other current
liabilities............................................ 10,490 12,349
--------- ---------
Net cash used in operating activities.............. (64,424) (49,248)
--------- ---------
Cash Flows from Investing Activities:
Purchases of property and equipment....................... (202,160) (152,308)
Purchases of short-term investments....................... (31,070) (47,717)
Proceeds from sale of investments......................... 42,495 167,655
Business acquisitions, net of cash acquired............... (20,999) (34,861)
--------- ---------
Net cash used in investing activities.............. (211,734) (67,231)
--------- ---------
Cash Flows from Financing Activities:
Deferred debt issuance costs.............................. (12,334) (6,362)
Proceeds from issuance of common stock.................... 719,675 510,618
Proceeds from stock options exercised..................... 2,520 83
Proceeds from issuance of common stock under the Employee
Stock Discount Purchase Plan............................ 1,954 529
Other financing activities................................ (1,426) (14)
--------- ---------
Net cash provided by financing activities.......... 710,389 504,854
--------- ---------
Net increase in cash and cash equivalents.......... 434,231 406,541
Cash and cash equivalents, beginning of period..... 502,234 262,502
--------- ---------
Cash and cash equivalents, end of period........... $ 936,465 $ 669,043
========= =========
Supplemental disclosures of cash flow information:
Cash paid for interest.................................... 16,664 13,911
Supplemental disclosure of noncash investing and financing
activities:
Assets acquired under capital lease obligations........... 3,997 --
Fair value of assets acquired in business acquisitions.... 16,961 10,166
Liabilities assumed in business acquisitions.............. 4,992 8,898
Common stock issued for business acquisitions (393,482
shares)................................................. 25,033 --
Options issued for business acquisitions (63,088
shares)................................................. 2,009 --
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
financial statements.
4
<PAGE> 6
ALLEGIANCE TELECOM, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
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 36 of the
largest metropolitan areas in the United States. As of June 30, 2000, the
Company is operational in 24 markets: Atlanta, Baltimore, Boston, Chicago,
Cleveland, Dallas, Denver, Detroit, Fort Worth, Houston, Long Island, Los
Angeles, Miami, New York City, Northern New Jersey, Oakland, Orange County,
Philadelphia, San Diego, San Francisco, San Jose, Seattle, St. Louis and
Washington, D.C. The Company is in the process of deploying networks in three
additional markets: Phoenix, Minneapolis and Tampa.
The Company's success will be affected by the challenges, expenses and
delays encountered in connection with the formation of any new business, and the
competitive environment in which the Company operates. The Company's performance
will further be affected by its ability to assess and access potential markets,
implement interconnection and collocation with the facilities of incumbent local
exchange carriers (ILECs), lease adequate trunking capacity from and otherwise
develop efficient and effective working relationships with ILECs and other
carriers, obtain peering agreements with Internet service providers, collect
interexchange access and reciprocal compensation charges, purchase and install
switches in additional markets, implement efficient operations support systems
(OSS) and other back office systems, develop and retain a sufficient customer
base and attract, retain and motivate qualified personnel. The Company's
networks and the provisioning of telecommunications services are subject to
significant regulation at the federal, state and local levels. Delays in
receiving required regulatory approvals or the enactment of new adverse
regulation or regulatory requirements may have a material adverse effect upon
the Company. Although management believes that the Company will be able to
successfully mitigate these risks, there is no assurance that the Company will
be able to do so or that the Company will ever operate profitably.
Expenses are expected to exceed revenues in each 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 several years,
and positive cash flows from operations are not expected in the near future.
2. BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements have
been prepared by the Company in accordance with generally accepted accounting
principles for interim financial information and are in the form prescribed by
the Securities and Exchange Commission in instructions to Form 10-Q and Article
10 of Regulation S-X. Accordingly, they do not include all of the information
and footnotes required by generally accepted accounting principles for complete
financial statements. The interim unaudited financial statements should be read
in conjunction with the audited financial statements of the Company as of and
for the year ended December 31, 1999. In the opinion of management, all
adjustments (consisting only of normal recurring adjustments) considered
necessary for a fair presentation have been included. Operating results for the
three and six months ended June 30, 2000 are not necessarily indicative of the
results that may be expected for the year ending December 31, 2000.
Certain amounts in the prior period's condensed consolidated financial
statements have been reclassified to conform to the current period presentation.
5
<PAGE> 7
ALLEGIANCE TELECOM, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
3. ACQUISITIONS
During the quarter ending June 30, 2000, the Company acquired all of the
outstanding stock of two regional Internet service providers (ISPs): CONNECTnet
Internet Network Services, Inc. and InterAccess Co. The Company acquired these
ISPs for an aggregate purchase price of $51,684, consisting of $21,038 in cash,
393,482 shares of the Company's common stock, and 63,088 options to purchase
shares of the Company's common stock granted to employees. Included in the
aggregate purchase price is $3,604 consisting of cash and approximately 27,893
shares of the Company's common stock which has been held as security for
indemnification claims against the former owners of the acquired entities. The
excess of the initial purchase price over the fair value of the net assets from
these two acquisitions has been recorded as goodwill of $39,676.
The merger agreement with CONNECTnet Internet Network Services, Inc.
provides for additional contingent consideration payable in cash and shares of
the Company's common stock effective six months following the closing date. The
contingent consideration is based on the satisfaction of certain conditions,
including the maintenance of certain minimum recurring revenues. Based on
information available at June 30, 2000, the contingent consideration is expected
to be approximately $2,500 (consisting of $450 cash and approximately 33,694
shares of the Company's common stock). If such contingent consideration becomes
due and payable, such additional purchase price will result in the recording of
a corresponding amount of goodwill.
The merger agreement with InterAccess Co. provides for additional
contingent consideration payable in cash and shares of the Company's common
stock effective seven months following the closing date. The contingent purchase
payments are based on the satisfaction of certain conditions, including the
maintenance of certain minimum recurring revenues. Based on information
available at June 30, 2000, the contingent consideration is expected to be
approximately $1,800 (consisting of $899 cash and approximately 13,947 shares of
the Company's common stock). If such contingent consideration becomes due and
payable, such additional purchase price will result in the recording of a
corresponding amount of goodwill.
During 1999, the Company acquired 100% of the outstanding stock of
ConnectNet, Inc. and Kivex, Inc. and certain assets of ConnecTen, L.L.C. for
cash.
Each of the acquisitions discussed above were accounted for using the
purchase method of accounting; accordingly, the net assets and results of
operations of the acquired companies have been included in the Company's
consolidated financial statements since the acquisition dates. The purchase
price of the acquisitions was allocated to assets acquired, including identified
intangible assets, and liabilities assumed, based on their respective estimated
fair values at acquisition. The Company's purchase price allocation of the
acquisitions made in 2000 is preliminary, subject to post-acquisition due
diligence of the acquired entities, and may be adjusted as additional
information is obtained.
The following presents the unaudited pro forma results of operations of the
Company for the three and six months ended June 30, 1999 as if the acquisition
of Kivex, Inc. had been consummated at the beginning of each of the periods
presented. The pro forma results of operations are prepared for comparative
purposes only and do not necessarily reflect the results that would have
occurred had the acquisition occurred at the beginning of the periods presented
or the results which may occur in the future. The pro forma results of
operations for CONNECTnet Internet Network Services, Inc., InterAccess Co.,
ConnecTen, L.L.C. and
6
<PAGE> 8
ALLEGIANCE TELECOM, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
ConnectNet, Inc. are not included in this table as the results would not have
been material to the Company's results of operations.
<TABLE>
<CAPTION>
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, 1999 JUNE 30, 1999
------------------ ----------------
<S> <C> <C>
Revenues........................................... $ 19,872 $ 31,660
Net loss before extraordinary items................ (51,423) (102,984)
Net loss applicable to common stock................ (51,423) (102,984)
Net loss per share, basic and diluted.............. (0.56) (1.23)
</TABLE>
4. PROPERTY AND EQUIPMENT
Property and equipment includes network equipment, leasehold improvements,
software, office equipment, furniture and fixtures, and
construction-in-progress. These assets are stated at cost, which includes direct
costs and capitalized interest and are depreciated over their respective useful
lives using the straight-line method. During the three months ended June 30,
2000 and 1999, $4,508 and $1,359, respectively, of interest expense related to
network construction-in-progress was capitalized. During the six months ended
June 30, 2000 and 1999, $7,032 and $2,450, respectively, of interest expense
related to network construction-in-progress was capitalized. Repair and
maintenance costs are expensed as incurred.
Property and equipment at June 30, 2000 and December 31, 1999, consisted of
the following:
<TABLE>
<CAPTION>
USEFUL
JUNE 30, DECEMBER 31, LIVES
2000 1999 (IN YEARS)
-------- ------------ ----------
<S> <C> <C> <C>
Network equipment.................................. $333,008 $266,727 5-7
Leasehold improvements............................. 55,449 52,980 5-10
Software........................................... 42,424 26,169 3
Office equipment and other......................... 16,813 11,073 2
Furniture and fixtures............................. 8,727 6,061 5
-------- --------
Property and equipment, in service................. 456,421 363,010
Less: Accumulated depreciation..................... (97,464) (58,113)
-------- --------
Property and equipment, in service,
net.................................... 358,957 304,897
Construction-in-progress........................... 190,412 72,516
-------- --------
Property and equipment, net.............. $549,369 $377,413
======== ========
</TABLE>
5. OTHER ASSETS
Other assets consisted of the following:
<TABLE>
<CAPTION>
JUNE 30, DECEMBER 31,
2000 1999
-------- ------------
<S> <C> <C>
Goodwill.................................................... $ 73,342 $34,211
Other acquired intangibles.................................. 15,111 5,705
Long-term deposits.......................................... 2,432 2,143
Other....................................................... 960 2,616
-------- -------
Total other assets.......................................... 91,845 44,675
Less: Accumulated amortization.............................. (14,108) (6,762)
-------- -------
Other assets, net................................. $ 77,737 $37,913
======== =======
</TABLE>
7
<PAGE> 9
ALLEGIANCE TELECOM, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Other acquired intangibles include acquired subscriber lists and acquired
workforces, which were obtained in connection with certain acquisitions made in
2000 and 1999. Goodwill and other acquired intangibles are being amortized over
their estimated useful lives of three years using the straight-line method.
6. ACCRUED LIABILITIES AND OTHER CURRENT LIABILITIES
Accrued liabilities and other current liabilities consisted of the
following:
<TABLE>
<CAPTION>
JUNE 30, DECEMBER 31,
2000 1999
-------- ------------
<S> <C> <C>
Accrued employee compensation and benefits.................. $ 8,411 $ 4,709
Accrued network expenses.................................... 14,241 7,896
Accrued taxes............................................... 5,309 3,823
Accrued interest expense.................................... 3,332 3,449
Other....................................................... 13,398 8,991
------- -------
Accrued liabilities and other current
liabilities..................................... $44,691 $28,868
======= =======
</TABLE>
7. LONG-TERM DEBT
Long-term debt consisted of the following:
<TABLE>
<CAPTION>
JUNE 30, DECEMBER 31,
2000 1999
-------- ------------
<S> <C> <C>
Series B 11 3/4% Notes, face amount $445,000 due February
15, 2008; effective interest rate of 12.21%; at accreted
value..................................................... $323,028 $304,393
12 7/8% Senior Notes, face amount $205,000 due May 15, 2008;
effective interest rate of 13.24%; at accreted value...... 201,397 201,259
Capital lease obligations................................... 11,684 8,780
-------- --------
Long-term debt.................................... $536,109 $514,432
======== ========
</TABLE>
Credit Facilities
In February 2000, the Company closed on $500 million of new senior secured
credit facilities (Credit Facilities), which replaced the existing $225 million
revolving credit facility. The Credit Facilities consist of a $350 million
seven-year revolving credit facility and a $150 million two-year delayed draw
term loan facility. The Credit Facilities will be available, subject to
satisfaction of certain terms and conditions, to provide financing for network
build-out, including the cost to develop, acquire and integrate the necessary
operations support and back office systems, as well as for additional dark fiber
purchases and central office collocations. Interest on amounts drawn is variable
based on the Company's leverage ratio and is initially expected to be the London
Interbank Offered Rate (LIBOR) plus 3.25%. The initial commitment fee on the
unused portion of the Credit Facilities will be 1.5% per annum, paid quarterly
and will be reduced based upon usage.
The Credit Facilities carry certain restrictive covenants that, among other
things, limit the ability of the Company to incur indebtedness, create liens,
engage in sale-leaseback transactions, pay dividends or make distributions in
respect of their capital stock, redeem capital stock, make investments or
certain other restricted payments, sell assets, issue or sell stock of certain
subsidiaries, engage in transactions with stockholders or affiliates, effect a
consolidation or merger and require the Company to maintain certain operating
and financial performance measures. The Company was in compliance with all such
restrictive covenants at June 30, 2000. No advances have been made to the
Company through the Credit Facilities as of June 30, 2000.
8
<PAGE> 10
ALLEGIANCE TELECOM, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Unamortized deferred debt issuance costs of $5,854 related to the $225
million revolving credit facility were expensed as additional interest expense
during first quarter 2000, upon termination of the $225 million revolving credit
facility and establishment of the Credit Facilities.
8. CAPITALIZATION
Common Stock
During the three and six months ended June 30, 2000, 17,011 and 48,946
shares of common stock were issued under the Company's Employee Stock Discount
Purchase Plan for proceeds of $901 and $1,954, respectively.
On February 2, 2000, the Company raised $693,000 of gross proceeds from the
sale of the Company's common stock. The Company sold 9,900,000 shares at a price
of $70 per share. Net proceeds from this offering were $665,562. On February 29,
2000, the underwriters of the offering exercised an option to purchase an
additional 803,109 shares of Common Stock, providing an additional $56,218 gross
proceeds and $54,113 net proceeds to the Company.
On February 28, 2000, a three-for-two stock split of the Company's common
stock was effected in the form of a 50% stock dividend to shareholders of record
on February 18, 2000. Par value remained unchanged at $.01 per share. All
references to the number of common shares and per share amounts have been
restated to reflect the stock split for all periods presented.
Warrants
During the three and six months ended June 30, 2000, 17,000 and 29,975
Warrants were exercised to purchase 37,203 and 65,592 shares of common stock,
respectively. Fractional shares are not issued; cash payments are made in lieu
thereof, according to the terms of the Warrant Agreement. At June 30, 2000 and
December 31, 1999, 158,886 and 188,861 Warrants, respectively, were outstanding.
9. COMMITMENTS AND CONTINGENCIES
In April 2000, the Company executed a procurement agreement with Lucent
Technologies, Inc. for a broad range of advanced telecommunications equipment,
software and services. This agreement contains a three-year $350 million
purchase commitment. The Company must complete purchases totaling $80 million by
December 31, 2000, an aggregate of $180 million of purchases by December 31,
2001, and the full $350 million of aggregate purchases on or before December 31,
2002. As of June 30, 2000, the Company has completed purchases totaling
approximately $50 million, and expects to meet the required purchase milestones
for the remainder of the procurement agreement. If the Company does not meet the
required intermediate purchase milestones, the Company will be required to
provide cash settlement in an amount equal to the shortfall. Such cash
settlements may be applied to future purchases during the commitment period. If
the Company does not purchase $350 million of products and services from Lucent
and its affiliates by December 31, 2002, the Company will be required to provide
cash settlement in an amount equal to the shortfall.
9
<PAGE> 11
ALLEGIANCE TELECOM, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
The Company has entered into various operating lease agreements, with
expirations through 2009, for office space, equipment and network facilities.
Future minimum lease obligations related to the Company's operating leases as of
June 30, 2000 are as follows:
<TABLE>
<S> <C>
2000....................................................... $ 6,701
2001....................................................... 12,974
2002....................................................... 12,739
2003....................................................... 11,721
2004....................................................... 10,401
2005....................................................... 10,637
Thereafter................................................. 24,356
</TABLE>
Total rent expense for the three months ended June 30, 2000 and 1999, and
the six months ended June 30, 2000 and 1999, was $3,842, $2,091, $7,215, and
$3,826, respectively.
During July, 2000, the Company entered into an operating lease for office
facilities for its corporate headquarters in Dallas, Texas. The lease for the
new facility has an initial term of approximately twelve years.
10. LOSS PER SHARE
The net loss per share amounts included on the condensed consolidated
statements of operations and the number of shares outstanding on the condensed
consolidated balance sheets reflect a 426.2953905 for-one stock split, which
occurred in connection with the initial public offering of common stock on July
7, 1998 and a three-for-two stock split which occurred on February 28, 2000. The
warrants, options and shares to be issued under the Employee Stock Discount
Purchase Plan are not included in the diluted net loss per share calculation as
the effect from the conversion would be antidilutive. The net loss applicable to
common stock includes the accretion of warrant values of $130 for the six months
ended June 30, 1999.
11. REVENUE RECOGNITION
In December 1999, the SEC issued Staff Accounting Bulletin No. 101,
"Revenue Recognition in Financial Statements," (SAB No. 101) which currently
must be adopted for the fourth quarter of 2000. SAB No. 101 provides additional
guidance on revenue recognition as well as criteria for when revenue is
generally realized and earned and also requires the deferral of incremental
costs. The Company is currently assessing the impact of SAB No. 101.
12. RELATED PARTIES
In connection with the Credit Facilities and the February 2, 2000 equity
offering, the Company incurred approximately $1,091 and $2,944, respectively in
fees to an affiliate of an investor in the Company.
10
<PAGE> 12
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
Allegiance Telecom, Inc. (Allegiance) is a leading competitive provider of
telecommunications services to small and medium-sized business, government and
other institutional users in major metropolitan areas across the United States.
Allegiance offers an integrated set of telecommunications services including
local, long distance, data and a full suite of Internet services. Our principal
competitors are incumbent local exchange carriers (ILECs), such as the regional
Bell operating companies and GTE Corporation operating units.
We are developing networks throughout the United States using what we refer
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, we install our own switch in each market but then lease other
elements of the network from the ILECs and others. The smart build strategy
specifically involves:
- 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
- installing, or physically locating, transmission equipment in these
central offices to route customer traffic through them to our switch.
Locating equipment at ILEC facilities, also known as "collocation," is
central to the success of the smart build strategy. By collocating, we have the
ability to lease, on a monthly or long-term basis, local loop and other network
elements owned by the ILEC. This enables us 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 us
to:
- accelerate market entry by nine to 18 months through eliminating or at
least deferring the need for city franchises, rights-of-way and building
access;
- reduce initial capital expenditures in each market, allowing us to focus
our 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;
- improve return on capital by generating revenue with a smaller capital
investment;
- defer a portion of capital expenditures for network assets to the time
when revenue generated by customer demand is available to finance such
expenditures; and
- address attractive service areas selectively throughout target markets
and not just in those areas where we have constructed fiber transmission
facilities.
We believe that the smart build approach allows us to reduce up-front
capital expenditures to approximately 25% of the total capital expenditures
required to develop such a network as compared with up-front capital
expenditures of approximately 50% under traditional build-out models. The level
of "up-front" capital required to be spent to develop a network will vary
depending on a number of factors. These factors include:
- the size and geography of the market;
- the cost of development of our network in each market;
- the degree of penetration of the market;
- the extent of price and service competition for telecommunications
services; regulatory and technological developments;
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- our ability to negotiate favorable prices for purchases of equipment; and
- the timing and extent of our acquisition of long-term rights to use
dedicated fiber in the market.
We initiated service by buying phone lines at wholesale prices and then
reselling them to customers in Dallas during December 1997. We began providing
service using our own switch and transmission equipment in April 1998 to
customers in New York City. Throughout the remainder of 1998, we initiated
facilities-based services in Atlanta, Boston, Chicago, Dallas, Fort Worth, Los
Angeles, Oakland and San Francisco. During 1999, we commenced operations in
Baltimore, Detroit, Houston, Long Island, Northern New Jersey, Orange County,
Philadelphia, San Diego, San Jose and Washington, D.C. During 2000, we commenced
operations in Denver (February 2000), St Louis (April 2000), Cleveland (May
2000), Seattle (June 2000), and Miami (June 2000).
Although we initiated resale of local services in Dallas in 1997, reselling
local service is not our core focus and comprises a small percentage of our
sales. We now generally resell local services in order to provide a
comprehensive telecommunications solution to a customer that has a need for
local services both within and outside of our markets. In these cases, we resell
services to those locations that are not within markets where we have
facilities. We also resell services in certain cases where customers require
services that we do not currently provide on a facilities basis or where we and
the customer desire to initiate service in advance of our provisioning of
facilities-based service to such customer. We earn significantly higher margins
by providing facilities-based services instead of resale services and our sales
teams have focused their efforts on selling services that require the use of our
facilities.
We acquire unused fiber capacity to which we add our own electronic
transmission equipment once traffic volume justifies this investment or other
factors make it attractive. This unused fiber is known as "dark fiber" because
no light is transmitted through it while it is unused. We believe that dark
fiber is readily available in most major markets. We are moving to the next
stage of our smart build strategy in most of our existing markets by acquiring
dark fiber capacity to connect many of the central offices at which we are
located. These dark fiber rings will replace the network elements that we are
leasing on a short-term basis from the ILECs and are expected to provide us with
higher operating margins and more reliable network services. We currently have
dark fiber rings in operation in Dallas, Houston and New York City, and we have
entered into contracts for dark fiber rings in an additional 16 metropolitan
markets, all of which are expected to be in operation before the end of 2000. We
have also contracted for similar long-term arrangements for long-haul fiber
routes connecting our Boston, New York City and Washington, D.C. networks.
The table below provides selected key operational data for the quarters
ended:
<TABLE>
<CAPTION>
JUNE 30, JUNE 30,
2000 1999
-------- --------
<S> <C> <C>
Markets served.............................................. 24 15
Number of switches deployed................................. 20 10
Central office collocations................................. 475 210
Addressable market -- business lines (in millions).......... 13.2 7.0
Lines sold.................................................. 122,800 55,800
Lines installed (cumulative)................................ 407,800 122,300
Sales force employees....................................... 1,115 552
Total employees............................................. 2,548 1,243
</TABLE>
Our business plan covers 36 of the largest metropolitan areas in the United
States. We believe we have successfully raised the projected capital required to
build our networks and operate in each of these markets to the point at which
operating cash flow from the market is sufficient to fund such market's
operating costs and capital expenditures.
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RESULTS OF OPERATIONS -- THREE AND SIX MONTHS ENDED JUNE 30, 2000 COMPARED WITH
THREE AND SIX MONTHS ENDED JUNE 30, 1999
During the second quarter of 2000 and 1999, we generated revenues of $63.0
million and $17.7 million, respectively. For the six months ended June 30, 2000
and 1999, we generated revenues of approximately $110.2 million and $27.7
million, respectively. For the three months ended June 30, 2000 and 1999, we
sold 122,800 lines and 55,800 lines, and installed 81,100 lines and 41,200
lines, respectively. Facilities-based lines represented 89% of all lines
installed as of June 30, 2000 as compared to 83% as of June 30, 1999.
Voice service revenues for the three months ended June 30, 2000 and 1999
were approximately $48.7 million and $16.6 million and for the six months ended
June 30, 2000 and 1999 were $83.4 million and $25.7 million, respectively. Voice
service revenues consisted of:
- the monthly recurring charge for basic service;
- usage-based charges for local and toll calls in certain markets;
- charges for services such as call waiting and call forwarding;
- certain non-recurring charges, such as charges for additional lines for
an existing customer; and
- interconnection revenues.
Interconnection revenues included in voice service revenues above,
comprised of access charge revenue and reciprocal compensation revenue,
accounted for $18.3 million and $8.1 million of our revenues for the three
months ended June 30, 2000 and 1999, and $35.6 million and $11.9 million of our
revenues for the six months ended June 30, 2000 and 1999.
We earn "access charge" revenue by connecting our voice service customers
to their selected long distance carriers for outbound calls or by delivering
inbound long distance traffic to our voice service customers. Our interstate
access charges were filed largely mirroring those used by the National Exchange
Carrier Association (NECA), an association of independent local exchange
carriers and our state access charges were generally set the same as those of
state associations similar to NECA or of individual ILECs operating in other
areas within the same state. These charges are generally higher than those
charged by the larger ILECs operating in the same areas because these large
ILECs have many more customers and therefore have lower per unit costs. Access
charges are intended to compensate the local exchange carrier for the costs
incurred in originating and terminating long distance calls on its network and
we believe our access charges are appropriately set at levels approximately the
same as those of the smaller ILECs. Access charge levels in general, and those
charged by CLECs in particular, are subject to various disputes and are under
review by the FCC.
Some interexchange carriers, including AT&T and Sprint, have challenged the
switched access rates of Allegiance and other CLECs and have withheld some or
all payments for the switched access services that they continue to receive.
AT&T and other interexchange carriers have asserted that they have not ordered
switched access service from us and/or that our charges for switched access
services are higher than those of the ILEC serving the same territory and are
therefore unjust and unreasonable. AT&T has refused to pay us any originating
access charges at our tariffed rates and other carriers are paying us less than
our tariffed rates. Given the uncertainty as to whether such amounts will
ultimately be paid to Allegiance by AT&T and Sprint, we recognize such access
revenues from these carriers only when realization of it is certain, which in
most cases is upon receipt of cash. On March 30, 2000, we filed a lawsuit
against each of AT&T and Sprint in the Federal District Court of the District of
Columbia requesting that such parties pay us for outstanding interstate and
intrastate access charges. AT&T and Sprint have filed counterclaims against us
alleging that our access charges fail to comply with the Telecom Act because
they are unjust and unreasonable. Although we believe we will ultimately receive
payment for AT&T and Sprint for the amounts owed to us, we cannot provide any
assurance as to the amount of payments that we will ultimately receive, the
actual outcome of the FCC proceedings or our lawsuits or the positions various
states will take on the similar issue of intrastate switched access rates. If we
do not receive payment from AT&T, Sprint or the other interexchange carriers for
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interstate and intrastate access charges that we believe are owed to us, this
will have a material adverse effect on us unless we are able to offset this
access revenue with other revenues. In addition, our switched access rates will
have to be adjusted to comply with future decisions of the FCC or state
commissions and these adjustments could have a material adverse effect on
Allegiance. For a more detailed discussion of these access charge issues, see
"Risk Factors" below.
We earn "reciprocal compensation" revenue by terminating on our network,
local calls that originate on another carrier's network. 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. A majority of our reciprocal compensation revenues
are from calls to our customers that are Internet service providers. Regulatory
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 and
could have a material adverse effect on Allegiance. Given the uncertainty as to
whether reciprocal compensation should be payable in connection with calls to
Internet service providers, we recognize such revenue only when realization of
it is certain, which in most cases is upon receipt of cash. In addition, we
anticipate that the per minute reciprocal compensation rate we receive from
ILECs under our new interconnection agreements will be lower than it was under
our previous agreements. These reductions in reciprocal compensation will have a
material adverse effect on us if we are unable to offset them with other
revenues. For a more detailed discussion of these reciprocal compensation
issues, see "Risk Factors" below.
Data revenues, including Internet access and high-speed data services, for
the three months ended June 30, 2000 and 1999 were approximately $12.2 million
and $0.6 million and for the six months ended June 30, 2000 and 1999 were
approximately $23.0 million and $0.8 million.
We are in the process of implementing plans to accelerate our Internet
access and other data revenue growth as well as our long distance revenue growth
as a means of offsetting any reduction in access charge revenue and reciprocal
compensation revenue that we may experience. We can provide no assurances,
however, that these efforts will be successful.
Long distance revenues for the second quarter of 2000 and 1999 were
approximately $2.1 million and $0.3 million, and for the six months ended June
30, 2000 and 1999 were approximately $3.8 million and $0.8 million,
respectively.
We are using the purchase method of accounting for the acquisitions of the
common stock of InterAccess Co., CONNECTNet Internet Network Services, Inc.,
Kivex, Inc. and ConnectNet, Inc. and the acquisition of certain assets of
ConnecTen, L.L.C. We have recognized the revenues earned since the closing of
each of these acquisitions in our condensed consolidated statement of operations
for the period ended June 30, 2000. We have had discussions, and will continue
to have discussions in the foreseeable future, concerning other potential
acquisitions of Internet service providers and other providers of
telecommunications and Internet services.
The systems that have historically been used to switch customers from their
existing carrier to Allegiance and to begin providing them service generally
required multiple entries of customer information by hand and were exchanged by
fax with the ILEC. In January 1999, we announced that we had successfully
achieved "electronic bonding" between our operations support systems and those
of Bell Atlantic in the New York City market with respect to processing local
service orders. Electronic bonding is a method by 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
which we must use in the absence of electronic bonding is not only labor
intensive, but also creates numerous opportunities for:
- errors in providing new service and billing;
- service interruptions;
- poor customer service; and
- increased customer turnover.
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These problems create added expenses and decrease customer satisfaction.
Without electronic bonding, confirmation of receipt and installation of orders
has taken from between 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.
In addition to Bell Atlantic in New York City, we are now electronically
bonding with Bell Atlantic in Boston and Long Island and with Southwestern Bell
in Dallas, Fort Worth and Houston. Testing with SBC Communications (SBC) and
Pacific Bell in California was completed during the third quarter 1999 on the
electronic data interface which is now in use there. Local service requests for
all Texas and California markets are now processed electronically with SBC.
During the second quarter 2000, we completed electronic bonding testing with
Ameritech and Bell South, and currently we are processing data for local service
requests electronically with these carriers. We are currently testing electronic
bonding with Bell Atlantic in their southern region and expect to begin sending
production orders during third quarter 2000. We plan on testing electronic
bonding with US West in the fourth quarter 2000. We are also working towards the
electronic bonding of that portion of the billing process in which we gather
customer specific information, including their current service options, and the
process of identifying and resolving customer service problems. These additional
"electronic bonding" initiatives will require additional capital expenditures
and should result in additional efficiencies.
For the quarters ended June 30, 2000 and 1999, network expenses were $34.6
million and $12.7 million, respectively. For the six months ended June 30, 2000
and 1999, network expenses were $61.7 million and $20.3 million, respectively.
The increase in network expenses is consistent with the deployment of our
networks and initiation and growth of our services during 2000 and 1999. Network
expenses included:
- the cost of leasing high-capacity digital lines that interconnect our
network with ILEC networks;
- the cost of leasing high-capacity digital lines that connect our
switching equipment to our transmission equipment located in ILEC central
offices;
- the cost of leasing local loop lines which connect our customers to our
network;
- the cost of completing local and long distance calls originated by our
customers;
- the cost of leasing space in ILEC central offices for collocating our
transmission equipment; and
- the cost of leasing our 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. We believe that in many instances there are
multiple carriers in addition to the ILEC from whom we can lease high-capacity
lines, and that we can generally lease those lines at lower prices than are
charged by the ILEC. We expect that the costs associated with these leases will
increase with customer volume and will be a significant part of our ongoing cost
of services. The cost of leasing switch sites is also a significant part of our
ongoing cost of services.
On July 19, 2000, in a decision on remand from the Supreme Court, the
United States Court of Appeals for the Eighth Circuit vacated certain of the
FCC's total element long run incremental (TELRIC) pricing rules. While
sustaining the FCC's use of a forward-looking incremental cost methodology to
set rates for interconnection and unbundled network elements, the Court rejected
the FCC's conclusion that the costs should be based on the use of the most
efficient technology currently available and the lowest cost network
configuration. Instead, the Court stated that the statute required that costs be
based on the use of the incumbent local exchange carrier's existing facilities
and actual network equipment but that these costs should not be based on the
historic costs actually paid by such carrier for network elements. The Court
also found that the FCC erred in using avoidable, rather than actually avoided,
costs to calculate the wholesale discount for resale products. Interconnection
and unbundled network element rates set using the Court's methodology may be
higher than and the wholesale discounts set using the Court's methodology may be
lower than the comparable rates established using the FCC's methodology. It is
difficult to evaluate the potential impact of this ruling on the prices
Allegiance pays ILECs for unbundled network elements because the impact depends
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primarily on how state commissions interpret the ruling. Allegiance believes
that the pricing of unbundled network elements approved by many state
commissions and reflected in many of Allegiance's interconnection agreements is
already materially in compliance with the standard set forth in this ruling.
This ruling could have a material adverse effect on Allegiance, however, if it
is interpreted to authorize materially higher charges for unbundled network
elements than those prevailing in Allegiance's current interconnection
agreements.
In constructing switching and transmission equipment for a new market, we
capitalize as a component of property and equipment only the non-recurring
charges associated with our 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 generally expense the monthly 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.
We incur "reciprocal compensation" costs in providing both voice and data
services and expect reciprocal compensation costs to be a major portion of our
cost of services. We must enter into an interconnection agreement with the ILEC
in each market to make widespread calling available to our 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 other carrier's network. These reciprocal
compensation costs will grow as our customers' outbound calling volume grows.
The cost of securing long distance service capacity is a variable cost that
increases in direct relationship to increases in our customer base and their
long distance calling volumes. We believe that these costs, measured as a
percentage of long distance revenues, will be relatively consistent from period
to period. However, we do expect period over period growth in the absolute cost
of such capacity, and that the cost of long distance capacity will be a
significant portion of our cost of long distance services. We have entered into
one resale agreement with a long distance carrier to provide Allegiance with the
ability to provide our customers with long distance service. We expect 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. Our
existing resale agreement, however, does not contain a minimum volume
commitment. If we agree to minimum volume commitments and fail to meet them, we
may be obligated to pay underutilization charges. Under most of these types of
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.
We have developed a national Internet data network by connecting our
markets with leased high-capacity digital lines. The costs of these lines will
increase as we increase capacity to address customer demand, open new markets
and connect additional markets to our Internet network.
Selling, general and administrative expenses increased to $56.7 million in
the second quarter of 2000 from $30.7 million in the second quarter of 1999
primarily due to the growth of our business. On a year-to-date basis, selling,
general, and administrative expenses increased to $104.7 million for the six
months ended June 30, 2000 from $58.2 million for the six months ended June 30,
1999. Selling, general and administrative expenses include salaries and related
personnel costs, facilities costs and legal and professional fees. The number of
employees increased to 2,548 as of June 30, 2000, from 1,243 as of June 30,
1999. As of June 30, 2000, the sales force, including sales managers and sales
administrators, had grown to 1,115 from 552 as of June 30, 1999. As we continue
to grow in terms of number of customers and call volume, we expect that ongoing
expenses for customer care and billing will increase.
We amortized $2.2 million and $4.6 million of the deferred management
ownership allocation charge, a non-cash charge to income, for the three and six
months ended June 2000, respectively. The same charge for the three and six
months ended June 30, 1999 was $5.5 million and $11.3 million, respectively. Our
original private equity fund investors and 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 our outstanding capital
stock prior to our initial public offering of common stock. As a result of that
offering, the assets of
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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 would be 66.7% and 33.3%, respectively, based upon the
valuation implied by the initial public offering. We 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. This transaction was
recorded during the third quarter of 1998. 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 will further
amortize this deferred charge at $2.0 million and $0.1 million during the
remainder of 2000 and 2001, respectively. This period is the time frame over
which we have the right to repurchase a portion 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 Allegiance is terminated. During the first
quarter of 2000, we repurchased 289,527 shares from terminated management
employees, and reversed the remaining deferred charge of $0.1 million related to
these shares to additional paid-in capital. During 1999, we repurchased 37,968
shares from terminated management employees, and reversed the remaining deferred
charge of $0.6 million related to these shares to additional paid-in capital.
For the three months ended June 30, 2000 and 1999, we recognized $2.0 million
and $2.0 million of amortization of deferred compensation expense, and for the
six months ended June 30, 2000 and 1999, we recognized $4.0 million and $3.8
million of amortization of deferred compensation expense, respectively. Such
deferred compensation was recorded in connection with membership units of
Allegiance Telecom, LLC sold to certain management employees and options granted
to employees under our 1997 Stock Option Plan and 1998 Stock Incentive Plan.
During the second quarter 2000 and 1999, we recorded depreciation and
amortization of property and equipment of $21.4 million and $9.9 million,
respectively. For the six months ended June 30, 2000 and 1999, depreciation and
amortization expense was $39.4 million and $17.1 million, respectively. Such
increase was consistent with the deployment of our networks and initiation of
services in 24 markets by June 30, 2000.
In connection with the acquisitions completed during 2000 and 1999, we
assigned an aggregate of $15.1 million of the purchase price to customer lists
and workforces. We also recorded an aggregate of $73.3 million of goodwill. Each
of these intangible assets is being amortized over their estimated useful lives
of three years, beginning at their respective date of the acquisition. For the
second quarter 2000 and 1999, we recorded $3.4 million and $0.1 million of
amortization for goodwill and $0.6 million and $0.1 million of amortization of
customer list and workforces, respectively. For the six months ending June 30,
2000 and 1999, we recorded $6.2 million and $0.1 million of amortization for
goodwill and $1.1 million and $0.1 million of amortization of customer list and
workforces, respectively. Our purchase price allocation of the acquisitions made
in 2000 is preliminary, subject to post acquisition due diligence of the
acquired entities, and may be adjusted as additional information is obtained.
For the three months ended June 30, 2000 and 1999, and for the six months
ended June 30, 2000 and 1999, interest expense was $15.3 million $15.2 million,
$36.3 million and $29.5 million, respectively. Interest expense reflects the
accretion of the 11 3/4% notes and related amortization of the original issue
discount, and the amortization of the original issue discount on the 12 7/8%
notes. Interest expense in 2000 also includes amortization of deferred debt
issuance costs related to the new $500 million Senior Secured Credit Facilities
(Credit Facilities). Unamortized deferred debt issuance costs of $5.9 million
related to the $225 million revolving credit facility were charged to interest
expense during first quarter 2000, upon termination of the $225 million
revolving credit facility and completion of the $500 million Credit Facilities.
The amount of interest capitalized for the three and six months ended June 30,
2000 was $4.5 million and $7.0 million, respectively. For the same periods in
1999, the amounts were $1.4 million and $2.5 million, respectively. Interest
income for the three and six months ended June 30, 2000 was $16.4 million and
$29.9 million, respectively. Interest income for the three and six months ended
June 30, 1999 was $9.0 million and $14.3 million, respectively. Interest income
results from the investment of cash and from U.S. government securities, which
we purchased and placed in a pledge account to secure the semiannual payments of
interest through May 2001 on the 12 7/8% notes. Interest income during 2000 is
greater than for the comparable periods
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in 1999 because we had additional cash invested in interest-bearing instruments
as a result of our February 2000 equity offering.
From February 1998 through March 1999, we recorded accretion of our
redeemable warrants to reflect the possibility that they would be redeemed at
fair market value in February 2008. Amounts were accreted using the effective
interest method and management's estimate of the future fair market value of
such warrants at the time redemption is permitted. Amounts accreted increased
the recorded value of such warrants on the balance sheet and resulted in
non-cash charges to increase the net loss applicable to common stock. As the
terms and conditions of the Warrant Agreement do not specify a date certain for
redemption of the warrants and the exchange of warrants for cash is no longer
beyond the control of management, we have ceased accretion of the warrants and
reclassified the accreted value of the redeemable warrants at April 1, 1999 to
the stockholders' equity section. If a repurchase event occurs in the future or
becomes probable, we will adjust the warrants to the estimated redemption value
at that time.
Our net loss for the second quarter of 2000, after amortization of the
non-cash management ownership allocation charge and amortization of deferred
compensation, was $56.7 million, and it was $118.0 million for the six months
ended June 30, 2000. Our net loss for the second quarter of 1999, after
amortization of the non-cash management ownership allocation charge and
amortization of deferred compensation but before the accretion of warrant
values, was $49.3 million and it was $98.3 million for the six months ended June
30, 1999. After deducting accretion of redeemable warrant values, the net loss
applicable to common stock was $98.4 million for the six months ended June 30,
1999.
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 measuring the performance of a company. EBITDA is not
derived pursuant to generally accepted accounting principles (GAAP), and
therefore should not be construed as an alternative to operating income, as an
alternative to cash flows from operating activities, or as a measure of
liquidity. We had EBITDA losses of $28.3 million and $56.2 million for the three
months and six months ended June 30, 2000, respectively. For the three and six
months ended June 30, 1999, we had EBITDA losses of $25.6 million and $50.9
million. In calculating EBITDA, we also exclude the non-cash charges to
operations for the management ownership allocation charge and deferred
compensation expense totaling $4.2 million and $8.6 million for the three and
six months ended June 30, 2000 and $7.5 million and $15.1 million for the three
and six months ended June 30, 1999.
We expect to continue to experience operating losses and negative EBITDA as
a result of our development and market expansion activities. We typically do not
expect to achieve positive EBITDA in any market until at least its third year of
operation.
LIQUIDITY AND CAPITAL RESOURCES
Our financing plan is predicated on the pre-funding of each market's
expansion to positive free cash flow. By using this approach, we avoid being in
the position of seeking additional capital to fund a market after we have
already made a 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.
On January 3, 2000, we announced a significant expansion of our business
plan to include a total of 36 target markets and which:
- includes an increase in our collocation footprint by approximately 100
central offices in our initial 24 target markets; and
- provides for the acquisition of dark fiber capacity in an additional 16
of our target markets as well as in the Boston -- New York -- Washington,
D.C. corridor.
We do not begin to develop a new market until we have raised the capital
that we project to be necessary to build and operate our network in the market
to the point at which operating cash flow from the market is
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sufficient to fund such market's ongoing operating costs and capital
expenditures. All of our 36 target markets are now fully funded in this manner.
We may decide to seek additional capital in the future to expand our
business. Sources of additional financing may include vendor financing and/or
the private or public sale of our equity or debt securities. We cannot assure
you, however, that such financing will be available at all or on terms
acceptable to us, or that our estimate of additional funds required is accurate.
The actual amount and timing of future capital requirements may differ
materially from our estimates as a result of, among other things:
- the cost of the development of our networks in each of our markets;
- a change in or inaccuracy of our development plans or projections that
leads to an alteration in the schedule or targets of our roll-out plan;
- the extent of price and service competition for telecommunications
services in our markets;
- the demand for our services;
- regulatory and technological developments, including additional market
developments and new opportunities in our industry;
- an inability to borrow under our new credit facilities; and
- the consummation of acquisitions.
Our cost of rolling out our networks and operating our business, as well as
our revenues, will depend on a variety of factors, including:
- our ability to meet our roll-out schedules;
- our ability to negotiate favorable prices for purchases of equipment;
- our ability to develop, acquire and integrate the necessary operations
support systems and other back office systems;
- the number of customers and the services for which they subscribe;
- the nature and penetration of new services that we may offer; and
- 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 our future
capital requirements.
For the quarter ended June 30, 2000 and 1999, we made capital expenditures
of $99.6 million and $73.8 million, respectively. For the six months ended June
30, 2000 and 1999, we made capital expenditures of $202.2 million and $152.3
million, respectively. We also used capital during these periods to fund our
operations. Excess cash was used to purchase short-term investments and money
market investments. As of June 30, 2000, we had transmission equipment
collocated in 475 ILEC central offices.
In April 2000, we executed a procurement agreement with Lucent
Technologies, Inc. for a broad range of advanced telecommunications equipment,
software and services. This agreement contains a three-year $350 million
purchase commitment. We must complete purchases totaling $80 million by December
31, 2000, an aggregate of $180 million of purchases by December 31, 2001, and
the full $350 million of aggregate purchases on or before December 31, 2002. If
we do not meet the required intermediate purchase milestones, we will be
required to provide cash settlement in an amount equal to the shortfall. Such
payments may be applied to future purchases during the commitment period. If we
do not purchase $350 million of products and services from Lucent and its
affiliates by December 31, 2002, we will be required to provide cash settlement
in an amount equal to the shortfall. As of June 30, 2000, we have completed
purchases totaling approximately $50 million, and we expect to be able to meet
the required purchase milestones for the remainder of the purchase agreement.
Pursuant to our expanded business plan, we expect to incur approximately $440.0
million
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of capital expenditures in 2000 (which amount includes the Lucent capital
expenditures of $80 million in 2000).
As of June 30, 2000, we had approximately $962.5 million of cash and
short-term investments. In addition, $25.6 million of restricted U.S. government
securities have been placed in a pledge account to fund interest payments on our
12 7/8% notes through May 2001.
On February 28, 2000, a three-for-two stock split of our common stock was
effected in the form of a 50% dividend to shareholders of record on February 18,
2000. All references to the number of common shares and per share amounts have
been restated to reflect the stock split for the periods presented.
On February 3, 1998, we 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. Net proceeds of approximately $240.7 million
were received from that offering. The 11 3/4% notes have a principal amount at
maturity of $445.0 million and an effective interest rate of 12.21%. 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 June 30, 2000 to February 15, 2003 of $122.0 million.
We completed the initial public offering of our common stock and the
offering of the 12 7/8% notes early in the third quarter of 1998. We raised net
proceeds of approximately $137.8 million from our initial public offering of
common stock and approximately $124.8 million from the offering of these notes.
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. The
accretion of original issue discount will cause an increase in indebtedness from
June 30, 2000 to May 15, 2008 of $3.6 million. In connection with the sale of
the 12 7/8% notes, we 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 June 30, 2000, at an accreted value of approximately
$25.6 million, which is classified as a current asset.
On April 20, 1999, we completed the public offering of 17,739,000 shares of
our common stock at a price of $25.33 per share, raising gross proceeds of
$449.4 million. After underwriters' fees and other expenses, we realized net
proceeds of approximately $430.3 million. On April 28, 1999, the underwriters of
this offering exercised an option to purchase an additional 3,302,100 shares of
common stock at the same price per share. As a result, we raised an additional
$83.6 million of gross proceeds and $80.3 million of net proceeds, at that time.
On February 2, 2000, we completed the public offering of 9,900,000 shares
of our common stock at a price of $70.00 per share, raising gross proceeds of
$693.0 million. After underwriters' fees and other expenses, we realized net
proceeds of approximately $665.6 million. On February 29, 2000, the underwriters
of this offering exercised an option to purchase an additional 803,109 shares of
common stock at the same price per share. As a result, we raised an additional
$56.2 million of gross proceeds and $54.1 million of net proceeds.
In February 2000, we closed on $500.0 million of new Credit Facilities,
which replaced the $225 million revolving credit facility. The Credit Facilities
consist of a $350.0 million revolving credit facility and a $150.0 million
delayed draw term loan facility. The Credit Facilities are available, subject to
satisfaction of certain terms and conditions, to provide purchase money
financing for network build-out, including the cost to develop, acquire and
integrate the necessary operations support and back office systems, as well as
for additional dark fiber purchases and central office collocations. Interest on
amounts drawn is variable, based on leverage ratios, and is expected to be the
London Interbank Offered Rate + 3.25%. The initial commitment fee on the unused
portion of the Credit Facilities will be 1.5% per annum, paid quarterly and will
be reduced based upon usage. The Credit Facilities contain certain
representations, warranties, covenants and events of default customary for
credit of this nature and otherwise agreed upon by the parties.
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In July 2000, we entered into an operating lease for office facilities for
our corporate headquarters in Dallas, Texas. The lease for the new office
facility has an initial term of approximately twelve years.
We believe that the our current capital resources are sufficient to fund
operating expenses, capital expenditures, and debt service requirements.
FORWARD-LOOKING STATEMENTS
Certain statements in this Management's Discussion and Analysis of
Financial Condition and Results of Operations constitute "forward-looking
statements" within the meaning of Section 27A of the Securities Act of 1933, as
amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and
Allegiance intends that such forward-looking statements be subject to the safe
harbors created thereby. You generally can identify these statements by our use
of forward-looking words such as "plans," "estimates," "believes," "expects,"
"may," "will," "shall," "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 and
statements regarding the development of our businesses, the markets for our
services and products, our anticipated capital expenditures, operations support
systems or 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: (1) successfully market our services to current and new
customers; (2) interconnect with and develop cooperative working relationships
with ILECs; (3) develop efficient operations support systems and other back
office systems; (4) successfully and efficiently transfer new customers to our
networks and access new geographic markets; (5) identify, finance and complete
suitable acquisitions; (6) borrow under our credit facilities or borrow under
alternative financing sources; (7) install new switching facilities and other
network equipment; (8) electronically bond with ILECs; (9) obtain leased fiber
optic line capacity, rights-of-way, building access rights and any required
governmental authorizations, franchises and permits; and (10) collect
interexchange access and reciprocal compensation charges at the rates charged by
us. 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 represent management's view only as of the dates we
make them.
RISK FACTORS
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. Reciprocal
compensation represents a material portion of our revenues. A majority of these
revenues are from calls to Internet service providers. 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. The
reciprocal compensation rules do 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
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agreements. The Court of Appeals for the District of Columbia Circuit issued a
decision on March 24, 2000, vacating the Declaratory Ruling. The court held that
the FCC had not adequately explained its conclusion that calls to Internet
service providers should not be treated as "local" traffic. Allegiance views
this decision as favorable, but the court's direction to the FCC to re-examine
the issue will likely result in further delay in the resolution of pending
compensation disputes, and there can be no assurance as to the ultimate outcome
of these proceedings or as to the timing of such outcome. Currently, over 30
state commissions and several federal and state courts have ruled that
reciprocal compensation arrangements do apply to calls to Internet service
providers, while five jurisdictions have ruled to the contrary. A number of
these rulings are subject to appeal. Additional disputes over the appropriate
treatment of Internet service provider traffic are pending in other states and
federal legislation seeking to resolve this issue has been and continues to be
proposed and considered.
In addition, we anticipate that the per minute reciprocal compensation rate
we receive from ILECs under our new interconnection agreements will be lower
than it was under our previous agreements. These reductions in reciprocal
compensation will have a material adverse effect on us if we are unable to
offset them with other revenues.
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 the long distance service
providers who originate or terminate calls on our local network. 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.
On July 5, 1999, the FCC issued a ruling to address this issue in the
context of a complaint filed by MGC Communications, Inc. (now known as Mpower
Communications), a CLEC that had not been receiving payments from AT&T. In that
ruling, the FCC stated that "AT&T is liable to MGC, at MGC's tariffed rate, for
the originating access service that it received . . ." The FCC indicated that
AT&T had no obligation to purchase access from MGC based on the arguments that
MGC had made, but the FCC also made clear that there may be other requirements
that could limit AT&T's ability to not purchase such access from a CLEC. In
response to that FCC decision, AT&T filed a Petition for Review with the FCC,
which was denied on December 28, 1999. The FCC is also reviewing the switched
access rate level issue and related matters in its Access Charge Reform docket.
In this docket, the FCC has requested comment as to whether interexchange
carriers may refuse to purchase switched access services from particular
carriers. Allegiance is an active participant in that proceeding.
On May 31, 2000, the FCC approved a proposal made by a coalition of the
largest ILECs, AT&T and Sprint to restructure interstate access charges.
Pursuant to the proposal, price cap ILECs are required to reduce their
interstate access rates to targeted levels approved by the FCC or submit cost
studies to justify different rates. We anticipate that implementation of the
FCC's decision will lead to an industry wide reduction in interstate access
rates, even by those carriers that are not bound by the decision, including
smaller ILECs and CLECs. Reduction in interstate access rates will have a
material adverse effect on Allegiance unless we are able to offset the access
revenue with other revenues.
Several states, including Colorado, Maryland, Massachusetts, Missouri, New
Jersey, New York, Texas, Virginia and Washington, have proposed or required that
CLEC access charges be limited to those charged by ILECs operating in the same
area as the CLEC with respect to calls originating or terminating in such area,
except where the CLEC in question can establish that its costs justify a higher
access rate through a formal cost proceeding. We believe that it is possible
that other states will enact similar requirements. We also
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believe, however, that it is more likely that many states will use the same
approach for intrastate long distance as the FCC ultimately decides to use for
interstate long distance.
In light of the FCC's decision in the MGC/AT&T proceeding and the support
ILECs, including the large ILECs, have generally given to the principle that
interexchange carriers should not be permitted to refuse to purchase switched
access services from particular carriers, we believe that we will ultimately
receive payment owed to us from AT&T, Sprint and any other interexchange carrier
that withholds payment for switched access services that we provide. We cannot
provide any assurance, however, as to the amount of payments that we will
ultimately receive, the actual outcome of the FCC proceedings or our lawsuits or
the positions various states will take on the similar issue of intrastate
switched access rates. If we do not receive payment from AT&T, Sprint or the
other interexchange carriers for interstate and intrastate access charges that
we believe are owed to us, this will have a material adverse effect on us if we
are unable to offset this access revenue with other revenues. In addition, our
switched access rates will have to be adjusted to comply with future decisions
of the FCC or state commissions and these adjustments could have a material
adverse effect on Allegiance.
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 that you can use to evaluate our performance and determine
whether you should invest in our common stock.
If We Do Not Effectively Manage Rapid Expansion of Our Business, Our
Financial Condition Will Suffer
We are rapidly expanding our operations and providing bundled
telecommunications services on a widespread basis. This continued rapid
expansion may 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:
- we have and will likely continue to have difficulties in getting products
and services from our vendors delivered in a timely and effective manner,
at acceptable costs and at the service and performance level required;
- we may fail to adequately identify all of our information and processing
needs;
- our processing or information systems may fail or be inadequate;
- we may not be able to effectively integrate such products or services;
- we may fail to upgrade systems as necessary; and
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- third party vendors may cancel or fail to renew license agreements that
relate to these systems.
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 believe that the borrowings expected to be available under our
credit facilities, together with our cash on hand, will be sufficient to
pre-fund our expanded business plan. However, we will only be able to borrow
under these credit facilities if we are in compliance with the financial
covenants and other conditions. In the event we cannot borrow under these credit
facilities, 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.
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.
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 expanded business plan, including under
our credit facilities that closed in February 2000. On June 30, 2000, we had
$536.1 million of outstanding indebtedness and $1,085.3 million of stockholders'
equity.
This level of debt could:
- impair our ability to obtain additional financing for working capital,
capital expenditures, acquisitions or general corporate purposes;
- 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;
- place us at a competitive disadvantage with those of our competitors who
do not have as much debt as we do;
- impair our ability to adjust rapidly to changing market conditions; and
- make us more vulnerable if there is a downturn in general economic
conditions or in our business.
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 our credit facilities contain covenants that restrict
our ability to:
- incur additional indebtedness;
- pay dividends and make other distributions;
- prepay subordinated indebtedness;
- make investments and other restricted payments;
- enter into sale and leaseback transactions;
- create liens;
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- sell assets; and
- engage in certain transactions with affiliates.
Our current and future financing arrangements contain and will continue to
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 current and 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 or meet our 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 Financing Agreements
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.
Our credit facilities provides that upon a change of control, we may be required
to repay all of our obligations under these credit facilities. It is possible
that we will not have sufficient funds at that time to repurchase our notes or
repay any debt outstanding under our credit facilities.
If We Do Not Interconnect with and Maintain Efficient Working Relationships
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 FCC recently granted approval to
Bell Atlantic to provide in-region long distance service in New York and to SBC
Communications to provide in-region long distance service in Texas. Other
regional Bell operating companies in our markets may petition and receive
approval from 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 or
a regional Bell operating company otherwise fails to meet our requirements, for
example, because of labor shortages, work stoppages or disruption caused by
mergers or other organizational changes, our ability to offer local services in
such region on a timely and cost-effective basis will be adversely affected.
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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. Although we currently have peering arrangements, we
cannot assure you that we will be able to negotiate "peer" status 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
We offer long distance services as part of our "one-stop shopping" offering
of bundled telecommunications services to our customers. 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.
The Need to Move from Tariffs to Individual Contracts for Domestic
Interstate Long Distance Services May Increase Our Costs.
In a decision issued April 28, 2000, the United States Court of Appeals for
the District of Columbia affirmed the FCC's 1996 order that prohibits the filing
of tariffs for domestic interstate long distance service. The FCC's order, which
had been stayed by the Court pending its decision, goes into effect on January
31, 2001, as of which date carriers must cancel all interstate domestic long
distance tariffs on file with the FCC and file no new tariffs for such service.
Although the FCC will not accept interstate long distance tariffs for filing
after January 31, 2001, carriers will still be required to maintain and make
available to the public upon request the rates, terms and conditions applicable
to their domestic long distance services. In the absence of retail tariffs,
Allegiance will be required to memorialize its legal relationship with its long
distance customers by some other means, such as individual contracts setting
forth the rates, terms and conditions of service. Negotiating individual
contracts in this manner is likely to increase our cost of providing domestic
interstate long distance services.
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
ILEC serving that area. These ILECs 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
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and state regulatory authorities. FCC and state administrative decisions and
initiatives provide the incumbent local exchange carriers with pricing
flexibility for their:
- private lines, which are private, dedicated telecommunications
connections between customers;
- special access services, which are dedicated lines from a customer to a
long distance company provided by the local phone company; and
- 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 recently
approved incumbent local exchange carriers increased pricing flexibility and
deregulation for such access services 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 CLECs,
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.
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. The FCC has recently granted approval to provide in-region long
distance service to Bell Atlantic in New York and to SBC Communications in
Texas, and other regional Bell operating companies may petition and be granted
such approval in the future. 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.
The Internet services market is highly competitive and there are limited
barriers to entry. We expect that competition will continue to intensify. Our
competitors in this market include Internet service providers, other
telecommunications companies, online service providers and Internet software
providers. Most of the regional Bell operating companies and GTE Corporation
operating units have announced plans to rapidly roll out DSL services. Some of
these entities, including SBC Communications, US West and Bell Atlantic, have
already commenced deployment of DSL services in selected markets and may in the
future deploy DSL services on a widespread basis.
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<PAGE> 29
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 tariffs detailing our services and pricing with the FCC
for both international and domestic long-distance services. As noted above, as
of January 31, 2001, we will be prohibited from filing tariffs with the FCC for
domestic interstate long distance service and will be required to cancel any
such tariffs on file as of that date. There is no change in our obligation to
file tariffs with the FCC for international 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 ongoing 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.
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. On November 5, 1999, the FCC released an
order revising its unbundled network element rules to conform to the Supreme
Court's
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<PAGE> 30
interpretation of the law, and reaffirmed the availability of the basic network
elements, such as loops and dedicated transport, used by Allegiance. It is
likely that this order may be subject to further agency reconsideration and/or
court review. While these court and FCC 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 any of these
agreements will be so renegotiated or whether Allegiance will be able to obtain
renewal of these agreements on favorable terms when they expire.
A recent decision of the United States Court of Appeals for the Eighth
Circuit vacated and remanded to the FCC certain of the FCC's total element long
run incremental cost (TELRIC) rules that are used to set cost-based rates for
unbundled network elements. This ruling could have a material adverse effect on
Allegiance to the extent that it is interpreted to authorize materially higher
rates than Allegiance is now paying for unbundled network elements.
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 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. In addition, Vulcan Ventures recently purchased six
million shares (as adjusted for our 3-for-2 stock split effected on February 28,
2000) of our common stock from existing stockholders and in connection with that
transaction, Allegiance agreed to nominate two Vulcan Ventures designated
directors to Allegiance's board. As a result of these relationships, 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.
Future Sales of Our Stock by Existing Stockholders May Adversely Affect Our
Stock Price
As of August 4, 2000, we had 108,864,633 million shares of common stock
outstanding. Many of these shares are "restricted securities" under the federal
securities laws, and 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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<PAGE> 31
If We Become 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 and these will
increase if we borrow funds under our credit facilities. This may result in
Allegiance being treated 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 and are
not primarily engaged in businesses other than investing, reinvesting, owning,
holding or trading securities.
Allegiance believes that it 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 the law, we
are currently working with the SEC to obtain confirmation that we are not
subject to Investment Company Act requirements for investment companies.
If we were required to register as an investment company under the 1940
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 seek an extension of the effectiveness of our exemption from the SEC or
we may have to invest a portion of our liquid assets in cash and demand deposits
instead of securities. The extent to which we will have to do so will depend on
the composition and value of our total assets on June 8, 2000. 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.
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<PAGE> 32
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our investment policy is limited by our existing bond indentures. We are
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.
We are thus exposed to market risk related to changes in short-term U.S.
interest rates. We manage these risks by closely monitoring market rates and the
duration of our investments. We do not enter into financial or commodity
investments for speculation or trading purposes and are not a party to any
financial or commodity derivatives.
Interest income earned on our investment portfolio is affected by changes
in short-term interest rates. We believe that we are not exposed to significant
changes in fair value because of our conservative investment strategy. However,
the estimated interest income for 2000, based on the estimated average 1999
earned rate on investments is $47.8 million. Assuming a 100 basis point drop in
the estimated average rate, we would be exposed to a $9.5 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
2000 2000 2000 2000 TOTAL
------ -------- --------- -------- -----
(DOLLARS IN MILLIONS)
<S> <C> <C> <C> <C> <C>
Estimated average investments.............. $821.3 $1,039.6 $988.2 $905.5 N/A
Estimated average interest earned at the
estimated average rate of 5.1% for the
year ended December 31, 1999............. $ 10.5 $ 13.3 $ 12.5 $ 11.5 $47.8
Estimated impact of interest rate drop..... $ 2.1 $ 2.6 $ 2.5 $ 2.3 $ 9.5
</TABLE>
Our outstanding long-term debt consists principally of long-term, fixed
rate notes, not subject to interest rate fluctuations.
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<PAGE> 33
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Not applicable.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
Not applicable.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
Not applicable.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
(a) The 2000 annual meeting of stockholders was held on May 10, 2000. The
number of shares of common stock present at the annual meeting in person or by
proxy and voting and withholding authority to vote in the election of directors
was 102,279,900 or 94.5% of the common stock of Allegiance outstanding on April
5, 2000, the record date for the annual meeting.
(b) The following nominees, having received the FOR votes set opposite
their respective names, constituting a plurality of the votes cast at the annual
meeting for the election of directors, were elected directors of Allegiance to
terms expiring in 2003.
<TABLE>
<CAPTION>
DIRECTOR FOR WITHHELD
-------- ----------- --------
<S> <C> <C>
Richard D. Frisbie.................................... 101,820,848 459,052
Thomas M. Lord........................................ 101,787,180 492,720
Dino Vendetti......................................... 101,784,491 495,409
C. Daniel Yost........................................ 101,785,830 494,070
</TABLE>
(c) Stockholders ratified the appointment of Arthur Andersen LLP, as
independent public accountants, to audit the consolidated financial statements
for the current year ending December 31, 2000. The vote was 102,264,994 shares
FOR and 7,221 shares AGAINST such ratification, with 7,685 shares abstaining.
ITEM 5. OTHER INFORMATION
Not applicable.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) The following exhibits are filed with this report and made a part
hereof.
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
------- -----------
<C> <S>
11.1 -- Statement regarding computation of per share loss for the
three months ended June 30, 2000
11.2 -- Statement regarding computation of per share loss for the
six months ended June 30, 2000
11.3 -- Statement regarding computation of per share loss for the
three months ended June 30, 1999
11.4 -- Statement regarding computation of per share loss for the
six months ended June 30, 1999
27.1 -- Financial Data Schedule
</TABLE>
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<PAGE> 34
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
ALLEGIANCE TELECOM, INC.
By: /s/ ROYCE J. HOLLAND
----------------------------------
Name: Royce J. Holland
Title: Chairman and Chief Executive
Officer
By: /s/ THOMAS M. LORD
----------------------------------
Name: Thomas M. Lord
Title: Executive Vice President and
Chief
Financial Officer
Dated: August 14, 2000
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<PAGE> 35
INDEX TO EXHIBITS
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
------- -----------
<C> <S>
11.1 -- Statement regarding computation of per share loss for the
three months ended June 30, 2000
11.2 -- Statement regarding computation of per share loss for the
six months ended June 30, 2000
11.3 -- Statement regarding computation of per share loss for the
three months ended June 30, 1999
11.4 -- Statement regarding computation of per share loss for the
six months ended June 30, 1999
27.1 -- Financial Data Schedule
</TABLE>
