<PAGE>
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------
AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON NOVEMBER 16, 1998
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
----------------
FORM 10-Q/A
AMENDMENT NO. 1 TO QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OFTHE
SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended June 30, 1998
COMMISSION FILE NUMBER
333-49397
FOCAL COMMUNICATIONS CORPORATION
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 36-4167094
(STATE OF INCORPORATION) (IRS EMPLOYER IDENTIFICATION NUMBER)
200 N. LASALLE STREET
SUITE 800
CHICAGO, IL 60601
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
(312) 895-8400
(REGISTRANT'S TELEPHONE NUMBER)
----------------
Indicate by check mark whether the registrant (1) has filed all reports to
be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or required 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 NO X
The number of shares outstanding of the issuer's common stock, as of June
30, 1998:
COMMON STOCK ($.01 PAR VALUE) .... 100,307
SHARES
- -------------------------------------------------------------------------------
- -------------------------------------------------------------------------------
<PAGE>
INDEX
<TABLE>
<CAPTION>
PAGE
----
<C> <S> <C>
PART I--FINANCIAL INFORMATION
Item 1. Financial Statements (Unaudited)
Consolidated Statements of Operations Three months ended June 30,
1998 and 1997, and the Six months ended June 30, 1998 and 1997.. 3
Consolidated Balance Sheets June 30, 1998 and December 31,1997... 4
Consolidated Statements of Cash Flows Six months ended June 30,
1998 and 1997 .................................................. 5
Condensed Notes to Unaudited Interim Consolidated Financial
Statements...................................................... 6
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations........................................... 10
PART II--OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K................................. 14
SIGNATURES................................................................ 15
</TABLE>
2
<PAGE>
PART I--FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
FOR THE THREE MONTHS FOR THE SIX MONTHS
ENDED JUNE 30 ENDED JUNE 30
------------------------ ------------------------
1998 1997 1998 1997
----------- ----------- ----------- -----------
<S> <C> <C> <C> <C>
Revenues................... $ 8,078,043 $ 86,908 $13,180,491 $ 86,908
Expenses:
Customer service and
network operations...... 2,787,055 244,271 4,613,948 252,962
Selling, general and
administrative.......... 1,964,160 578,104 3,271,785 994,597
Depreciation and
amortization............ 1,115,398 85,222 2,006,269 92,559
Non-cash compensation
expense................. 325,000 325,000 650,000 650,000
----------- ----------- ----------- -----------
Total operating
expenses.............. 6,191,613 1,232,597 10,542,002 1,990,118
----------- ----------- ----------- -----------
Operating Income(Loss). 1,886,430 (1,145,689) 2,638,489 (1,903,210)
----------- ----------- ----------- -----------
Other Income (Expense):
Interest income.......... 2,064,813 55,884 3,080,715 98,939
Interest expense......... (4,534,642) (3,562) (6,643,794) (3,697)
----------- ----------- ----------- -----------
(2,469,829) 52,322 (3,563,079) 95,242
----------- ----------- ----------- -----------
Net Loss................... $ (583,399) $(1,093,367) $ (924,590) $(1,807,968)
Accretion to Redemption
Value of Class A Common
Stock..................... -- (25,890) -- (51,780)
----------- ----------- ----------- -----------
Net Loss Applicable to
Common Stockholders....... $ (583,399) $(1,119,257) $ (924,590) $(1,859,748)
=========== =========== =========== ===========
Basic and Diluted Net Loss
Per Share of Common Stock. $ (6.61) $ (13.34) $ (10.47) $ (22.23)
=========== =========== =========== ===========
</TABLE>
3
<PAGE>
FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
JUNE 30, 1998 AND DECEMBER 31, 1997
<TABLE>
<CAPTION>
JUNE 30, 1998 DECEMBER 31, 1997
------------- -----------------
<S> <C> <C>
ASSETS
Current Assets:
Cash and cash equivalents.................... $140,077,423 $ 2,256,552
Accounts receivable, trade (net of allowance
for Doubtful accounts of $469,000 and
$1,298,000 at December 31, 1997 and June 30,
1998, respectively)......................... 7,879,444 2,355,814
Related-party receivables.................... -- 34,883
Other current assets......................... 384,104 90,559
------------ -----------
Total current assets....................... 148,340,971 4,737,808
Fixed Assets, at cost: 32,188,565 11,793,741
Less--Accumulated depreciation and
amortization................................ 2,079,666 616,967
------------ -----------
Fixed assets, net.......................... 30,108,899 11,176,774
Other Non-Current Assets, net................ 5,573,279 --
------------ -----------
$184,023,149 $15,914,582
============ ===========
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current Liabilities:
Accounts payable............................. $ 2,083,051 $ 1,502,479
Accrued liabilities.......................... 1,103,570 367,890
Current maturities of long-term debt......... -- 943,621
------------ -----------
Total current liabilities.................. 3,186,621 2,813,990
Long-Term Debt, net of current maturities.... 156,624,309 2,593,265
Other Noncurrent Liabilities................... 358,963 179,481
Redeemable Common Stock:
Class A, $.01 par value, 85,567 shares
authorized and 80,307 issued and outstanding
at December 31, 1997........................ -- 12,403,218
Stockholders' Equity (Deficit):
Common stock, Class A, $.01 par value, 85,567
shares authorized and 80,307 issued and
outstanding at June 30, 1998................ 803 --
Common stock, Class B, $.01 par value; 35,000
shares authorized, 20,000 shares issued at
December 31, 1997 and June 30, 1998......... 200 200
Common stock, Class C, $.01 par value; 15,000
shares authorized, 14,711 shares issued at
December 31, 1997 and June 30, 1998......... 147 147
Additional paid-in capital..................... 31,298,850 5,096,435
Deferred compensation.......................... (3,141,667) (3,791,667)
Accumulated deficit............................ (4,305,077) (3,380,487)
------------ -----------
Total stockholders' equity (deficit)....... 23,853,256 (2,075,372)
------------ -----------
$184,023,149 $15,914,582
============ ===========
</TABLE>
4
<PAGE>
FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
FOR SIX MONTHS
ENDED JUNE 30
-------------------------
1998 1997
------------ -----------
<S> <C> <C>
Cash Flows From Operating Activities:
Net loss.......................................... $ (924,590) $(1,807,968)
Adjustments to reconcile net loss to net cash
provided by (used in) operating activities--
Depreciation and amortization................... 2,006,269 92,559
Deferred lease costs............................ 179,484 --
Deferred compensation........................... 650,000 650,000
Amortization of discount on Senior Discount
Notes.......................................... 6,596,702 --
Provision for losses on accounts receivable..... 829,000 11,051
Changes in operating assets and liabilities--
Accounts receivable........................... (6,352,630) (97,959)
Related-party receivables..................... 34,883 16,883
Other assets.................................. (293,545) (96,985)
Accounts payable and accrued liabilities...... 1,316,252 273,432
------------ -----------
Net cash provided by (used in) operating
activities................................. 4,041,825 (958,987)
------------ -----------
Cash Flows From Investing Activities:
Capital expenditures.............................. (20,394,824) (3,695,993)
------------ -----------
Net cash used in investing activities....... (20,394,824) (3,695,993)
------------ -----------
Cash Flow From Financing Activities:
Proceeds from issuance of long-term debt(net)..... 143,910,756 67,448
Payments on bank credit facility and capital
leases........................................... (3,536,886) (7,061)
Proceeds from Class A common capital
contributions.................................... 13,800,000 4,275,000
------------ -----------
Net cash provided by financing activities... 154,173,870 4,335,387
------------ -----------
Net Increase in Cash and Cash Equivalents........... 137,820,871 (319,593)
Cash and Cash Equivalents, beginning of period...... 2,256,552 3,790,121
------------ -----------
Cash and Cash Equivalents, end of period............ $140,077,423 $ 3,470,528
============ ===========
</TABLE>
5
<PAGE>
FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS
THREE MONTHS AND SIX MONTHS ENDED JUNE 30, 1998
1. BASIS OF PRESENTATION
The accompanying unaudited interim consolidated financial statements reflect
all adjustments, consisting of normal recurring accruals, which management
believes are necessary to present fairly the financial position, results of
operations, and cash flows for Focal Communications Corporation and
Subsidiaries (the "Company") for the respective periods presented. Certain
information and footnote disclosures normally included in the annual financial
statements prepared in accordance with generally accepted accounting
principles have been condensed or omitted pursuant to the rules and
regulations of the Securities and Exchange Commission for Form 10-Q. These
unaudited interim consolidated financial statements should be read in
conjunction with the audited financial statements and the notes thereto
included in Amendment No. 4 to the Registration Statement on Form S-4 (File
No. 333-49397) filed by the Company with the Securities and Exchange
Commission on August 13, 1998 and Form 8-K filed on November 13, 1998 revised
the calculation of basic and diluted net loss per share of common stock
contained in the financial statements set forth in such Form S-4. The
consolidated balance sheet included herein was derived from audited
consolidated financial statements, but does not include all disclosures
required under generally accepted accounting principles.
As of the second quarter 1998 reporting period, the company has adopted a
change in accounting and applied it retroactively in order to recognize non-
cash compensation expense related to the issuance of certain common shares
upon the Company's recapitalization in November 1996. All prior periods have
been adjusted to reflect this change in accounting.
2. PROPERTY AND EQUIPMENT
Property and equipment consist of the following:
<TABLE>
<CAPTION>
JUNE 30, 1998 DECEMBER 31, 1997
------------- -----------------
(UNAUDITED)
<S> <C> <C>
Communications Network.................... $12,772,941 $ 7,906,336
Construction in progress.................. 14,686,578 1,938,236
Computer Equipment........................ 1,692,504 941,237
Leasehold Improvements.................... 2,486,749 652,173
Furniture and fixtures.................... 530,504 355,759
Motor vehicles............................ 19,289 --
----------- -----------
$32,188,565 $11,793,741
=========== ===========
</TABLE>
3. DEBT
Long-term debt at December 31, 1997 and June 30, 1998 consisted of the
following:
<TABLE>
<CAPTION>
JUNE 30, 1998 DECEMBER 31, 1997
------------- -----------------
(UNAUDITED)
<S> <C> <C>
Credit facility with bank, maximum
borrowing level at $6,000,000.......... $ -- $3,480,972
12.125% senior discount notes due 2008,
net of unamortized discount of
$113,375,691........................... 156,624,309 --
Capital leases on equipment with
interest at 14.66%, $2,327 due monthly
through April, 2000.................... -- 55,914
------------ ----------
156,624,309 3,536,886
Less--current maturities................ -- 943,621
------------ ----------
$156,624,309 $2,593,265
============ ==========
</TABLE>
6
<PAGE>
FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS--
(CONTINUED)
In February 1998 the Company completed its offering of $270 million stated
principal amount at maturity of its 12.125% senior discount notes due 2008
(the "Notes"), which resulted in gross proceeds of $150,027,606. The Notes
bear interest at the rate of 12.125 % per annum (computed on a semiannual bond
equivalent basis). In the period prior to February 15, 2003, interest will
accrue but will not be payable in cash. From February 15, 2003, interest on
the stated principal amount at maturity of the Notes will be payable in cash
semi-annually on August 15 and February 15 of each year, beginning on August
15, 2003.
The Notes are senior unsecured obligations of the Company ranking pari passu
in right of payment with all other existing and future senior indebtedness of
the Company, if any, and will rank senior in right of payment to all existing
and future subordinated indebtedness of the Company, if any. Holders of
secured indebtedness of the Company, however, will have claims with respect to
the assets securing such other indebtedness that are prior to the claims of
the holders of the Notes. The Notes will be effectively subordinated to all
existing and future indebtedness and other liabilities of the Company's
subsidiaries (including trade payables).
The Notes are redeemable, at the Company's option, in whole or in part, at
any time or from time to time, on or after February 15, 2003, at 106.063% of
their stated principal amount at maturity, plus accrued and unpaid Current
Interest, declining ratably to 100% of their stated principal amount at
maturity, plus accrued and unpaid Current Interest, on or after February 15,
2006. In addition, at any time and from time to time, prior to February 15,
2001, the Company may redeem in the aggregate up to 35% of the original
aggregate stated principal amount at maturity of the Notes with the proceeds
from one or more public equity offerings following which there is a public
market, at a redemption price (expressed as a percentage of accreted value on
the redemption date) of 112.125%, plus current interest, if any; provided that
at least 65% of the original aggregate stated principal amount at maturity of
the Notes remains outstanding after each such redemption.
The indenture for the Notes contains certain covenants which, among other
things, restrict the ability of the Company and certain of its subsidiaries to
incur additional indebtedness (and, in the case of certain subsidiaries, issue
preferred stock), pay dividends or make distributions in respect of the
Company's or such subsidiaries' capital stock, make other restricted payments,
enter into sale and leaseback transactions, incur liens, cause encumbrances or
restrictions to exist on the ability of certain subsidiaries to pay dividends
or make distributions in respect of their capital stock, issue and sell
capital stock of certain subsidiaries, enter into transactions with
affiliates, sell assets, or amalgamate, consolidate, merge or sell or
otherwise dispose of all or substantially all of their property and assets.
These covenants are subject to important exceptions and qualifications.
The Company anticipates commencement of an Exchange Offer for the Notes on
August 14, 1998, which will allow holders to exchange existing Notes for
12.125% Senior Discount Notes due 2008, Series B, which will have been
registered with the Securities and Exchange Commission. The Series B Notes are
identical in all material terms with the existing senior discount notes.
4. EARNINGS PER SHARE
In February 1997, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards (SFAS) No. 128 "Earnings Per Share". SFAS
No. 128 changed the methodology of calculating earnings per share and renamed
the two calculations to basic earnings per share and diluted earnings per
share. The Company adopted SFAS No. 128 in January 1998 and has retroactively
restated all periods presented. Basic earnings per common share are based on
the average quarterly weighted average number of shares of common stock
outstanding, as discussed further in Note 8. Under the requirements of SFAS
No. 128 the Company's basic and diluted weighted average number of shares
outstanding at June 30, 1998 and 1997 is as follows:
<TABLE>
<CAPTION>
JUNE
JUNE 30 30
1998 1997
------- ------
<S> <C> <C>
Basic Weighted Average Number of Common Shares Outstanding....... 88,307 83,884
Dilutive Stock Options and Unvested Class B Common Stock......... 13,405 16,081
------- ------
Dilutive Weighted Average Number of Common Shares Outstanding.... 101,712 99,965
======= ======
</TABLE>
7
<PAGE>
FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS--
(CONTINUED)
Diluted earnings per common share are adjusted for the assumed exercise of
dilutive stock options. Dilutive weighted average common shares outstanding
are anti-dilutive and have been excluded from the loss per share calculation
for the three month and six month periods ended June 30, 1998, and June 30,
1997.
5. COMMITMENTS AND CONTINGENCIES
Under the terms of various short- and long-term contracts, the Company is
obligated to pay office rents and rent for leasing fiber optic transmission
facilities. The Company is obligated to pay office rents through 2012. The
office rent contracts provide for certain scheduled increases and for possible
escalation of basic rentals based on a change in the cost of living or on
other factors. The Company expects to enter into other contracts for
additional office space, other facilities, equipment and maintenance services
in the future.
A summary of such fixed commitments at June 30, 1998 is as follows:
<TABLE>
<CAPTION>
YEAR AMOUNT
---- -----------
<S> <C>
1998......................... $ 877,490
1999......................... 1,935,529
2000......................... 1,964,064
2001......................... 1,869,199
2002......................... 1,911,780
Thereafter................... 14,809,367
-----------
Total.................... $23,367,429
===========
</TABLE>
In the ordinary course of business, the Company is involved in various
regulatory matters, proceedings and claims.
The Company has recorded accounts receivable totaling $4.4 million as of
June 30, 1998, and revenues of $2.4 million for the six month period ended
June 30, 1998 from another carrier who is currently disputing its obligations
to the Company. This dispute was ruled on in favor of the Company by the
Illinois Commerce Commission ("ICC") in March of 1998. The other carrier
appealed the ICC ruling to the United States District Court for the Northern
District of Illinois. The District Court rendered a decision on July 21, 1998
affirming the ICC order. The ICC order has been stayed for an additional 50
days to allow the parties to appeal.
In July, 1998 Ameritech filed a complaint with the ICC alleging that Focal's
Virtual Office service violates the interconnection agreement between
Ameritech and the Company and certain state statutes. Ameritech also alleged
that through its Virtual Office service, Focal is contributing to the
exhaustion of phone numbers in the 847 area code. Ameritech complained that
calls on Focal's Virtual Office network are circumventing local toll charges,
and should not be subject to reciprocal compensation. Ameritech also alleged
that the Company is offering service in violation of the state's pay-per-call
rules. The case is set for hearing before the ICC in September, 1998. The
Company believes that these claims lack merit. Nevertheless, an adverse
outcome in this dispute could have a material adverse effect on the Company.
6. STOCK OPTIONS
The Company established the Focal Communications Corporation 1997 Non-
Qualified Stock Option Plan (the "Plan") effective February 27, 1997. The Plan
is administered by the compensation committee of the Company's Board of
Directors (the "Board"). The Board has sole and complete authority to select
participants and grant options for the Company's Class A common shares which
shall not exceed 5,260 shares, as defined in
8
<PAGE>
FOCAL COMMUNICATIONS CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS--
(CONTINUED)
the plan. The Company has chosen to account for stock based compensation using
the intrinsic value method prescribed in Accounting Principals Board Opinion
("APB") No. 25, "Accounting for Stock Issued To Employees." Accordingly, no
compensation expense has been recorded for its stock option awards, but
rather, the Company has determined the pro forma net loss amount for the first
quarter and second quarter of 1997 and 1998 as if compensation expense had
been recorded for options granted during 1997 and the first six months of 1998
under the fair value method described in SFAS No. 123, "Accounting for Stock-
Based Compensation".
The Company utilizes the Black-Scholes option pricing model to estimate the
fair value of options at the date of grant. Had the Company adopted SFAS No.
123, pro forma net loss applicable to common stockholders and pro forma basic
and diluted net loss per share of common stock would have been approximately
$(997,263) and $(11.29) for the six months ended June 30, 1998.
The following summarizes option activity:
<TABLE>
<CAPTION>
WEIGHTED
SHARES OF AVERAGE
CLASS A EXERCISE EXERCISE
COMMON PRICES PRICE
--------- ---------- --------
<S> <C> <C> <C>
Outstanding at December 31, 1997........... 1,222 $290-$ 320 $296.61
Granted during the six months ended June
30, 1998.................................. 1,784 $335-1,050 $788.54
----- ---------- -------
Outstanding at June 30, 1998............. 3,006 $290-1,050 $588.56
===== ========== =======
</TABLE>
7. REDEEMABLE COMMON STOCK
On January 23, 1998, the Company amended the Stock Purchase Agreement. As a
result of the amendment, the redeemable Class A common stock was reclassified
into permanent equity. The amended Stock Purchase Agreement also allows
Institutional Investors (as defined therein) at any time and from time to time
on or after November 27, 2003, but not after the consummation of a public
offering of the Company's equity securities, to require the Company to
voluntarily liquidate the assets of the Company. Upon receipt of notice of the
required liquidation, the Company may elect to purchase all but not less than
all of the Institutional Investors' Class A common shares.
8. SUBSEQUENT EVENT
On August 13, 1998, Amendment No. 4 to the Company's Registration Statement
on form S-4 was declared effective by the Securities and Exchange Commission.
In connection with this registration statement, the Company has given
retroactive effect to a change in accounting. This change in accounting was
due to the fact that the Class B common shares held by the founding executives
vest over the term of employment. Accordingly, basic and diluted share counts
were retroactively adjusted to eliminate unvested Class B common shares in
accordance with this revised accounting. The effects on previously reported
loss per share are presented below:
<TABLE>
<CAPTION>
FOR THE THREE
MONTHS ENDED
JUNE 30
---------------
1997 1998
------- ------
<S> <C> <C>
Net loss per share, as previously reported.............. $ (7.92) $(5.82)
Net loss per share, as revised.......................... (13.34) (6.61)
</TABLE>
9
<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
OVERVIEW
General: The Company began operations during 1996 and has operated in
Chicago since May 1997 and New York since January 1998, currently serving a
total of 6 MSAs (metropolitan statistical areas). The Company plans to offer
services in 37 additional MSAs by the end of 1999, reaching a total of 43 MSAs
in ten metropolitan markets. As of June 30, 1998, the Company had 30,385
access lines sold, of which 24,357 were installed and in service. This
compares to 13,411 lines sold and 7,394 lines installed as of December 31,
1997.
The Company's plan to expand into 37 additional MSAs requires significant
expenditures to fund operating losses and the purchase of capital equipment.
The Company believes it can lower its initial capital requirements and
generate a substantially greater return on invested capital by concentrating
its investments in switching and information, billing, and support systems,
while leasing transport facilities. This network investment strategy differs
from many other competitive local exchange carries (CLECs) who build and
maintain their own transport facilities.
The Company targets its services to telecommunications-intensive customers
and, as a result, expects to generate revenue per line in excess of the
industry average. In addition, the Company believes that its cost structure is
below the industry average. Consequently, the Company expects to more rapidly
generate positive operating cash flow from its new networks as compared to
other CLECs. Nevertheless, the simultaneous development of a number of new
networks may result in negative consolidated operating cash flow.
Revenues: The Company's revenue is comprised of monthly recurring charges,
usage charges, and initial, non-recurring charges. Monthly recurring charges
include the fees paid by customers for lines in service, additional features
on those lines, and colocation space. Monthly recurring charges are derived
only from end user customers. Usage charges consist of fees paid by end users
for each call made, fees paid by the incumbent local exchange carrier (ILEC)
and other CLECs as reciprocal compensation (which results from the Company
terminating calls made by ILEC customers or other CLEC customers to Focal's
customers), and access charges paid by the interexchange carriers (IXCs) for
long distance traffic originated and terminated by the Company. Usage charges
are derived from both end user customers and from other carriers. Initial non-
recurring charges are paid by end users, if applicable, for the installation
of service by the Company.
Reciprocal compensation is currently a significant component of the
Company's total revenue, representing 75% of total revenue recorded during the
first six months of 1998. This is the result of an imbalance of inbound and
outbound traffic due to the preponderance of inbound applications utilized by
the Company's customers. Such inbound applications include Focal Virtual
Office service which is used by Focal's corporate customers and Focal Multi-
Exchange Service which is used by Focal's Internet Service Provider (ISP)
customers. The Company expects the proportion of revenue represented by
reciprocal compensation to decline over time as the percentage of lines sold
for outbound applications increases as each given market matures.
End user invoices are sent to customers monthly with recurring charges being
billed in advance and usage charges being billed in arrears. Reciprocal
compensation and carrier access invoices are sent monthly to the appropriate
ILECs and IXCs according to industry standard practices and in industry
standard formats.
Operating Expenses: The Company's operating expenses are categorized as
customer service and network operations; selling, general and administrative;
depreciation and amortization; and non-cash compensation expense. Settlement
costs are a significant portion of customer service and network operations
expense and are comprised of leased transport charges and reciprocal
compensation payments. Leased transport charges are the
10
<PAGE>
lease payments incurred by Focal for the fiber optic transmission facilities
used to connect the Company's customers to its switch and to connect the
Company's network to the ILEC and other CLEC networks. The Company's strategy
of leasing rather than building its own fiber transport facilities results in
the Company's cost of service being a significant component of total costs.
The Company has to date been successful in negotiating lease agreements which
match the duration of its customer contracts, thereby allowing the Company to
avoid the risk of continuing expenses associated with transmission facilities
that are not being used by revenue generating customers. The Company pays
reciprocal compensation to ILECs and other CLECs for terminating calls made by
Focal's customers to customers of the ILEC or CLEC.
Other customer service and network operations expense consists of the costs
to operate the Company's network and the costs of providing customer care
activities. Major components include: wages, rent, power, equipment
maintenance, supplies, and contract employees.
Selling, general and administrative expenses consist of sales force
compensation and promotional expenses as well as the cost of corporate
activities related to regulatory, finance, human resources, legal, executive,
and other administrative activities.
The Company records non-cash compensation expense each quarter as a result
of having given retroactive effect to a change in accounting related to
certain shares issued to the Company's founders in November 1996. This change
in accounting is further described in Amendment No. 4 to Form S-4 filed with
the Securities and Exchange Commission on August 13, 1998.
The Company's strategy of leasing, rather than building, its transport
network results in capital expenditures which are proportionately lower than
most fiber-based CLECs. In addition, the proportion of capital expenditures
which are "success-based" are higher than most fiber-based CLECs. In contrast,
the Company incurs operating expenses for leased facilities, which are
proportionately higher than fiber-based CLECs. The margin impact of these
higher, anticipated operating expenses is expected to be mitigated, in part,
by a higher revenue per line, which the Company anticipates as a result of its
focus on telecommunications-intensive users.
RESULTS OF OPERATIONS
Three Months Ended June 30, 1998 Compared to Three Months Ended June 30, 1997
Total revenue for the three months ended June 30, 1998 was $8,078,043
compared to $86,908 for the three months ended June 30, 1997. The significant
increase in revenue is due to the Company's rapid growth in its Chicago and
New York markets during 1998 and the fact that service was first initiated in
May 1997. Customer service and network operations expense was $244,271 in the
three months ended June 30, 1997 and $2,787,055 during the most recent three-
month period. The increase resulted from the Company's rapid expansion and
related costs for leased facilities, usage settlements, customer care and
operations personnel, equipment maintenance, and other operating expenses.
Selling, general and administrative expense also increased due to the
Company's expansion from $578,104 during the three months ended June 30, 1997
to $1,964,160 during the most recent three-month period. Similarly,
depreciation and amortization increased from $85,222 to $1,115,398 in the
comparative periods as a result of a significant increase in the level of
fixed assets put into service by the Company. Non-cash compensation expense
was $325,000 for each period since the value of shares recognized as
compensation in each period was the same. Non-cash compensation expense
relates to the Class B common shares held by the founding executives which
vest over the term of employment. Interest income increased from $55,884 in
the three months ended June 30, 1997 to $2,064,813 in the three months ended
June 30, 1998 due to a substantial increase in cash balances held by the
Company, primarily from financing activities. Interest expense increased from
$3,562 in the three months ended June 30, 1997 to $4,534,642 in the most
recent three-month period due to accrued interest expense from the Company's
12.125% senior discount notes due 2008 (the "Notes"), which were issued in
February 1998. The Company's net loss decreased from ($1,119,257) during the
three months ended June 30, 1997 to ($583,399) in the three-month period ended
June 30, 1998.
11
<PAGE>
Six Months Ended June 30, 1998 Compared to Six Months Ended June 30, 1997
Total revenue for the six months ended June 30, 1998 was $13,180,491
compared to $86,908 for the six months ended June 30, 1997. The significant
increase in revenue is due to the Company's rapid growth in its Chicago and
New York markets during 1998 and the fact that service was first initiated in
May 1997. Customer service and network operations expense was $252,962 in the
six months ended June 30, 1997 and $4,613,948 during the most recent six-month
period. The increase resulted from the Company's rapid expansion and related
costs for leased facilities, usage settlement, customer care and operations
personnel, equipment maintenance, and other operating expenses. Selling,
general and administrative expense also increased due to the Company's
expansion from $994,597 during the six months ended June 30, 1997 to
$3,271,785 during the most recent six-month period. Similarly, depreciation
and amortization increased from $95,559 to $2,006,269 in the comparative
periods as a result of a significant increase in the level of fixed assets put
into service by the Company. Non-cash compensation expense was $650,000 for
each period since the value of shares recognized as compensation in each
period was the same. Non-cash compensation expense relates to the Class B
common shares held by the founding executives which vest over the term of
employment. Interest income increased from $98,939 in the six months ended
June 30, 1997 to $3,080,715 in the six months ended June 30, 1998 due to a
substantial increase in cash balances held by the Company, primarily from
financing activities. Interest expense increased from $3,697 in the six months
ended June 30, 1997 to $6,643,794 in the most recent six month period due to
accrued interest expense from the Company's 12.125% senior discount notes due
2008 (the "Notes"), which were issued in February 1998. The Company's net loss
decreased from ($1,859,748) during the six months ended June 30, 1997 to
($924,590) in the six-month period ended June 30, 1998.
LIQUIDITY AND CAPITAL RESOURCES
The Company's existing operations have required, and its planned operations
will require, significant capital to fund the purchase and installation of
telecommunications switches, equipment, infrastructure, and the operating
losses expected during the start-up phase of each new market. Capital
expenditures were $20,394,824 for the six months ended June 30, 1998. The
Company expects total capital expenditures for the year ended December 31,
1998 to be approximately $60 million. Total capital expenditures for the
buildout of the Company's ten city plan are currently estimated to be $110
million. Prior to issuance of the Notes, the Company funded a substantial
portion of its capital expenditures through the private sale of equity
securities. In November 1996, the Company entered into a stock purchase
agreement which provided for the contribution over time of approximately $26.1
million of equity funding by a group of investors. As of February 13, 1998,
the equity investors have contributed the entire $26.1 million to the Company.
In addition, in 1997, the Company's Illinois subsidiary borrowed approximately
$3.5 million under a bank credit facility. The Company used a portion of the
net proceeds from the senior discount note offering to prepay this
indebtedness and cancel the facility.
On February 18, 1998, the Company received gross proceeds of $150,027,606
from the completion of its offering of 12.125% senior discount notes due 2008.
The Notes will accrete to an aggregate stated principal amount of $270,000,000
by February 15, 2003. No interest will be payable on the Notes prior to August
15, 2003. Thereafter, interest will be payable semiannually on August 15 and
February 15 of each year.
The Company has incurred net losses since inception. A portion of the prior
equity investments and debt proceeds have been used to fund the Company's
negative cash flow and net losses. Management believes the Company may produce
negative operating cash flow on a consolidated basis as it completes the
buildout of its ten city plan. There can be no assurance the Company will
realize positive consolidated operating cash flow in subsequent periods. Until
sufficient cash flow is generated, the Company will continue to rely on cash
on hand and outside capital to meet its cash requirements.
The Company's cash flows for the period from May 31, 1996 (the Company's
commencement of operations) to December 31, 1996, was $3,790,121. During this
period, net cash used in operating activities consisted of $152,576; net cash
used in investing activities consisted of $82,303; and net cash provided by
12
<PAGE>
financing activities consisted of $4,025,000. The Company's cash flows for the
year ended December 31, 1997 was $1,533,569. During this period, net cash used
in operating activities consisted of $1,634,017; net cash used in investing
activities consisted of $11,655,524; and net cash provided by financing
activities consisted of $11,755,972. The Company's cash flows for the six
months ended June 30, 1998 was $137,820,871. During this period, net cash
provided by operating activities consisted of $4,041,825; net cash used in
investing activities consisted of $20,394,824; and net cash provided by
financing activities consisted of $154,173,870.
The Company expects its available cash, including the net proceeds from the
sale of its senior discount notes, will be sufficient to fund its capital
requirements through 1999. However, if the Company's expansion occurs more
rapidly than currently anticipated or if its operating results are below
expectations, the Company may require additional capital. The Company may
decide to raise additional capital before such time. The Company may secure
additional funding through the sale of public or private debt and/or equity
securities or enter into a future bank credit facility. There can be no
assurance, however, that the Company will be successful in raising sufficient
additional capital on terms that it will consider acceptable or that the
Company's operations will produce positive consolidated cash flow in
sufficient amounts to meet its debt obligations. Failure to raise and generate
sufficient funds may require the Company to delay or abandon some of its
planned future expansion or expenditures, which could have a material adverse
effect on the Company's growth and its ability to compete in the
telecommunications industry.
IMPACT OF THE YEAR 2000 ISSUE
The year 2000 issue is the result of computer programs being written using
two digits rather than four to define the applicable year. Any of the computer
programs or systems of the Company or the Company's suppliers that have date-
sensitive software may recognize a date using "00" as the year 1900 rather
than the year 2000. This could result in a system failure or miscalculation
causing disruption of operations, including among other things, a temporary
inability to process transactions, send invoices or engage in similar normal
business activities, or interruptions of customer service.
The Company has performed an internal assessment of its information systems,
including its DMS-500 Super-Node central office switches and hardware, to
determine whether such systems and hardware are year 2000 compliant. The
Company has received assurances from its material hardware vendors and from
all but one of its major software vendors that the products used by the
Company are year 2000 compliant and will function adequately. In addition, the
Company has been advised by its remaining major software vendor, which
provides the Company's billing system, that an upgrade to the current system,
which is expected to be operational by the end of 1998, will be year 2000
compliant. The Company does not anticipate that the cost of such upgrade will
be material.
The Company's services are also dependent on network systems, including
switching systems, maintained by other carriers, including the ILECs and IXCs.
The Company is in the process of assessing the year 2000 compliance status of
certain other carriers with whom the Company has material relationships. Such
assessment relies (without any independent verification) on the statements,
including the assumptions underlying such statements, from such carriers that
appear in such carriers' periodic reports filed with the Commission pursuant
to the Exchange Act. The risks associated with the failure of such carriers'
systems would include potential interruption of service, including blocked
calls and delayed call completion, especially for the Company's high-volume
corporate customers. Because the Company leases its transport capacity and is
dependent on the availability of fiber optic transport facilities owned by
other carriers, there are few, if any, contingency measures that the Company
could take if year 2000 non-compliance were to cause the facilities of the
Company's carriers to become unavailable. While the Company leases transport
facilities from multiple carriers in each of its relevant markets and attempts
to provide redundancy and diversity in service, there can be no assurance that
multiple network failures in a particular market could not occur. Should such
vendors experience facilities failures, it could prove disruptive to the
Company's business and could have a material adverse effect on the Company. In
addition, there can be no assurance that devoting additional resources of the
Company to year 2000 non-compliance, if arising, would not have a material
adverse effect on the Company. The Company will continue its
13
<PAGE>
year 2000 compliance assessment of its own computer programs and systems. If
it comes to the attention of the Company's management that any of its systems,
or the systems of those on which the Company relies, are not year 2000
compliant, the Company intends to develop an action plan, and assess the
resources it would be required to devote, to address such problem. See "Risk
Factors--Reliance on Leased Transport Facilities and ILEC Interconnection" and
"--Impact of Year 2000 Issue."
The foregoing discussion contains forward-looking statements. The Company's
future performance is subject to numerous risks and uncertainties that could
cause actual results to deviate substantially from those discussed in these
forward-looking statements. Factors that could impact the variability of
future results include: the outcome of legal and regulatory proceedings
regarding reciprocal compensation for Internet-related calls and certain of
the Company's product offerings; successful execution of the Company's
expansion activities into new geographic markets on a timely and cost-
effective basis; the pace at which new competitors enter the Company's
existing and planned markets; competitive responses of the ILECs; execution of
interconnection agreements with ILECs on terms satisfactory to the Company;
maintenance of the Company's supply agreements for transport facilities;
continued acceptance of the Company's services by new and existing customers;
the Company's ability to attract and retain talented employees, the Company's
ability to successfully access markets, install switching electronics, and
obtain the use of leased fiber transport facilities and any required
governmental authorizations, franchises and permits, all in a timely manner,
at reasonable costs and on satisfactory terms and conditions, as well as
regulatory, legislative and judicial developments that could cause actual
results to differ materially from the future results indicated, express or
implied, in such forward-looking statements.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBITS
27.1 Financial Data Schedule
(b) REPORTS ON FORM 8-K
The Company did not file any current reports on Form 8-K during the
quarter ended June 30, 1998.
14
<PAGE>
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.
<TABLE>
<S> <C>
Focal Communications Corporation
Date: November 16, 1998 /s/ Robert C. Taylor, Jr.
-------------------------------------
Robert C. Taylor, Jr., President and Chief
Executive Officer (Authorized Officer)
Date: November 16, 1998 /s/ Joseph A. Beatty
-------------------------------------
Joseph A. Beatty, Executive Vice President
and Chief Financial Officer (Principal
Financial Officer)
Date: November 16, 1998 /s/ Robert M. Junkroski
-------------------------------------
Robert M. Junkroski, Controller
(Principal Accounting Officer)
</TABLE>
15
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<S> <C>
<PERIOD-TYPE> 6-MOS
<FISCAL-YEAR-END> DEC-31-1997
<PERIOD-START> JAN-01-1998
<PERIOD-END> JUN-30-1998
<CASH> 140,077,423
<SECURITIES> 0
<RECEIVABLES> 9,177,444
<ALLOWANCES> 1,298,000
<INVENTORY> 0
<CURRENT-ASSETS> 148,340,971
<PP&E> 32,188,565
<DEPRECIATION> (2,079,666)
<TOTAL-ASSETS> 184,023,149
<CURRENT-LIABILITIES> 3,186,621
<BONDS> 156,624,309
0
0
<COMMON> 1,150
<OTHER-SE> 23,852,106
<TOTAL-LIABILITY-AND-EQUITY> 184,023,149
<SALES> 13,180,491
<TOTAL-REVENUES> 13,180,491
<CGS> 10,542,002
<TOTAL-COSTS> 10,542,002
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> (3,563,079)
<INCOME-PRETAX> (924,590)
<INCOME-TAX> 0
<INCOME-CONTINUING> (924,590)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (924,590)
<EPS-PRIMARY> (10.47)
<EPS-DILUTED> (10.47)
</TABLE>
