<PAGE>
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the Quarterly Period Ended June 30, 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>
<S> <C>
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Statements of Operations
Three months ended June 30, 1998 and 1997 (Unaudited), and
the Six months ended June 30, 1998 and 1997. 3
Consolidated Balance Sheets
June 30, 1998 (Unaudited) and December 31,1997 4
Consolidated Statements of Cash Flows
Six months ended June 30, 1998 and 1997 (Unaudited) 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
Item 3. Quantitative and Qualitative Disclosures
About Market Risk 13
PART II - OTHER INFORMATION
Item 1. Legal Proceedings 14
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
(Unaudited) (Unaudited)
1998 1997 1998 1997
<S> <C> <C> <C> <C>
REVENUES $ 8,078,043 $ 86,908 $13,180,490 $ 86,908
EXPENSES:
Customer service and network operations 2,787,055 244,271 4,613,949 252,962
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 10,542,003 1,990,118
----------- ----------- ----------- -----------
Operating Income(Loss) 1,886,430 (1,145,689) 2,638,487 (1,903,210)
----------- ----------- ----------- -----------
OTHER INCOME (EXPENSE):
Interest income 2,064,813 55,884 3,080,716 98,939
Interest expense (4,534,642) (3,562) (6,643,793) (3,697)
----------- ----------- ----------- -----------
(2,469,829) 52,322 (3,563,077) 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 $ (5.82) $ (7.92) $ (9.22) $ (18.62)
=========== =========== =========== ===========
</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
ASSETS (Unaudited)
------------- -----------------
<S> <C> <C>
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 1,103,571 367,890
Current maturities of long-term debt - 943,621
------------ -----------
Total current liabilities 3,186,622 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 and
outstanding 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 and
outstanding 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 (4,305,078) (3,380,487)
------------ -----------
Total stockholders' equity (deficit) 23,853,255 (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 $ (924,591) $(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
Accretion of Senior Discount Notes 6,596,702 -
Provision for losses on accounts receivable 829,000 11,051
(Increase) decrease 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 1,316,253 273,432
------------ -----------
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 the Registration Statement on Form
S-4 (File No. 333-49397) filed by the Company with the Securities and Exchange
Commission. 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.
1. 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>
6
<PAGE>
2. 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>
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.
7
<PAGE>
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.
3. 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.
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.
4. 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>
8
<PAGE>
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.
5. 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 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 ($9.94) 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>
6. 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.
9
<PAGE>
Item 2.
Management's Discussion and Analysis of Financial
Condition and Results of Operations
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.
10
<PAGE>
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 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. 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 $13,180,490 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 $4,613,949 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. Interest income increased from $98,939
in the six months ended June 30, 1997 to $3,080,716 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 $6,643,793 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
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.
12
<PAGE>
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 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 3. Quantitative and Qualitative Disclosures About Market Risk
Not Required
13
<PAGE>
PART II- OTHER INFORMATION
Item 1. Legal Proceedings
From time to time the Company is party to routine litigation and proceedings in
the ordinary course of its business. Other than listed below, the Company and
its subsidiaries are not aware of any current or pending litigation that the
Company believes would have a material adverse effect on the Company's results
of operations or financial condition. The Company and its subsidiaries continue
to participate in regulatory proceedings before the FCC and state regulatory
agencies concerning the authorization of services and the adoption of new
regulations.
Focal, together with other CLECs, contend that Ameritech Illinois owes
reciprocal compensation for calls originated by customers of Ameritech Illinois
and terminated by CLECs to Internet service providers, who then route traffic
onto the Internet. The Company has recorded cumulative revenue and related
accounts receivable totaling $4.4 million as of June 30, 1998, from Ameritech
Illinois who is currently disputing this obligation to the Company. The
Illinois Commerce Commission ("ICC") ruled in favor of the Company and other
CLECs regarding this dispute in March of 1998. On March 27, 1998, Ameritech
Illinois filed suit in the United States District Court for the Northern
District of Illinois seeking to reverse the ICC order and seeking a stay of the
ICC order pending consideration of the appeal. The 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.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
27.1 Financial Data Schedule
27.2 Restated 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.
Focal Communications Corporation
Date: August 14, 1998 /s/ Robert C. Taylor, Jr.
--------------------------
Robert C. Taylor, Jr., President and Chief
Executive Officer (Authorized Officer)
Date: August 14, 1998 /s/ Joseph A. Beatty
--------------------
Joseph A. Beatty , Executive Vice President
and Chief Financial Officer (Principal
Financial Officer)
Date: August 14, 1998 /s/ Robert M. Junkroski
-----------------------
Robert M. Junkroski, Controller
(Principal Accounting Officer)
15
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