Table of Contents

UNITED STATES

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 September 30, 1999

or

[   ]	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Transition Period from           to           

Commission File Number: 0-24581

CAPROCK COMMUNICATIONS CORP.

15601 Dallas Parkway, Suite 700

Registrant’s telephone number, including area code:  (972) 982-9500

     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  [   ]

     The number of shares of the registrant’s Common Stock outstanding as of October 31, 1999 was 33,198,864.

CAPROCK COMMUNICATIONS CORP.

Table of Contents

PART I.  FINANCIAL INFORMATION

Item 1. Financial Statements

CAPROCK COMMUNICATIONS CORP. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

ASSETS

See accompanying notes to consolidated financial statements.

1

Table of Contents

CAPROCK COMMUNICATIONS CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

See accompanying notes to consolidated financial statements.

2

Table of Contents

CAPROCK COMMUNICATIONS CORP. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOW

See accompanying notes to consolidated financial statements.

3

Table of Contents

CAPROCK COMMUNICATIONS CORP. AND SUBSIDIARIES

(1)  Summary of Significant Accounting Policies

      The consolidated financial statements include CapRock Communications Corp. (“CapRock” or the “Company”) and its majority owned subsidiaries. The Company was formed on February 3, 1998, to serve as a holding company for the operations of CapRock Telecommunications Corp., a Texas corporation (“Telecommunications”), CapRock Fiber Network Ltd., a Texas limited partnership (“CapRock Fiber”), and IWL Communications, Incorporated, a Texas corporation, doing business as CapRock Services Corp. (“CapRock Services”), and its wholly owned subsidiaries upon the consummation of the business combination of those companies (the “Combination”). All significant inter-company transactions are eliminated in the consolidation. The equity method is used to account for unconsolidated investments in companies in which the Company exercises significant influences over operating and financial policies, but does not have a controlling interest. On August 26, 1998, pursuant to the Agreement and Plan of Merger and Plan of Exchange dated February 16, 1998, as amended (the “Merger Agreement”), among the Company, Telecommunications, CapRock Fiber, CapRock Services and certain other parties, the Company completed the Combination (note 2).

      The Company is a regional facilities-based integrated communications provider offering local, long distance, Internet, data and private line services to small and medium-sized businesses. The Company also provides switched and dedicated access, regional and international long distance, private lines and dark fiber to carrier customers. The Company is in the process of building an advanced fiber network throughout Texas, Louisiana, Oklahoma, Arkansas, New Mexico and Arizona. Additionally, the Company, through its wholly owned subsidiary — CapRock Services, provides communications solutions to customers with operations in remote, difficult-access regions. The Company markets its services through its internal sales representatives and a network of independent agents.

      The accompanying unaudited consolidated financial statements, which should be read in conjunction with the consolidated financial statements and footnotes included in the Company’s 1998 Annual Report on Form 10-K, have been prepared in accordance with generally accepted accounting principles for interim financial information. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting only of normal recurring adjustments) considered necessary for a fair presentation have been included. Accounting measurements at interim dates inherently involve greater reliance on estimates than at year-end. The results of operations for the nine months ended September 30, 1999 are not necessarily indicative of the results to be expected for the entire fiscal year ending December 31, 1999.

(2)  Business Combination

      On August 26, 1998, pursuant to the Merger Agreement, the Company completed the Combination with Telecommunications, CapRock Fiber and CapRock Services. Accordingly, the Consolidated Balance Sheets as of December 31, 1998 and September 30, 1999 and the Consolidated Statements of Operations and Consolidated Statements of Cash Flows for the nine months ended September 30, 1998 and 1999 include Telecommunications, CapRock Fiber and CapRock Services as though these entities had always been a part of CapRock.

      Upon the consummation of the Combination, all previously outstanding shares of CapRock Services common stock ceased to exist and each such share was converted into and became exchangeable for one share of CapRock common stock, and all previously outstanding shares of Telecommunications common stock ceased to exist, and each such share was converted into and became exchangeable for 1.789030878 shares of CapRock common stock and each one percent (1%) of CapRock Fiber interests issued and

4

Table of Contents

outstanding was exchanged for 63,194.54 shares of CapRock common stock. The Company issued 28,910,221 common shares in the Combination. Additionally, outstanding employee stock options of CapRock Services and Telecommunications were converted at the above exchange factors into options to purchase shares of CapRock common stock. The Combination constituted a tax-free reorganization and was accounted for as a pooling of interests.

      In May 1998, CapRock Services changed its fiscal year end to coincide with the fiscal years of CapRock, Telecommunications and CapRock Fiber. The Consolidated Statement of Operations for the nine months ended September 30, 1998 and 1999 combine the operating activity for all three entities for these periods.

      The transactions between Telecommunications, CapRock Services and CapRock Fiber have been eliminated for all respective periods presented. Certain reclassifications were made to CapRock Services’ financial statements to conform to CapRock’s presentations.

(3)  Secondary Public Offering

      On May 6, 1999, the Company entered into an underwriting agreement with various underwriters to sell 4,000,000 shares of its common stock at a price of $22.00 per share in a public offering. The registration statement for the equity offering was declared effective by the SEC on May 6, 1999 and closed on May 12, 1999. The net proceeds, after deducting underwriting discounts and the expenses associated with the offering, were approximately $81.9 million.

(4)  Senior Note Offering

      On May 18, 1999, the Company issued $210 million aggregate principal amount of private senior notes (the “1999 Senior Notes”) due May 1, 2009. Interest on the 1999 Senior Notes is payable semi-annually in arrears on May 1 and November 1 of each year, commencing November 1, 1999, at the rate of 11 1/2% per year. The Company received net proceeds from the offering, after deducting the initial purchasers’ discount and expenses, of approximately $201.3 million. The 1999 Senior Notes are senior unsecured obligations and as such rank pari passu in right of payment with the Company’s existing senior notes issued in July 1998 (the “1998 Senior Notes”) and with all the Company’s future unsecured and unsubordinated indebtedness. The indenture governing the 1999 Senior Notes has restrictions similar to those which currently exist for the Company’s 1998 Senior Notes. The proceeds have been, and will be, used to fund capital expenditures for the construction of the fiber optic network, switching equipment and other capital expenditures and to expand the Company’s sales offices, for potential acquisitions and for general working capital purposes. Unutilized funds have been invested in short-term, high-grade investment securities classified as available for sale.

      In July 1999, the Company filed an exchange offer Registration Statement (“Exchange Offer Registration Statement”) with the SEC for the registration of $210 million of principal amount of its registered senior notes due May 1, 2009 (the “Exchange Notes”) to be offered in exchange for the 1999 Senior Notes (the “Exchange Offer”). The Exchange Offer Registration Statement was declared effective by the SEC on July 30, 1999 and the Exchange Offer expired on September 1, 1999. The terms of the Exchange Notes are identical in all material respects to the 1999 Senior Notes except that the Exchange Notes have been registered under the Securities Act of 1933, as amended.

5

Table of Contents

(5)  Earnings per share

      The following table sets forth the computation of basic and diluted earnings (loss) per share (in thousands, except per share amounts):

6

Table of Contents

(6) Segment Reporting

      In June 1997, the Financial Accounting Standards Board issued Statement No. 131, Disclosures about Segments of an Enterprise and Related Information, which the Company adopted in 1998. The Company identifies such segments based on management responsibility. The Company measures segment profit as operating income, which is defined as income before interest income and expense and income taxes. The service revenue from the Telecommunications division includes all revenues generated from the sale of telecommunications products to business and residential customers. These products include local, long distance, Internet, data and private line services. The Fiber division includes the operating activity and the assets relating to the fiber build out. The revenues for the Fiber division primarily relate to the sale of dark fiber through indefeasible rights of use agreements (“IRUs”). The product and service revenue from the Services division includes the revenues generated from the design, installation, leasing and sale of voice and data systems and products, primarily to companies in the oil and gas industry. The Corporate division includes certain general and administrative functions and operating expenses. Information regarding operating segments is as follows (in thousands):

      All revenue was derived from unaffiliated customers.

7

Table of Contents

(7) Fiber Build Agreement

      In February 1999, the Company entered into a joint build arrangement with Enron Communications, Inc., a wholly owned subsidiary of Enron Corp., to jointly build approximately 1,050 miles of fiber optic network within the state of Texas. The build plan includes four conduits to be placed throughout the 1,050 miles, with one and one-quarter conduits to be owned and funded by CapRock and one and one-quarter conduits to be owned and funded by Enron Communications, Inc., and one and one-half conduits to be owned and funded by a limited partnership formed by CapRock and Enron Communications, Inc. The limited partnership will sell a specified amount of fiber usage rights and CapRock will own 48 fibers.

      The total required capital contributions will depend on the costs to construct the segment. CapRock and Enron are committed to each contribute equally to fund the construction. The total construction costs for the 1,050 miles are estimated at approximately $100 million.

8

Table of Contents

ITEM 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

      The following discussion and analysis should be read in conjunction with CapRock’s consolidated financial statements and notes thereto for the year ended December 31, 1998. The Company believes that all necessary adjustments (consisting of normal recurring adjustments) have been included in the amounts stated below to present fairly the following quarterly information. Accounting measurements at interim dates inherently involve greater reliance on estimates than at year-end. The results for interim periods are not necessarily indicative of results to be expected for the year. In this Form 10-Q, the “Company,” “CapRock,” “we,” “us” and “our” refer to CapRock and its subsidiaries, including Telecommunications, CapRock Fiber and CapRock Services, which are our three predecessor companies, as well as CapRock Network Services, L.P., CapRock Telecommunications Leasing Corp. and CapRock Design Services, L.P., unless the context otherwise requires.

Forward Looking Information

      This Quarterly Report on Form 10-Q includes forward-looking statements. We have based these forward-looking statements on our current expectations and projections about future events. These forward-looking statements are subject to risks, uncertainties and assumptions about CapRock, including:

	•	our anticipated growth strategies,
	•	anticipated trends in our business, including trends in technology and the growth of communications network products and services,
	•	future expenditures for capital projects, and
	•	our ability to continue to control costs and maintain quality.

      Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including risks related to, among other things, building a fiber network (including obtaining the necessary rights-of-way, permits and regulatory approvals), supply and demand for data services, competition, the need for additional capital, debt and interest payment obligations, restrictions in our senior note indenture, rapid growth, dependence on local telephone companies and long distance carriers, our information systems, retention of key personnel, dependence on major customers, year 2000 problems, the continued integration of our predecessor companies, service interruptions, potential liability as an internet service provider and protection of our intellectual property.

      We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise. Because of these risks, uncertainties and assumptions, the forward-looking events discussed in this Form 10-Q might not occur.

Overview

      We own and operate a scalable long-haul fiber network which upon completion is expected to cover approximately 6,100 route miles throughout the Southwest region, which includes Texas, Louisiana, Arkansas, Oklahoma, New Mexico and Arizona. This fiber network supports the voice, data, bandwidth and dark fiber services we provide to our carrier and retail customers.

      In August 1998, we announced that we had completed a business combination transaction in which our predecessor companies combined to form our Company as it exists today. The combination was accounted for as a pooling of interests. Accordingly, our consolidated results include our three predecessor companies (i.e., Telecommunications, CapRock Fiber and CapRock Services) as though these entities had always been a part of CapRock.

      We intend to be the premier provider of carriers’ carrier services and the leading facilities-based integrated communications provider in the Southwest region. To measure our progress, we classify our

9

Table of Contents

      Our proximity to Mexico allows us to directly connect to the fiber networks of multiple Mexican telecommunications carriers. Subject to compliance with certain regulatory requirements, we are capable of providing dark fiber to these carriers at several border crossings enabling them to close open fiber rings in Mexico by using CapRock fiber on the U.S. side of the border. Additionally, our direct connect agreements with foreign carriers position us to capture increased levels of growing international traffic.

      In addition, in February 1999, CapRock entered into a joint build agreement with Enron Communications, Inc. to jointly build approximately 1,050 miles of fiber network in Texas. Through this joint build arrangement, we will connect Amarillo, Lubbock, Dallas, Fort Worth, Waco, Bryan, Austin, San Marcos, San Antonio and Houston, Texas. The build plan includes four conduits to be placed throughout the approximately 1,050 miles, with one and one-quarter conduits to be owned and funded directly by us, one and one-quarter to be owned and funded by Enron Communications and one and one-half to be owned and funded by a limited partnership formed by us and Enron Communications. Our agreements with Enron Communications provide that the partnership will install 192 fibers in the first conduit and will sell 96 of the 192 fibers to be installed. Of the remaining 96 fibers, we will own 48 fibers and Enron Communications will own 48 fibers. The joint build arrangement provides several benefits, including reduction of construction costs, accelerated acquisition of right of way and franchise agreements, the majority of which are essentially in place, and the freeing up of resources to potentially accelerate the build of the remaining portion of the network.

Results of Operations

      CapRock recognizes revenue from the following sources: carriers’ carrier, integrated services and systems services.

      Carriers’ Carrier. Carriers’ carrier revenue includes all carrier revenues generated from the sale of domestic and international switched services, from the sale of T-1 and DS-3 broadband capacity and from the sale and lease of dark fiber. The revenue generated from the international switched services represent minutes of long distance traffic terminating in foreign countries, but generated by domestic U.S.-based long distance carriers. Such revenues are recognized when the services are provided. The cost of revenues associated with these services is based primarily on the direct costs associated with owned and leased transmission capacity and the cost of transmitting and terminating traffic on other carriers’ facilities. Commissions paid to sales representatives or agents to acquire customer call traffic are expensed in the period when associated call revenues are recognized.

      We account for long-term construction contracts relating to the development of telecommunications networks for customers using the percentage-of-completion method, which would include the sale of fiber usage rights through IRUs and the related construction services associated with building the fiber network specified in the IRUs. Our revenues from IRUs are generated from the amount of fiber we build on our network in excess of that which we intend to retain for our own use. As a result, we expect that revenues from IRUs will diminish over time as our supply of excess fiber is sold. Progress under the percentage-of-completion method is measured based upon costs incurred to date compared with total estimated construction costs. Customers are billed based upon contractual milestones.

      Recent accounting pronouncements have effected the recognition of revenue associated with IRUs entered into after June 30, 1999. See “New Accounting Pronouncements.” Accordingly, revenue from the

10

Table of Contents

      Integrated Services. Integrated services revenue includes all revenues generated from the sale of telecommunications products to business and residential customers. These products include local, long distance, Internet, data and private line services.

      Systems Services. Systems services revenue includes revenues generated from the design, installation, leasing and sale of voice and data systems and products, primarily to companies in the oil and gas industry.

      The following table represents the various sources of revenues (in thousands):

      The following table sets forth, for the periods indicated, CapRock’s statement of operations as a percentage of its operating revenues:

Three Months Ended September 30, 1998 Compared to Three Months Ended September 30, 1999

      Revenues. Total revenues increased $13.7 million, or 39%, from $35.3 million during the three months ended September 30, 1998 to $49.0 million during the three months ended September 30, 1999. This increase was attributable to increases of 62% in carriers’ carrier, 16% in integrated services and offset by a slight decrease of 6% in systems services revenue for the comparable periods.

      Carriers’ carrier revenue increased $13.4 million from $21.7 million during the three months ended September 30, 1998 to $35.1 million during the three months ended September 30, 1999. The 62%

11

Table of Contents

increase resulted primarily from the sale of IRUs and dark fiber leases. Fiber related revenues, attributed to dark fiber leases or IRUs, increased $19.8 million from $1.3 million during the three months ended September 30, 1998 to $21.1 million during the three months ended September 30, 1999. The Company anticipates recurring fiber related revenue relating to IRUs and dark fiber leases to continue through the remainder of the year. However, period-to-period fluctuations can be expected as this type of revenue is affected by the negotiation and terms of these contracts and the build out of our network. The Company derived approximately $13.3 million and $8.2 million or 38% and 17% of its revenue from traffic terminated to international countries for the three months ended September 30, 1998 and 1999, respectively. Revenue per minute for a majority of the international countries, particularly Mexico, continues to decrease as a result of deregulation in the countries and competition. We anticipate this pricing trend for international traffic to continue.

      Integrated services revenue increased $838,000 from $5.4 million during the three months ended September 30, 1998 to $6.2 million during the three months ended September 30, 1999. The 16% increase was attributable to growth in the number of business and residential customers both from increased penetration in our existing markets and from the deployment of our network into new markets. The Company anticipates increased revenue from integrated services as its sales force for this revenue segment continues to grow.

      Systems services revenue decreased $498,000 from $8.2 million during the three months ended September 30, 1998 to $7.7 million during the three months ended September 30, 1999. The 6% decrease was attributable to a moderate reduction in the leasing and sale of voice and data systems products and projects involving the engineering and integration of telecommunications systems and sales, service and maintenance of telecommunications equipment. The Company anticipates quarterly systems services revenue for the remainder of the year to remain at comparable levels.

      Costs of Services. Cost of services increased $2.8 million, or 11%, from $26.0 million during the three months ended September 30, 1998 to $28.8 million during the three months ended September 30, 1999. The growth in cost of services was primarily attributable to the continued growth in revenue. The 15 percentage point increase in gross margin from 26% to 41% resulted primarily from favorable pricing attributable to the higher traffic and the sale of dark fiber. The increase in the gross margin during the three months ended September 30, 1999 was partially offset by lower margins attributable to Mexico and other international traffic, which carry a lower gross margin percentage. Gross margins may vary in future periods as a result of these and other factors.

      Selling, General and Administrative Expenses. Selling, general and administrative expenses (“SG&A”) include salaries, benefits, occupancy costs, commissions, sales and marketing expenses and administrative expenses. SG&A increased $8.3 million, or 155%, from $5.3 million during the three months ended September 30, 1998 to $13.6 million during the three months ended September 30, 1999. The increase resulted primarily from the additional personnel required to support CapRock’s growth, advertising to increase name recognition and brand awareness and additional sales commission payments.

      The Company recorded merger related expenses of $2.3 million during the three months ended September 30, 1998, as compared to no such costs during the corresponding period in 1999. The merger related expenses relate to the business combination of Telecommunications, CapRock Fiber and CapRock Services, our predecessor companies. This combination was consummated on August 26, 1998. The merger related expenses consist of fees for investment bankers, attorneys, accountants, financial printing and other related charges.

      Depreciation and Amortization Expense. Depreciation and amortization expense increased $1.5 million, or 113%, from $1.3 million during the three months ended September 30, 1998 to $2.8 million during the three months ended September 30, 1999. This increase resulted primarily from purchases of additional equipment and other fixed assets to accommodate CapRock’s growth. CapRock expects that depreciation and amortization expense will continue to increase in subsequent periods as CapRock continues to expand its facilities.

12

Table of Contents

      Interest Expense. Interest expense increased $5.0 million from $4.1 million during the three months ended September 30, 1998 to $9.1 million during the three months ended September 30, 1999. The increase resulted from interest expense related to the Company’s senior notes. See “— Liquidity and Capital Resources.”

      Interest Income. Interest income increased $2.1 million from $1.5 million during the three months ended September 30, 1998 to $3.6 million during the three months ended September 30, 1999. The increase was attributable to the interest and investment accretion associated with the marketable securities purchased with the proceeds from the Company’s senior notes issued in July 1998 and May 1999. See “— Liquidity and Capital Resources.”

      Income Tax Expense (Benefit). During the three months ended September 30, 1998, the Company incurred income tax benefit of $563,000 compared to an income tax expense of $32,000 for the three months ended September 30, 1999. The expense or benefit resulted from the income or loss for the respective periods. The effective tax rates for the three months ended September 30, 1998 and September 30, 1999 were 25% and 40%, respectively. The effective tax rate used to calculate income tax benefit for the three months ended September 30, 1998 was lower than the effective tax rate for the three months ended September 30, 1999 due to the non-deductibility of certain merger related costs.

      Net Income (Loss). Net income increased $1.7 million from a net loss of $1.7 million during the three months ended September 30, 1998 to net income of $49,000 during the three months ended September 30, 1999 as a result of the factors discussed above.

Nine Months Ended September 30, 1998 Compared to Nine Months Ended September 30, 1999

      Revenues. Total revenues increased $36.9 million, or 43%, from $86.7 million during the nine months ended September 30, 1998 to $123.6 million during the nine months ended September 30, 1999. This increase was attributable to increases of 69% in carriers’ carrier, 14% in integrated services and 1% in systems services revenue for the comparable periods.

      Carriers’ carrier revenue increased $34.7 million from $50.1 million during the nine months ended September 30, 1998 to $84.8 million during the nine months ended September 30, 1999. The 69% increase resulted primarily from the sale of IRUs and dark fiber leases. Fiber related revenues, attributed to dark fiber leases or IRUs, increased $40.5 million from $3.9 million during the nine months ended September 30, 1998 to $44.4 million during the nine months ended September 30, 1999. The Company anticipates recurring fiber related revenue relating to IRUs and dark fiber leases to continue through the remainder of the year. However, period-to-period fluctuations can be expected as this type of revenue is affected by the negotiation and terms of these contracts and the build out of our network. The Company derived approximately $24.0 million and $20.3 million or 28% and 16% of its revenue from traffic terminated to international countries for the nine months ended September 30, 1998 and 1999, respectively. Revenue per minute for a majority of the international countries, particularly Mexico, continues to decrease as a result of deregulation in the countries and competition. We anticipate this pricing trend for international traffic to continue.

      Integrated services revenue increased $1.8 million from $13.5 million during the nine months ended September 30, 1998 to $15.3 million during the nine months ended September 30, 1999. The 14% increase was attributable to growth in the number of business customers both from increased penetration in our existing markets and from the deployment of our network into new markets. The Company anticipates increased revenue from integrated services as its sales force for this revenue segment continues to grow.

      Systems services revenue increased $334,000 from $23.1 million during the nine months ended September 30, 1998 to $23.4 million during the nine months ended September 30, 1999. The 1% increase was attributable to moderate growth associated with the leasing and sale of voice and data systems products and projects involving the engineering and integration of telecommunications systems and sales, service and maintenance of telecommunications equipment. The Company anticipates quarterly systems services revenue for the remainder of the year to remain at comparable levels.

13

Table of Contents

      Costs of Services. Cost of services increased $13.7 million, or 23%, from $60.0 million during the nine months ended September 30, 1998 to $73.7 million during the nine months ended September 30, 1999. The growth in cost of services was primarily attributable to the continued growth in all three revenue categories. The nine percentage point increase in gross margin from 31% to 40% resulted primarily from favorable pricing attributable to the higher traffic and the sale of dark fiber. The increase in the gross margin during the nine months ended September 30, 1999 was partially offset by lower margins attributable to Mexico and other international traffic, which carry a lower gross margin percentage. Gross margins may vary in future periods as a result of these and other factors.

      Selling, General and Administrative Expenses. SG&A increased $23.7 million, or 159%, from $14.9 million during the nine months ended September 30, 1998 to $38.6 million during the nine months ended September 30, 1999. The increase resulted primarily from the additional personnel required to support CapRock’s growth, advertising to increase name recognition and brand awareness and additional sales commission payments.

      The Company recorded merger related expenses of $2.3 million during the nine months ended September 30, 1998, as compared to no such costs during the corresponding period in 1999. The merger related expenses relate to the business combination of Telecommunications, CapRock Fiber and CapRock Services, our predecessor companies. This combination was consummated on August 26, 1998. The merger related expenses consist of fees for investment bankers, attorneys, accountants, financial printing and other related charges.

      Depreciation and Amortization Expense. Depreciation and amortization expense increased $2.6 million, or 73%, from $3.6 million during the nine months ended September 30, 1998 to $6.2 million during the nine months ended September 30, 1999. This increase resulted primarily from purchases of additional equipment and other fixed assets to accommodate CapRock’s growth. CapRock expects that depreciation and amortization expense will continue to increase in subsequent periods as CapRock continues to expand its facilities.

      Interest Expense. Interest expense increased $14.1 million from $5.1 million during the nine months ended September 30, 1998 to $19.2 million during the nine months ended September 30, 1999. The increase resulted from interest expense related to the Company’s senior notes issued in July 1998 and May 1999. See “— Liquidity and Capital Resources.”

      Interest Income. Interest income increased $5.0 million from $1.6 million during the nine months ended September 30, 1998 to $6.6 million during the nine months ended September 30, 1999. The increase was attributable to the interest and investment accretion associated with the marketable securities purchased with the proceeds from the Company’s senior notes issued in July 1998 and May 1999. See “— Liquidity and Capital Resources.”

      Income Tax Expense (Benefit). During the nine months ended September 30, 1998, the Company incurred income tax expense of $1.3 million compared to an income tax benefit of $2.3 million for the nine months ended September 30, 1999. The expense or benefit resulted from the income or loss for the respective periods. The effective tax rates for the nine months ended September 30, 1998 and September 30, 1999 were 52% and 39%, respectively. The effective tax rate for the nine months ended September 30, 1998 was higher than the effective tax rate for the nine months ended September 30, 1999 due to the non-deductibility of certain merger related costs.

      Net Income (Loss). Net income decreased $4.8 million from net income of $1.2 million during the nine months ended September 30, 1998 to a net loss of $3.6 million during the nine months ended September 30, 1999 as a result of the factors discussed above.

14

Table of Contents

Liquidity and Capital Resources

      CapRock had cash and cash equivalents of $294,000 at December 31, 1998, as compared with $6.2 million at September 30, 1999 and marketable securities of $97.0 million at December 31, 1998 as compared to $245.9 million at September 30, 1999. CapRock had working capital of $102.5 million at December 31, 1998 as compared to working capital of $277.0 million at September 30, 1999. The increase in working capital was attributable to an increase in accounts receivable as well as the Company’s debt and equity offerings completed during the second quarter of 1999, discussed in more detail later in this section. This increase was partially offset by the utilization of working capital for the build out of the fiber optic network and increase in corporate overhead to support the Company’s growth.

      CapRock’s cash flow provided from operating activities for the nine months ended September 30, 1998 was $10.1 million as compared to $19.1 million used in operating activities during the nine months ended September 30, 1999. The change was primarily attributable to an increase in accounts receivable and unbilled services, and the timing of certain capital expenditure payments to vendors relating to the fiber optic network build out. IRU transactions typically have longer payment terms than other accounts receivable activity due to contractual milestones that must be met before payments are made.

      Cash used in investing activities during the nine months ended September 30, 1998 was $130.9 million as compared to cash used in investing activities during the nine months ended September 30, 1999 of $258.8 million. Capital resources used for the purchase of property, plant and equipment increased $80.7 million from $23.3 million during the nine months ended September 30, 1998 to $104.0 million during the nine months ended September 30, 1999. This increase primarily related to the purchase of telecommunications equipment and costs incurred with the build out of the fiber optic network. During the nine months ended September 30, 1998, the Company used $107.3 million to invest in marketable securities as compared to $283.6 million used to invest in marketable securities during the nine months ended September 30, 1999. Cash received from the sale of marketable securities was $134.8 million during the nine months ended September 30, 1999 as compared to no such sales during the nine months ended September 30, 1998.

      In January 1998, CapRock completed the acquisition of Integrated Communications and Engineering, Ltd., a communications systems integrator and maintenance provider in Aberdeen, Scotland. CapRock paid a total purchase price of approximately $2.2 million comprised of approximately $610,000 in cash and 207,266 shares of CapRock’s Common Stock.

      In July 1998, CapRock issued $150 million aggregate principal amount of its 1998 Senior Notes. Interest on the 1998 Senior Notes is payable semi-annually in arrears on January 15 and July 15 of each year, which commenced January 15, 1999, at the rate of 12% per year. A portion of the net proceeds from the offering of the 1998 Senior Notes was used to repay all existing debt obligations, totaling $26.8 million. The remaining proceeds, net of transaction costs, have been, or will be, used to fund additional capital expenditures for the construction of the Company’s fiber optic network, switching equipment and other capital expenditures to expand its sales offices, for potential acquisitions and for general working capital purposes. Unutilized funds have been invested in short-term, high-grade investment securities classified as available for sale. The indenture governing the issuance of the 1998 Senior Notes contains certain restrictive operating and financial covenants, including restrictive covenants relating to borrowing additional money, paying dividends or making other distributions to our shareholders, limiting the ability of subsidiaries to make payments to us, making certain investments, creating certain liens on our assets, selling certain assets and using the proceeds from those sales for certain purposes, entering into transactions with affiliates and engaging in certain mergers or consolidations. All of the covenants are subject to a number of important qualifications and exceptions. These covenants may adversely affect CapRock’s ability to finance its future operations or capital needs or to engage in other business activities that may be in the best interests of CapRock.

      On May 6, 1999, CapRock entered into an underwriting agreement with various underwriters to sell 4,000,000 shares of its common stock at a price of $22.00 per share in a public offering. The registration statement for the equity offering was declared effective by the SEC on May 6, 1999 and closed on May 12,

15

Table of Contents

1999. CapRock received net proceeds, after deducting underwriting discounts and expenses payable by CapRock, of approximately $81.9 million from the sale of its common stock.

      On May 18, 1999, the Company issued $210 million aggregate principal amount of its 1999 Senior Notes. Interest on the 1999 Senior Notes is payable semi-annually in arrears on May 1 and November 1 of each year, commencing November 1, 1999, at the rate of 11 1/2% per year. The Company received net proceeds from the offering, after deducting the initial purchasers’ discount and estimated expenses, of approximately $201.3 million. The 1999 Senior Notes are senior unsecured obligations and as such rank pari passu in right of payment with the Company’s existing 1998 Senior Notes and with all the Company’s future unsecured and unsubordinated indebtedness. The proceeds have been, and will be, used to fund capital expenditures for the construction of the fiber optic network, switching equipment and other capital expenditures and to expand its sales offices, for potential acquisitions and for general working capital purposes. Unutilized funds have been invested in short-term, high-grade investment securities classified as available for sale. The indenture governing the 1999 Senior Notes has restrictions and covenants similar to those which currently exist for the Company’s 1998 Senior Notes. All of the covenants are subject to a number of important qualifications and exceptions. These covenants may adversely affect CapRock’s ability to finance its future operations or capital needs or to engage in other business activities that may be in the best interests of CapRock.

      In July 1999, the Company filed an Exchange Offer Registration Statement with the SEC for the registration of $210 million of principal amount of its Exchange Notes to be offered in exchange for the 1999 Senior Notes. The Exchange Offer Registration Statement was declared effective by the SEC on July 30, 1999 and the Exchange Offer expired on September 1, 1999. The terms of the Exchange Notes are identical in all material respects to the 1999 Senior Notes except that the Exchange Notes have been registered under the Securities Act of 1933, as amended.

      CapRock is also considering various alternatives under a revolving credit facility. CapRock anticipates that this credit facility, if obtained, would be approximately $100 million. The proceeds from this credit facility would be used in a similar manner to the uses discussed for the notes issued by CapRock.

      CapRock expects to require significant financing for future capital expenditure and working capital requirements. By the end of the year 2000, CapRock intends to build out its fiber optic network to approximately 6,100 route miles throughout the Southwest region. CapRock intends to use advanced fiber capable of supporting dense wave division multiplexing with an OC-48 backbone scalable to OC-192, and intends to install 96 fibers throughout most of its network and intends to retain on average 24 fiber strands. CapRock is burying three to four conduits throughout its network. CapRock currently estimates that its aggregate capital requirements will total approximately $250 million for 1999 and approximately $205 million for 2000, including expenditures to be made under the joint build arrangement with Enron Communications. Capital expenditures will be required to (1) fund the construction and operation of the fiber optic network, including the portion to be constructed through the joint build arrangement with Enron Communications, (2) fund the installation of voice and data switches, and (3) open sales offices and add sales support and customer service personnel in markets throughout Texas, Louisiana, Oklahoma, Arkansas, New Mexico and Arizona.

      CapRock believes that its cash and marketable securities, cash flow from operations and sales of dark fiber will be sufficient to fund completion of its planned network. However, no assurances can be made as to whether additional sources of capital will be needed to complete the network and if such sources are needed, but CapRock is unable to obtain them, CapRock may have to curtail or delay the build out of its fiber network and its level of capital expenditures. CapRock’s earnings before interest, income taxes, depreciation and amortization (“EBITDA”) was $11.8 million (exclusive of $2.3 million in merger related expenses) for the nine months ended September 30, 1998. EBITDA was $11.3 million for the nine months ended September 30, 1999. EBITDA for the three months ended September 30, 1998 was $4.0 million (exclusive of $2.3 million in merger related expenses). For the three months ended September 30, 1999, EBITDA was $6.7 million.

16

Table of Contents

      CapRock may require additional capital in the future for new business activities related to its current and planned businesses, or in the event it decides to make additional acquisitions or enter into joint venture and strategic alliances. Sources of additional capital may include cash flow from operations, public or private equity and debt financings, bank debt, vendor financings and indefeasible right to use contracts. In addition, CapRock may enter into joint construction agreements with carriers, thereby reducing its capital expenditure requirements. However, we cannot assure you that CapRock will be successful in producing sufficient cash flow or raising sufficient debt or equity capital to meet its strategic business objectives or that such funds, if available, will be available on a timely basis and on terms that are acceptable to CapRock. If CapRock is unable to obtain such capital, the build out of portions of its expanded network may be significantly delayed, curtailed or abandoned. In addition, CapRock may accelerate the rate of deployment of its network, which in turn may accelerate CapRock’s need for additional capital. CapRock’s actual capital requirements will also be affected, possibly materially, by various factors, including the timing and actual cost of the deployment of CapRock’s network, the timing and cost of expansion into new markets, the extent of competition and the pricing of dark fiber and telecommunications services in its markets.

New Accounting Pronouncements

      In June 1998, the FASB issued SFAS No. 133, Accounting for Derivative Instruments and Hedging Activity (“SFAS 133”) which requires that all derivatives be recognized in the statement of financial position as either assets or liabilities and measured at fair value. In addition, all hedging relationships must be designated, reassessed and documented pursuant to the provisions of SFAS No. 133. SFAS 133 is effective for fiscal years beginning after June 15, 2000. The adoption of SFAS 133 will not have an impact on CapRock’s results of operations, financial position or cash flow.

      In June 1999, the Financial Accounting Standards Board (the “FASB”) issued Interpretation No. 43, “Real Estate Sales, an interpretation of FASB Statement No. 66.” The interpretation is effective for sales of real estate with property improvements or integral equipment entered into after June 30, 1999. Under this interpretation, dark fiber is considered integral equipment and accordingly title must transfer to a lessee in order for a lease transaction to be accounted for as a sales-type lease. The application of the provisions of FASB Interpretation No. 43 does not have an impact on CapRock’s financial condition, cash flow or results of operations.

Contingencies

      CapRock is party to ordinary litigation incidental to its business. No currently pending litigation is expected to have a material adverse effect on our results of operations, financial condition or cash flow.

Year 2000

      The year 2000 problem is the inability of a meaningful portion of the world’s computers, software applications and embedded semiconductor chips to cope with the change of the year from 1999 to 2000. This issue can be traced to the infancy of computing, when computer data and programs were designed to save disk space by truncating the date field to just six digits (two for the day, two for the month and two for the year). Therefore, information applications automatically assumed that the two-digit year field represented a year within the 1900’s. As a result of this, systems could fail to operate or fail to produce correct results when dates roll over to the year 2000.

State of Readiness

      The year 2000 problem affects computers, software and other equipment used, operated or maintained by CapRock for itself and its customers. CapRock has substantially completed the process of assessing and remediating the potential impact of the year 2000 problem for its internal systems, facilities systems and equipment.

17

Table of Contents

      CapRock’s business depends upon the operation of computer systems. CapRock has established a year 2000 committee made up of leaders from the operational areas of CapRock to assess CapRock’s year 2000 problem. The committee has the involvement of senior management and the Board of Directors and its objectives are a top priority. CapRock has undertaken various initiatives intended to provide that computer equipment and software will function properly with respect to dates in the year 2000 and thereafter. Computer equipment and software include systems that are commonly thought of as Information Technology, or IT, systems, including accounting, data processing, telephone/ PBX systems, scanning equipment and other miscellaneous systems, as well as systems that are not commonly thought of as IT systems, such as alarm systems, fax machines or other miscellaneous systems. Based upon its identification and assessment efforts, CapRock replaced certain computer equipment and software that was deemed to be non-compliant. In addition, in the ordinary course of replacing computer equipment and software, CapRock has obtained replacements that are warranted by the manufacturer to be year 2000 compliant.

      CapRock mailed questionnaires to its significant vendors, service providers and customers with whom CapRock’s systems electronically interface to determine the extent to which such interfaces and system processes are vulnerable to year 2000 issues and whether the products and services of such entities are year 2000 compliant. Substantially all of the parties responded to the request and no significant unresolved matters were noted from these responses.

      CapRock has evaluated its systems and has identified the following systems and functions as mission critical:

	•	switching systems,
	•	network operations and fiber,
	•	satellite/ microwave transmission equipment and satellite service providers,
	•	billing and call record collection systems, and
	•	supply chain (vendor provider of switched services).

      Switching equipment is used to connect calls to their destination while performing other advanced features and recording call information for future billing. The switch opens or closes circuits or selects the paths or circuits to be used for the transmission of information. CapRock currently owns seven switches, three of which are physically located in Dallas, Texas (two are calling card platforms), two in Houston, Texas, one in Victoria, Texas and one in Phoenix, Arizona. CapRock also manages a switch in Jersey City, New Jersey. CapRock has completed the assessment and test procedures relating to all switching equipment currently in service and had identified certain non-compliant features. These non-compliant features were remediated through software upgrades provided by the respective manufacturers.

18

Table of Contents

      Switches that have not been placed in service will be subject to integrated test procedures prior to being placed in service. The test will incorporate the call collection processes and the interfaces with the billing system. The test will involve simulating date changes with the switch, such that the call records will be processed, rated and properly captured in the billing system as a billable transaction.

      The test procedures consist of the following:

	•	process flow analysis,
	•	documentation of overall integrated test strategy,
	•	documentation and test case plans at an individual component level,
	•	committee agreement regarding the test plan,
	•	execution of the integrated test plan, and
	•	documentation regarding the results of test procedures.

      CapRock currently owns and operates a fiber optic network, for which approximately 2,000 route miles were substantially complete as of September 30, 1999. The total route miles upon completion of the network will be 6,100 miles (which CapRock expects to be completed by the end of the year 2000). The fiber optic network is designed to be scalable and will include network-advanced fiber, which is capable of supporting dense wave division multiplexing with an OC-48 backbone scalable to OC-192. The fiber optic network will include electronic equipment, which regenerates and transports the voice, data and other information. A detailed assessment and test procedures relating to the network operations and fiber equipment has been performed and no significant non-compliant issues were identified.

      CapRock utilizes satellite service providers to provide communication services to certain customers in remote locations. CapRock has received correspondence or other information from each of the three vendors supplying the satellite services regarding their year 2000 readiness efforts. Based upon this information, we believe there are no significant non-compliant issues relating to these satellite service providers.

      CapRock handles its provisioning, customer care, billing and traffic reporting functions on a proprietary software platform developed by RiverRock Systems, Ltd. (a Texas limited partnership in which CapRock has a 49% ownership interest), supplemented with various third party software applications. These operations support systems, or OSS systems, and other back office systems are used to enter, schedule and track a customer’s order from the point of sale to the installation and testing of service. The systems also include or interface with trouble management, inventory, billing, collection and customer service systems. The test procedures relating to the billing system and call record collection processes were performed in conjunction with the switching equipment test procedures and are complete.

      CapRock believes that the hardware, database platform and operating systems impacting the billing system function will not be materially affected by Year 2000 issues.

19

Table of Contents

      CapRock is dependent upon a number of telecommunications carriers during the process of initiating and terminating calls to end-users. CapRock has received correspondence from its significant suppliers regarding their year 2000 status. Based upon the diversity of the suppliers and other information received, we believe that our ability to utilize our supply chain will not be materially affected by Year 2000 issues.

      Based on current results and other factors, CapRock does not anticipate finding any material embedded system issues in its non-IT systems.

Costs

      CapRock has estimated costs of replacing or remediating remaining non-compliant systems, none of which are significant, and such amount is less than $150,000. Costs incurred to date are approximately $100,000.

Risks

      CapRock believes that the most reasonably likely worst case scenario would involve loss of revenues relating to traffic terminating in certain developing third world countries, which have not adequately prepared for the year 2000. CapRock relies upon certain vendors to supply international services and the possibility exists that some of the traffic in these developing third world countries may not be able to be completed. The estimated loss of revenue, if any, cannot reasonably determined, and we may not be able to identify the amount of any loss by the year 2000. Depending on the systems affected, the failure of any contingency plans developed by CapRock, if implemented, could have a material adverse effect on CapRock’s financial condition, cash flow and results of operations.

Contingency Plans

      CapRock’s year 2000 contingency planning effort is designed to provide immediate response and subsequent recovery from any unplanned business interruption due to failure of technical infrastructure resulting from the year 2000. Contingency planning is a process that aids in determining the most effective actions, identifies when contingent actions should be taken and helps to ensure those resources necessary for response are available.

      The contingency planning process included the development of certain mission critical functions and management (escalation) plans. The Company’s contingency plan also includes re-routing traffic from a vendor which experiences a year 2000 systems failure to one or more other vendors.

Disclaimer

      The discussion of CapRock’s efforts, and management’s expectations, relating to year 2000 compliance are forward-looking statements and the dates on which CapRock believes it will complete such efforts are based upon management’s best estimates. These estimates were derived using numerous assumptions regarding future events, including the continued availability of certain resources and other factors. We cannot assure you that these estimates will prove to be accurate, and our actual results could differ materially from those currently anticipated. Specific factors that could cause such material differences include, but are not limited to, the availability and cost of personnel trained in year 2000 issues, the ability to identify, assess, remediate and test all relevant computer codes and embedded technology and similar uncertainties. In addition, variability of definitions of “compliance with year 2000” relating to products and services sold by CapRock may lead to claims whose impact on CapRock is currently not estimable. We cannot assure you that the aggregate cost of defending and resolving such claims, if any, will not materially adversely affect our results of operations.

20

Table of Contents

ITEM 3.  Quantitative and Qualitative Disclosure About Market Risk

      CapRock is exposed to market risk from changes in marketable securities (which consist of money market and commercial paper). At September 30, 1999, marketable securities of CapRock were recorded at a fair value of approximately $246 million, with an overall weighted average return of approximately 5% and an overall weighted average life of less than 1 year. The marketable securities held by CapRock have exposure to price risk, which is estimated as the potential loss in fair value due to a hypothetical change of 50 basis points (10% of CapRock’s overall average return on marketable securities) in quoted market prices. This hypothetical change would have an immaterial effect on the recorded value of the marketable securities.

      CapRock is not exposed to material future earnings or cash flow fluctuations from changes in interest rates on long-term debt since 100% of its long-term debt is at a fixed rate as of September 30, 1999. The fair value of CapRock’s long-term debt at September 30, 1999 was estimated to be $344 million based on the overall rate of the long-term debt of 11.71% and an overall maturity of 9.25 years compared to terms and rates currently available in long-term financing markets. Market risk is estimated as the potential decrease in fair value of CapRock’s long-term debt resulting from a hypothetical increase of 117 basis points in interest rates (ten percent of CapRock’s overall borrowing rate). Such an increase in interest rates would result in approximately a $9 million decrease in fair value of CapRock’s long-term debt. To date, CapRock has not entered into any derivative financial instruments to manage interest rate risk and is currently not evaluating the future use of any such financial instruments.

      CapRock conducts business in Aberdeen, Scotland, through a wholly owned subsidiary. However, the business transacted by this subsidiary is in the local functional currency. Therefore, CapRock does not currently have any exposure to foreign currency transaction gains or losses. All other business transactions are in U.S. dollars. To date, CapRock has not entered into any derivative financial instrument to manage foreign currency risk and is currently not evaluating the future use of any such financial instruments.

21

Table of Contents

PART II.  OTHER INFORMATION

ITEM 1.  Legal Proceedings

      Information pertaining to this item is incorporated herein from Part I. Financial Information (Item 2 — Management’s Discussion and Analysis of Financial Condition and Results of Operations — Contingencies).

ITEM 2.  Changes in Securities and Use of Proceeds

      On May 6, 1999 (the “Effective Date”), the Company’s Registration Statement on Form S-1 (Registration No. 333-74735) relating to its public offering (the “Offering”) was declared effective and the offering of up to 4,600,000 shares of the Company’s Common Stock covered by such Registration Statement commenced. The Offering was managed by Merrill Lynch & Co., as the representative (the “Representative”) of the several underwriters (the “Underwriters”) of the Offering. Pursuant to the Offering, 4,000,000 shares were sold on May 12, 1999 (the “Offering Date”). From the Offering Date until September 30, 1999, total expenses of approximately $6.1 million were incurred for the Company’s account in connection with the Common Stock sold in the Offering, which expenses consisted of: (i) $5.3 million representing underwriters discounts and commissions paid to the Underwriters; and (ii) other offering expenses, including without limitation attorney’s fees, accountant’s fees, printing costs and filing fees, of approximately $750,000. None of such expense payments were direct or indirect payments to directors or officers of the Company or their associates or to persons owning 10 percent or more of any class of equity securities of the Company or to affiliates of the Company. The net offering proceeds of the 4,000,000 shares sold by the Company in the Offering, after deducting such expenses, was approximately $81.9 million through September 30, 1999. As of September 30, 1999, the Company had expended $68.5 million on infrastructure, property, plant and equipment. The remaining $13.4 was invested in high-grade liquid securities classified as available for sale pending application of such proceeds by the Company.

      Information pertaining to working capital restrictions and other limitations upon the payment of dividends is incorporated herein from Part I. Financial Information (Item 2 — Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources).

ITEM 6.  Exhibits and Reports on Form 8-K

(a)  Exhibits

	†	Filed herewith.

(b)  Reports on Form 8-K

      None.

22

Table of Contents

CAPROCK COMMUNICATIONS CORP.

      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.

	CAPROCK COMMUNICATIONS CORP.

	By:	/s/ MATTHEW M. KINGSLEY

	Matthew M. Kingsley
	Corporate Controller
	(Principal Accounting Officer)

Date: November 2, 1999

23

Table of Contents

INDEX TO EXHIBITS

†	Filed herewith.