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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934 (NO FEE REQUIRED)
FOR THE TRANSITION PERIOD FROM TO .
COMMISSION FILE NUMBER 333-61293
SPLITROCK SERVICES, INC.
(Exact name of registrant as specified in its charter)
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DELAWARE 76-0529757
(State or other jurisdiction (I.R.S. Employer Identification No.)
of incorporation or organization)
8665 NEW TRAILS DRIVE 77381
THE WOODLANDS, TEXAS (Zip Code)
(Address of principal executive offices)
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Registrant's telephone number, including area code: (281) 465-1200
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2170 BUCKTHORNE PLACE, STE. 350 77380
THE WOODLANDS, TEXAS (Zip Code)
(Former address of principal executive offices
If changed from last report)
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Securities registered pursuant to Section 12(b) of the Act:
NONE
(Title of Class)
Securities registered pursuant to Section 12(g) of the Act:
NONE
(Title of Class)
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 [ ].
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]
The aggregate market value on March 19, 1999, of the voting stock held by
non-affiliates of the registrant is not ascertainable. The registrant is a
private company and there is no public market for the registrant's common
equity. Therefore, there is no readily ascertainable market value for the
registrant's common equity.
As of March 19, 1999, there were 82,898,750 shares of Common Stock, par
value $.001, outstanding of the registrant. The registrant does not have any
publicly traded shares of common stock.
DOCUMENTS INCORPORATED BY REFERENCE
None.
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SPLITROCK SERVICES, INC.
TABLE OF CONTENTS
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PART I
Item 1. Business........................................ 1
Item 2. Properties and Facilities....................... 16
Item 3. Legal Proceedings............................... 17
Item 4. Submission of Matters to a Vote of Security
Holders................................................ 17
PART II
Item 5. Market For Registrant's Common Equity and
Related Shareholder Matters............................ 18
Item 6. Selected Financial Data......................... 19
Item 7. Management's Discussion and Analysis of
Financial Condition and Results of Operation.... 20
Item 7A. Quantitative and Qualitative Disclosures About
Market Risk............................................ 32
Item 8. Financial Statements and Supplementary Data..... 33
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure............. 33
PART III
Item 10. Directors and Executive Officers of the
Registrant............................................. 33
Item 11. Executive Compensation.......................... 36
Item 12. Security Ownership of Certain Beneficial Owners
and Management......................................... 38
Item 13. Certain Relationships and Related
Transactions........................................... 38
PART IV
Item 14. Exhibits, Financial Statement Schedules and
Reports on Form 8-K.................................... 40
Index to Financial Statements.................. F-1
Signatures..................................... S-1
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This report contains certain forward-looking statements within the meaning
of Section 27A of the Securities Act and Section 21E of the Exchange Act which
are intended to be covered by safe harbors created thereby. Stockholders are
cautioned that all forward-looking statements involve risks and uncertainty,
including, without limitation, the ability of the Company to continue its
Network Build, the ability of the Company to diversify its services and
customers, the ability to obtain necessary supplies, the ability to make
projected capital expenditures, and the ability to achieve projected quarterly
results, as well as general market conditions, competition, and pricing. All
statements, other than statements of historical facts, included or incorporated
by reference in this report that address activities, events or developments that
the Company expects or anticipates will or may occur in the future, including
such things as future capital expenditures (including the amount and nature
hereof), business strategy and measures to implement such strategy, competitive
strengths, goals, expansion and growth of the Company's business and operations,
plans, references to future success as well as other statements which include
words such as "anticipate," "believe," "plan," "estimate," "expect," and
"intend" and other similar expressions, constitute forward-looking statements.
Although the Company believes that the assumptions underlying the
forward-looking statements contained herein are reasonable, any of the
assumptions could be inaccurate, and the inclusion of such information should
not be regarded as a representation by the Company or any other person that the
objectives and plans of the Company will be achieved.
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PART I.
ITEM 1. BUSINESS
GENERAL
Splitrock Services, Inc. ("Splitrock" or the "Company") is a provider of
telecommunications services, including high speed Internet dial access services,
on an advanced nationwide network ("Splitrock Network" or "Network") based on
Asynchronous Transfer Mode ("ATM") switching technology which is deployed in
every point of presence ("POP") of the Network. The pervasive deployment of ATM
switches throughout the Network ("ATM-to-the-Edge"(TM)) enables the Company to
serve as a broad-based Internet Service Provider ("ISP") through the creation of
a multi-service platform which efficiently delivers Internet Protocol ("IP"),
frame relay and Internet services. This flexibility allows the Company to expand
its service offerings to provide fully integrated data, video and voice services
and to incorporate future technological innovations into its Network
architecture with a lower incremental investment than that required by other,
less flexible, networks. The Company currently provides nationwide Internet dial
access and related services to Prodigy Communications Corporation ("Prodigy"),
one of the largest U.S. ISPs, for its subscribers. In addition, the Company is
providing Internet dedicated access (transit), Web hosting, and virtual private
network ("VPN") services to other businesses. For the twelve months ended
December 31, 1998, the Company had revenues of $63.6 million.
The Splitrock Network reaches U.S. businesses and households with V.90
modem access (currently the fastest modem speed commercially available over
regular phone lines), including businesses and households in every market with a
population of at least 100,000 as well as several smaller markets. In September
1997 the Company began constructing and installing its advanced nationwide
Network ("Network Build") designed to have a physical presence in all 50 states,
targeting 90% of U.S. businesses and households with a local call. The Company
expects to achieve the planned coverage with approximately 370 POPs upon
completion of the Network Build.
In order to provide Internet dial access services to Prodigy for its
subscribers prior to the completion of the Splitrock Network, effective July 1,
1997 the Company entered into a series of agreements (collectively the "Prodigy
Agreement") to service the Prodigy subscribers and, as a part thereof, acquired
for interim use the legacy network infrastructure from Prodigy, which consisted
of substantially all network assets and related communications equipment owned
or leased by Prodigy (the "Prodigy Legacy Network"). Subsequently, the Company
agreed with International Business Machines Corporation ("IBM") to use the IBM
Global Services Network (the "IBM Network") to cover market areas that are
served neither by the Splitrock Network nor the Prodigy Legacy Network (the
Prodigy Legacy Network and the IBM Network are referred to collectively as the
"Legacy Network"). As of year end 1998, the Company was handling more than one
billion minutes of Internet traffic per month for Prodigy. As the Network Build
progresses, Prodigy Legacy Network POPs will continue to be decommissioned and
access to specific IBM Network POPs will be terminated when appropriate. About
75% of the Prodigy Legacy Network POPs were decommissioned by the end of 1998,
and the balance of such sites are planned for decommissioning by the end of
June, 1999. Likewise, usage of the IBM Network is expected to decline in the
first half of 1999 and such usage is expected to be substantially eliminated
during the third quarter of 1999.
The Company's executive offices are located at 8665 New Trails Drive, The
Woodlands, Texas 77381 and its telephone number is (281) 465-1200.
COMPETITIVE ADVANTAGES
The Company believes it benefits from the following competitive advantages
which will assist it in implementing its business strategy:
Flexible and Efficient New Network Infrastructure. The Splitrock Network is
designed to provide reliable, flexible and efficient services to the Company's
current and future customers. Since the Splitrock Network employs leading edge
equipment and architecture, the Company believes the Network contains
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many features that are not present in older networks and is able to readily
incorporate future developments and innovations. Older networks were typically
designed to provide one type of service, such as voice or data, and are less
efficient at carrying other traffic. Unlike many networks which deploy ATM
technology only along the core sites in the backbone, the Splitrock Network
deploys ATM switches at every POP site -- core, hub and remote. Each POP is
supported by the Lucent AC-120 switch which the Company believes provides
significant quality of service advantages over typical ATM switches. Management
believes that the Network contains more ATM-based switches than that of any
other commercial network. This pervasive use of ATM technology and the Lucent
AC-120 switch enables the Company to create a multi-service platform which
delivers IP, frame relay and other Internet services. In addition,
ATM-to-the-Edge(TM) provides additional capabilities to expand the Company's
service offerings to provide fully integrated data, video and voice services and
to incorporate future technological innovations into the Splitrock Network
architecture with a lower incremental investment than that required by other,
less flexible, networks.
Wholesale Provider of Quality Internet Dial Access. The Company currently
provides wholesale Internet data access services to Prodigy for its subscribers.
The Splitrock Network is designed to optimize network access, speed and
throughput. The Company believes that it offers a robust, reliable Network for
the delivery of high quality Internet dial access service.
Non-Aligned Carrier Status. The Company intends to market Internet dial
access services directly to ISPs rather than to individual end-users. As a
result, unlike many providers of network services, the Company does not intend
to compete directly against its ISP customers, thereby broadening the potential
customer base to include those ISPs unwilling to strengthen their competitors
with their own network business. Furthermore, the Company believes it will be
viewed as a non-competing vendor and, thus a potential partner, by major foreign
and regional telecommunications carriers, providing an alternative to their
primary U.S. competitors for delivering data, video and voice services.
Experienced Management Team. The Company's co-founders, Kwok L. Li,
Chairman of the Board and Chief Technical Officer, and William R. Wilson,
President and Chief Executive Officer, have assembled a management team with
significant data and voice communications experience. The 10 most senior
executives and managers of the Company have an average of over 12 years
experience in the data and voice communications industry. Previously, Mr. Li and
Mr. Wilson were both senior executives at WilTel Network Services, an operating
unit of The Williams Companies, Inc. ("WilTel"), a wholesale provider of
telecommunications services. During their tenure WilTel designed, constructed,
developed and managed modern packet switched networks (including frame relay and
ATM) and marketed related services. Mr. Li was a founder of Yurie Systems, Inc.
("Yurie"), which was sold to Lucent Technologies, Inc. ("Lucent") in May, 1998.
At the time of the sale of Yurie to Lucent, Mr. Li was a Director, Vice Chairman
and Chief Technical Officer at Yurie, where he created and designed the Lucent
AC-120 switch.
BUSINESS STRATEGY
Key elements of the Company's business strategy include:
Complete the Expansion of the Advanced Network Infrastructure. The Company
has designed, deployed and is in the process of expanding the Splitrock Network,
an advanced nationwide telecommunications network based on ATM switching
technology. The Company believes that its ATM-to-the-Edge(TM) network results
in: (i) a more easily upgradeable network; (ii) the ability to efficiently add
new services at a lower incremental investment; (iii) improved network
reliability; (iv) interoperability with other network platforms; and (v)
improved network manageability. The Company believes that the Network Build will
be substantially completed by the end of the second quarter of 1999.
Offer a Comprehensive Range of Services to Optimize Network
Utilization. Given the fixed cost nature of the Splitrock Network's
infrastructure, the Company seeks to increase total network utilization
primarily by targeting providers of business services (daytime intensive
traffic) and, to a lesser extent, providers of consumer services (evening
intensive traffic) to maximize the Network's usage throughout a 24-hour period.
The Network's flexibility will provide for service innovation (including data,
video and voice services) with lower incremental investment than less flexible
networks. To offer new services, the Company will only need to
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add the appropriate protocol processors and billing and service management
systems without changes to the core ATM switching platform. Therefore, the
Company believes it will be able to maximize Network utilization by offering
both daytime business-oriented services (such as dial VPN and frame relay
services) and evening-time consumer-oriented services (such as Internet dial
access services). The ability of the Company to offer a wide range of services
will enhance its ability to optimize traffic at all times of the day, thereby
increasing revenue and profitability. As its business strategy is implemented,
the Company will evaluate offering complementary services as they are required
by its customer base.
Development of Advanced Business Support Systems. Through the development
of scalable business support systems, the Company believes that it has the
opportunity to establish a competitive advantage relative to traditional network
service providers. Traditional network service providers typically operate
extensive legacy business support systems with compartmentalized architectures
that limit their ability to scale rapidly and introduce enhanced services and
features. In connection with the expansion of the Splitrock Network the Company
is creating business support systems with an architecture designed to maximize
both reliability and scalability. All database and billing systems will run on a
PC or UNIX distributed architecture rather than centralized mainframe systems.
Expand Target Market Opportunities. International Data Corporation ("IDC"),
a leading provider of industry data and analysis, estimates that the total
number of U.S. companies with Internet access will grow from an estimated 1.5
million, or 20.0% of total U.S. companies, in 1996 to 4.1 million, or 53.0% of
total U.S. companies, in 2000. IDC also estimates that the number of U.S.
households with a personal computer and a modem will grow from an estimated 8.8
million, or 24.0% in 1996, to 39.4 million, or 58.0% in 2000. IDC estimates that
there are over 4,000 ISPs in the U.S., consisting of national, regional and
local providers, of which the Company believes only a small percentage have
access to their own nationwide backbone network infrastructure. The Company
intends to capitalize on this expected growth in demand for network services by
aggressively marketing its services through a variety of distribution channels
and evaluating strategic alliances and acquisitions as they present themselves.
The Company believes that utilizing a range of distribution channels will enable
it to cost-effectively reach a broad base of potential customers. The Company
currently intends to develop and use a direct sales force to attract ISPs,
carriers, value added service providers and medium and large businesses. In
addition, the Company intends to use alternative distribution channels,
including agents, resellers and wholesalers, to gain access to a substantially
larger base of potential customers than the Company could otherwise initially
address through its direct sales force. Through the combination of a direct
sales force and alternative distribution channels, the Company will seek to
rapidly increase revenue-producing traffic on its Network.
The Company also intends to evaluate strategic alliances and acquisitions
that could provide additional traffic over the Splitrock Network. While the
Company is primarily focused on the domestic services market, it believes the
demand for Internet services outside the U.S. will grow over the next few years.
As a result, the Company will evaluate opportunities in Europe, Asia, and Latin
America, to partner with strong, established telecommunications service
providers. The Company intends to enter into international alliances to
originate and terminate international traffic on the Splitrock Network. For
example, in cooperation with Telefonos de Mexico, S.A. de C.V. ("Telmex"),
Mexico's primary telephone company, the Company intends to test connectivity
between the Splitrock Network and Telmex's data network.
Provide Superior Comprehensive Customer Service. Splitrock believes that
superior customer service is a critical element in attracting and retaining
customers and expanding value added services to existing customers. In
particular, the Company has established two 24-hours-a-day, seven-days-a-week
network operating centers ("NOC") located at The Woodlands, Texas and Yorktown
Heights, New York. The Company intends to maintain at least two geographically
dispersed NOC's, each of which will be able to monitor the entire Network and
provide rapid problem resolution.
SPLITROCK'S NETWORK
Overview. The Splitrock Network is a facilities-based nationwide ATM-based
commercial telecommunications network. The Network reaches U.S. businesses and
households by a local call with V.90 modem
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access in every market with a population of at least 100,000 as well as several
smaller markets. Upon completion of the Network Build, the Splitrock Network
will have approximately 370 active POPs with a physical presence in all 50
states, targeting over 90% of U.S. businesses and households with a local call.
On June 24, 1997, but effective July 1, 1997, the Company entered into the
Prodigy Agreement to provide nationwide Internet dial access and related
services to Prodigy for its subscribers on the new Splitrock Network. In order
to provide Internet dial access services to Prodigy while the Splitrock Network
was being deployed, the Company acquired the Prodigy Legacy Network and began
immediately providing Internet dial access and related services to Prodigy for
its subscribers. Additionally, the Company continued Prodigy's previous use of
the IBM Network to cover market areas that were served neither by the Splitrock
Network nor the Prodigy Legacy Network. As of December 31, 1998, the Company
handled more than one billion minutes of Internet traffic per month for Prodigy.
As of December 31, 1998, approximately two-thirds of the traffic was carried on
the Splitrock Network and approximately one-third on the Legacy Network. As the
Network Build progresses, Prodigy Legacy Network POPs are decommissioned and
access to specific IBM Network POPs are terminated when appropriate. About 75%
of the Prodigy Legacy Network POPs were decommissioned by the end of 1998, and
the balance are planned for decommissioning by the end of June, 1999. Likewise
usage of the IBM Network is expected to decline in the first half of 1999 and be
substantially eliminated during the third quarter of 1999. In addition to
providing Internet dial access and related services to Prodigy, the Company
launched Internet dedicated access (transit) services and VPN services on a
limited basis to select customers during the second half of 1998.
Network Performance. Inverse Technology, Inc. ("Inverse") measures and
reports eight parameters of ISP's network performance (24-hour call failure
rate, evening-hour call failure rate, business-hour call failure rate, initial
modem connect speed, average time to login, average DNS (Domain Name System)
lookup time, average Web throughput and average total Web failures/timeouts).
Overall, the ratings for Prodigy exceeded or equaled the industry ratings in at
least six of the eight parameters for each of the months of May through December
1998. In particular, Inverse reported that Prodigy's evening-hour call failure
rate was equal to or better than the industry average for 7 of the 8 months
between May and December 1998. The Company believes call failure rate is the
most important network measure in terms of customer satisfaction. The 13
providers making up the Inverse industry average are: AOL, AT&T, CompuServe,
Concentric, EarthLink, GTE, IBM, Cable & Wireless, Microsoft Network,
MindSpring, NETCOM, Prodigy, and UUNET. Investors should not place undue
reliance on Inverse's reports as a measure of network performance because such
reports do not measure and report on all factors that may affect the quality of
the Company's services. For example, Inverse's reports are based on tests
conducted on selected days at a random sampling of only 42 of Splitrock's POPs.
The Splitrock Network Architecture. The Splitrock Network, through its
ATM-to-the-Edge(TM) Network architecture, allows the Company to concurrently
provide multiple services such as data, video and voice to its customers and to
incorporate future technology changes at relatively low incremental investments.
As a result, the Company believes it has created a more efficient network than
its competitors, thereby reducing future operating costs and concurrently
improving reliability to the end user.
Communication service providers have typically provided services using two
predominant types of infrastructure, one geared towards voice service and the
other designed to optimize data communications. These infrastructures are based
on (i) telecommunications switches designed primarily for voice grade services
or (ii) data telecommunications routers and switches designed primarily for
communications between computers. Practical considerations and equipment
constraints have led to the development of these two types of distinct network
infrastructures. Voice telecommunications service providers historically have
needed to provide a high level of reliability because of the need for life
dependent emergency services such as 911 calls. Since telephone services use
relatively simple handsets that cannot redial or re-transmit automatically if
disconnected, telephone network providers depend upon equipment reliability,
network architecture design, network management and maintenance to meet their
service needs and reliability constraints. Data telecommunications service
providers, on the other hand, have the benefit of highly intelligent terminals
at the end-user. These terminals usually can determine if a transmission error
has occurred and automatically re-transmit data and even reconnect a session if
necessary. With the help of intelligent terminals, data telecommunication
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service equipment run complex routing algorithms that allow them to locate and
find the best route to transmit data. While providing a high degree of
flexibility, data telecommunication service equipment is generally plagued with
system reliability issues and often unpredictable performance. This attribute
has historically differentiated data telecommunication service equipment from
voice telecommunication service equipment.
In order to create a network which efficiently supplies multiple types of
services, such as data, video and voice, a company must make the platform
reliable enough to support voice, yet flexible enough to support data. To date,
companies successfully providing voice and data concurrently have partitioned
their network's bandwidth to support two separate service infrastructures. Part
of their bandwidth is used for voice, employing voice telecommunications service
switches, and the other part is used for data, employing standard data
telecommunication equipment in the network.
Separating bandwidth use has been a practical way to provide multiple
services. Particularly today, when voice traffic still dominates the majority of
bandwidth transferred over most networks, all major networks have partitioned
their bandwidth into two separate components, one to carry voice and the other
to carry data. As long as data represents a small portion of network traffic,
this partitioning remains practical. However, it is expected that the rapid
growth of data will soon cause data to consume more bandwidth than voice. When
that occurs, partitioning will make network bandwidth utilization very difficult
to optimize while creating significant management complexity.
The Splitrock Network was designed to address these and other constraints
facing older networks by not requiring the separation of bandwidth for different
types of services. In the process of designing the Network the Company sought to
create a Network infrastructure which could (i) efficiently offer data, video,
and voice services concurrently, (ii) reduce operating costs by more efficient
utilization of network resources and (iii) provide high quality service for all
services offered on the Network.
The Company believes that three features distinguish the Splitrock Network
from other telecommunications networks. First, Splitrock uses the Lucent AC-120
switch which supports multiple services at every POP of the Network. The Company
believes that this "intelligent" ATM switch differs from typical ATM backbone
switch engines because it supports many access protocols to the Network whereby
an array of data, video and voice services can be sent and/or received, such as
IP, frame relay, ATM, Ethernet, T-1, T-3, OC-3 and many other digital as well as
analog interfaces. Also, the Lucent AC-120 is scalable with up to fourteen
interface module slots designed to house interface cards supporting these
various services. The Lucent AC-120 translates these native service protocols
into standard ATM format and transports any service as an ATM connection. In
addition, the Lucent AC-120 implements a patented queuing algorithm, allowing
simultaneous support of data, video and voice services on a unified platform
without loss of quality of service even during periods of high network
utilization. The queuing algorithm eliminates the need for bandwidth allocation
to different kinds of services.
Second, to manage the large number of ATM switches in the Network, the
Company organized the Network architecture into classes and regions. This
architecture allows the Company to more quickly introduce new services because
all new services can be layered on the Network's ATM switching fabric without
alterations being made to the fabric itself. A new network service has two
components, the protocol that defines the format of the information payload and
the signaling or routing instructions required to direct the information to its
destination in the network. The Splitrock Network ATM switching platform
streamlines the signaling process because routing information is concentrated in
a limited number of central sites in the Network (known as core sites) rather
than having signaling or routing information interpreted by switches or routers
at every point of the network as occurs, for example, in a typical IP-based
network. Therefore, to introduce a new service, the Company only needs to deploy
the proper signaling or routing processors at a few core sites instead of
hundreds of switch or router sites distributed around the network. This reduced
number of routing decisions also allows for better management and typically
faster throughput than other networks.
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Third, most modern networks achieve transmission efficiencies by deploying
ATM switching engines in three to twenty access sites only in the core backbone
of their network. In contrast, Splitrock has created an ATM switching fabric
that blankets the entire network (i.e., ATM switches are located in all POPs
throughout the Splitrock Network). At the end of the Network Build, Splitrock
expects to have approximately 370 ATM switches deployed in its Network. The
ATM-to-the-Edge(TM) Network forms the basic platform for Splitrock to offer
multiple services to all users on the Network.
The Splitrock Network is organized into three classes of access sites: core
sites, hub sites and remote sites. The architecture partitions the entire
Network into 21 regions, with a core site in each region. The core site is
generally located in the city with the most traffic in that region. Users access
the Network within a region by connecting to either a core, a hub or a remote
site. The core sites form the backbone of the Splitrock Network, with the hub
and remote access sites extending the reach of the backbone.
The following diagram is a simplified illustration of the Company's
ATM-to-the-Edge(TM) Network architecture, and is designed for illustrative
purposes only. It does not represent the actual number or location of POPs.
[SITEMAP]
Splitrock's 21 core sites are equipped with Lucent AC-120 switches. Using
ATM technology, these core sites are logically fully meshed, allowing traffic to
pass directly from any one region to any other region. The core sites are
interconnected by standard transmission links such as DS-3 or OC-3, which are
available from Interexchange Carriers ("IXCs") such as MCI WorldCom, Inc. ("MCI
WorldCom") and Qwest Communications International Inc. ("Qwest"). Because the
Lucent AC-120 conforms to standard transmission specifications, the Company can
purchase bandwidth on an actual need basis between each site and upgrade these
links as the bandwidth demand increases.
In addition, each core site is equipped with special protocol processors to
enable the Network to accommodate demand for a wide variety of services. For
example, to support IP protocol for Internet services, standard Cisco IP routers
are installed, one per core site. These are the only routers installed in the
Network as opposed to other networks which have routers installed throughout the
network. Since a router has direct connections to every other router in the
Splitrock Network, the routers have very simple routing tables and can forward
packets from region to region efficiently and directly.
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Hub sites service the major cities within a region. Each hub site is
equipped with a Lucent AC-120 switch and all other user access equipment,
including Bay Network modems, necessary for Internet dial access service. Hub
sites connect to core sites over a DS-3 line or multiple T-1 lines depending on
the traffic requirements. Hub sites can be connected redundantly to other hub
sites or to core sites to increase network reliability. For IP traffic, all
packets from a hub site are forwarded directly to the region's core site, and
then forwarded to their destination region by the core site router.
The Network has a large number of remote sites to reach the smaller cities
within a region. These sites are also fully equipped with Lucent AC-120 switches
and other equipment to allow user access to the same services as elsewhere in
the Network. Remote access sites connect to a hub site, usually with a T-1 line.
The remote sites can also be protected from transmission failures by being
connected redundantly to other access sites in the region.
The following diagram is a simplified illustration of how the Splitrock
Network is designed to deliver data (including Internet), video and voice
services.
[GRAPH]
Network Infrastructure. The Company believes that it has provided for
future growth by ensuring that the Splitrock Network is scalable, flexible,
fault tolerant, open standards and interoperable and manageable from remote
locations.
- Scalable. Splitrock's flexible, multi-layer network architecture utilizes
a high-speed switching fabric enabling the Company to grow the number of
POPs and the number of users served in an incremental manner that matches
investment with demand. The Splitrock Network's scalability extends
beyond the currently installed base of POPs to allow for growth without
fundamental design changes.
- Flexible. The Company believes that the Splitrock Network will adapt to
new services and manages network resources according to each service's
needs, permitting the Network to efficiently offer data, video and voice
services concurrently. On the switching level, Lucent AC-120 switches
adjust Network responses based on the traffic's delay and loss
sensitivities. On the protocol level, the Network architecture is able to
sort and direct various protocols to its designated protocol processors,
including Internet packets to Cisco routers, integrated services digital
network ("ISDN") signaling to workstations with ISDN software, and
traditional voice network signaling to workstations with voice network
("SS7") software.
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- Fault Tolerant. Redundancy and adaptive technology in the Splitrock
Network reduces the impact of isolated failures. For example, all core
sites are interconnected, allowing traffic to be transferred among sites
in case of a failure. In addition, key switching, routers and
workstations are configured to search for alternate paths in the event of
individual component or transmission line failure. The Company also has
an uninterruptible power supply at each POP, limiting the impact of local
power outages on the Network.
- Open Standards and Interoperable. The Splitrock Network is entirely based
on standards compliant architecture supporting various protocols,
including IP, ATM, frame relay, ISDN video and SS7. This architecture
allows Splitrock to interconnect freely with other carrier networks or
customer networks. As a result, Splitrock can extend services of another
carrier outside of that carrier's own region. In addition, potential VPN
clients that use standards based protocols can easily access the Network
without having to purchase special equipment that would otherwise be
necessary with a proprietary network.
- Manageable. From its NOCs, the Company is able to monitor the Network
remotely, perform network diagnostics and equipment surveillance, and
inform customers when a network problem occurs. As a result of the
Company's network architecture, these tasks may be performed remotely
regardless of POP location or network status. This capability allows the
Company to control costs associated with on-site network configuration
and repair.
Network Management. The Company believes that superior customer service is
important in attracting and retaining new customers, and expanding value added
services to existing customers. In particular, the Company believes it is
critical to maintain two geographically dispersed NOCs, each of which is able to
monitor the entire Network and provide rapid problem resolution. The Company has
established two 24-hours per day, seven days per week NOC facilities located in
The Woodlands, Texas and Yorktown Heights, New York .
Peering. Peering arrangements between the Company and ISPs are necessary to
exchange traffic destined for other networks and to allow external traffic
access to the Splitrock Network. With Prodigy as a customer, the Company carries
a significant amount of Internet traffic. The Company is building an
infrastructure equivalent to other Tier 1 providers and it has sought peering
relationships with many Tier 1 and Tier 2 ISPs. Peering arrangements have been
established with six ISPs, including Sprint and PSINet, and the Company is
currently in discussions with other ISPs in order to broaden its peering
capabilities. The Company peers with other networks from a core site through an
industry standard Cisco router, which promotes proper protocol exchange between
Splitrock and other ISPs.
Transmission Services. The Company leases long distance connections of
various bandwidths to connect sites in the Network. The choice of long distance
carriers is based on their network reliability, bandwidth availability,
responsiveness and pricing. The Company currently leases a majority of its long
distance connections from WorldCom and periodically reviews the capability and
costs of such services by other suppliers, such as Sprint and Qwest. The Company
continues to monitor its needs for greater bandwidth and may enter into
agreements to enlarge its bandwidth capability.
The Company leases local connections (DS-1, T-1 or ISDN PRI) to access the
end-user. The local service providers are selected based on their reliability,
service availability, responsiveness, pricing and minimum switch congestion
during busy hours. Based on these criteria, the Company has existing
relationships with many competitive local exchange carriers ("CLECs") and all
major incumbent local exchange carriers ("ILECs") in the country.
PRODUCTS AND SERVICES
General. The ATM-to-the-Edge(TM) Network enables the Company to offer new
services with lower incremental investment than that required by less flexible
networks. Currently, the Company provides Internet access options and
related-services, including Internet dial access services and Internet dedicated
access services, as well as VPN services. The Company is seeking to increase
total Network utilization primarily by
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targeting providers of business services (daytime intensive traffic) and, to a
lesser extent, providers of consumer services (evening intensive traffic).
Internet Service Options. The Company provides the following Internet
access options and related services to its customers:
- Dial Access. The Company's Internet dial access services offer a cost
effective Internet solution that provides V.90 modem access to the
Company's advanced ATM-to-the-Edge(TM) Network via ordinary telephone
lines. The Company's Internet dial access services provide smaller ISPs
with the opportunity to increase their user base over time while at the
same time providing larger ISPs the opportunity to cost effectively
manage their growth. The Company currently provides Internet dial access
services to Prodigy for its subscribers. The Company intends to primarily
target business focused ISPs and businesses and, to a lesser extent, ISPs
with residential customers to maximize traffic throughout the Network.
During the twelve months ended December 31, 1998, Prodigy was the
Company's primary wholesale Internet dial access service customer
providing substantially all of the Company's revenues.
- Dedicated Access. The Company offers high speed dedicated connectivity to
the Internet for both business users and ISPs. The Company's Internet
dedicated access (transit) services provide full time dedicated Internet
connectivity at a range of access speeds from 56 Kbps to 155 Mbps. The
Company is targeting carriers (i.e. ISPs, ILECs, CLECs, regional long
distance providers and wireless providers) and corporate users as
potential customers for this service. The Company's Internet dedicated
access services provided less than 1% of total revenue during 1998.
VPN Services. Many companies today have private data communication networks
built on expensive leased lines designed to transfer data between office
locations. The Splitrock VPN services (both dedicated and dial) offer companies
a cost-effective alternative to leased lines. The Company expects that the
provision of VPN services will be an important focus of its future business.
DISTRIBUTION STRATEGY
Through the combination of a direct sales force and alternative
distribution channels, the Company believes that it will be able to access
markets and increase revenue-producing traffic on the Splitrock Network. To
implement its distribution strategy, the Company is developing an in-house sales
force. In addition, in November 1998, the Company launched its agent reseller
program and entered into an agreement with Community ISP, Inc. Under this
agreement, the Company will provide dial access services to Community ISP's
target market, primarily affinity groups and small businesses. The Company will
continue to pursue other alternative distribution channels in 1999.
The Company intends to also utilize its direct sales force to market its
products and services directly to ISPs, carriers, value added service providers
and medium and large businesses. The Company intends to utilize alternate
distribution channels to market its products and services to medium and small
businesses. These alternate distribution channels include agents, resellers and
wholesalers.
- Agents are independent organizations that sell the Company's products and
services under the Splitrock brand name to end-users in exchange for
revenue based commissions. The Company intends to identify agents that
generally focus on specific market segments (such as medium and small
businesses) and have existing customer bases. Sales through this
alternative distribution channel would require the Company to provide the
same type of services that would be provided in the case of sales through
its own direct sales force, such as order fulfillment, billing and
collections, customer service and direct sales management.
- Resellers are independent companies that would purchase the Company's
products and services and then "repackage" these services for sale to
their customers under their own brand name. The Company believes that
resellers will require access to certain of the Company's business
operating systems in connection with the sale of the Company's services
to the resellers' customers. Sales through this
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distribution channel generally would not require the Company to provide
order fulfillment, billing and collection and customer service.
- Wholesalers are independent companies that will purchase network service
capabilities in large quantities from the Company in order to market
their own products and services under a brand name other than Splitrock.
The Company believes that wholesalers would have minimal dependence on
the Company's business support systems in connection with the sale of
services to their customers.
CUSTOMERS
The Company currently provides Internet dial and dedicated access and VPN
services to its customers. To date, Internet dial access services have provided
substantially all of the Company's revenue. The Company expects this percentage
to decrease as the Company continues to add new customers.
Internet dial access customers. Prodigy has been the Company's customer
since July 1997 and has provided $22.7 million (100% of total revenues) of
Internet dial access revenue during the period from July 1997 to December 31,
1997 and $63.6 million (99% of total revenues) of Internet dial access revenues
during the twelve months ended December 31, 1998.
Under the terms of the Prodigy Agreement, the Company provides services for
each of the types of Prodigy subscribers, Prodigy Classic and Prodigy Internet.
The Company's services for Prodigy Classic subscribers was to end not later than
December 31, 1998. In mid-1998, the Company, at Prodigy's request, agreed to
extend the date for one year with termination to occur not later than December
31, 1999. Prodigy recently announced that it will only continue Prodigy Classic
service until October, 1999. As of December 31, 1998 Prodigy Classic users
represented less than 25% of the total subscriber count billed to Prodigy. The
Company has recently agreed, effective January 1, 1999, to lower the
Subscriber-Based Rate for those Prodigy Classic subscribers who are enrolled
with Prodigy under a reduced plan of $9.95 or less per month and are restricted
to lower usage. Since the latter part of 1997, Prodigy has sought to migrate
Prodigy Classic subscribers to Prodigy Internet and other service plans. Prodigy
Internet subscribers billed by the Company increased 46% from the end of 1997 to
the end of 1998. The Company expects Prodigy Internet subscribers to continue to
increase in 1999.
Internet Customers. There are over 4,000 ISPs in the U.S. today. Most of
these do not have their own nationwide network and thus require transit service
to the Internet. Commencing in May 1998, the Company has provided Internet
dedicated services to businesses which offer business critical connectivity
featuring redundant, high-speed (T-1, T-3) backbone connections, and 24-hour
operational and environmental monitoring. The Company does not expect that
revenues from Internet dedicated services will be significant in comparison to
other revenues for the foreseeable future.
VPN customers. The Company has entered into VPN service contracts but
through December 31, 1998 no significant services have been rendered and no
revenues have been derived from VPN customers for VPN services. The Company will
continue targeting VPN services in 1999.
CUSTOMER SERVICE
Splitrock believes that superior customer service is a critical element in
attracting and retaining customers and expanding value added services to
existing customers. In particular, the Company believes it is critical to
maintain two geographically dispersed NOCs, each of which is able to monitor the
entire Network and provide rapid problem resolution. Since the first quarter of
1998, the Company believes that it has developed a customer service platform
which will minimize the impact of future service interruptions and provide
superior customer service. Specifically, the Company has established two NOCs
operating 24 hours per day, seven days per week located in The Woodlands, Texas
and Yorktown Heights, New York. Each of these NOCs has the capability to manage
traffic, monitor system status and remotely implement solutions to system
interruptions.
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In the first half of 1998, the Company implemented a number of systems and
procedures to provide superior customer service. The Company has installed a
leading customer support trouble ticketing and workflow management system from
Remedy Corporation ("Remedy") to track, route and report on customer service
issues. In addition, software installed at the NOCs enables the Company to
remotely service customer connections to the Splitrock Network. In addition,
field service personnel from the Company or third party vendors are dispatched
in the event of an equipment failure that cannot be serviced remotely.
To support anticipated growth in customers on the Network, beginning in the
first quarter of 1999, the Company intends to establish a customer call center
to provide customer support 24 hours per day, seven days a week.
BUSINESS SUPPORT SYSTEMS
General. Through the development of scalable business support systems, the
Company believes that it has the opportunity to establish a competitive
advantage relative to traditional network service providers. Traditional network
service providers typically operate extensive legacy business support systems
with compartmentalized architectures that limit their ability to scale rapidly
and introduce enhanced services and features. In connection with the expansion
of the Splitrock Network, the Company is creating business support systems with
an architecture designed to maximize both reliability and scalability.
Furthermore, in establishing its business support systems, the Company has
attempted to develop Company-wide standardization of hardware, software,
database platforms and problem solving in order to maximize system automation
and minimize employee manual processing. Business support systems are, or will
be, distributed throughout the Splitrock Network, which improves network
performance, recovery and reliability, while also providing real-time capture of
statistical and accounting data. Splitrock utilizes, when available, industry
standard software systems developed and maintained by third party vendors but
customized for the Company's specific needs.
Network Management. The Company believes that an up-to-date management
platform is critical for the Company to be competitive and provide customers
with quality services. The Company has put in place a modern management platform
to manage the extensive Splitrock Network. The new management platform performs
operations, administration and management tasks. The Company has selected UNIX
and Windows NT based computing systems for network management to ensure ease of
upgrades in the future. Key features of the system are provided by third party
vendors, including an SQL database for information management, NetExpert from
Objective Systems, Inc. for equipment monitoring, Remedy for trouble request
tracking, and other software running tasks that monitor network utilization. The
Company has customized most of these platforms to ensure maximum Network
flexibility and efficiency. The systems also have sufficient capacity to expand
without significant design changes.
Billing. The Company selected an industry-standard billing system and began
implementation in late 1998. This billing system and the associated
infrastructure systems are adequate for the Company's current needs but must be
refined and tailored to address the Company's evolving products and service
offerings. The Company expects to modify its systems on a continuing basis to
meet the demands of its customers.
SUPPLIERS
The Company is dependent on third parties for key components of its Network
infrastructure, including leased lines, transmission services and networking
equipment, such as routers, switches and modems. The quantities and quality of
such networking equipment required by the Company are available only from
limited sources. The Company currently utilizes Lucent for ATM switching
products, including the Lucent AC-120 switch, Bay Networks for its Internet dial
access platform, Cisco for routers and Sun for servers. The Company also depends
upon a variety of LECs and IXCs to provide telecommunication services, including
leased line and collocation facilities. For long distance connections and
backbone long distance transmission facilities, the Company currently uses MCI
WorldCom. In addition, the Company obtains bandwidth capacity under leased line
connection agreements with LECs, including Regional Bell Operating Companies
("RBOCs"), or is provided telecommunications services and leased physical space
under local access/
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collocation agreements with various CLECs. The Company continues to monitor its
needs for greater bandwidth and may enter into agreements to enlarge its
bandwidth capability.
The Company has an agreement with IBM to use the IBM Network to cover
market areas that are neither served by the Splitrock Network nor the Prodigy
Legacy Network. The terms of the IBM agreement provide that either party may,
upon 60 days prior notice, terminate its respective obligations under the
contract for the remaining POP sites.
As part of the Company's strategy to replace remaining POPs covered by the
IBM Network and to complete the Network Build, the Company will rely upon third
parties to provide equipment and services to assist in the deployment of the
remaining Network Build. In 1998, the Company entered into an agreement with a
contractor to provide turnkey services for the construction of 99 POP sites.
This contractor also provided the Company with a $5.0 million credit facility to
be used to pay amounts due under the agreement, of which $1.5 million was
borrowed in early 1998 and was repaid with proceeds from the Company's offering
of debt securities in 1998 ("Senior Note Offering"). Because of a failure to
meet construction milestones, in November, 1998, the Company entered into
agreements with other service providers and suppliers for lease acquisition and
construction management services. In addition, the Company added field and
office personnel for construction management, equipment rack-and-stack of the
fabricated concrete shelters necessary for the POPs, provisioning, and related
project management services. Management believes implementation of these
additional measures, put in place before year-end 1998, was necessary for
completion of the remaining sites on a timely basis. The Company expects that
the planned Network Build will be substantially complete by mid-1999.
In addition to field operation employees and contractors of the Company,
the Company also engages third party vendors for routine maintenance, on-call
repair and certain related services. The Company recently entered into a
two-year agreement with Lucent to provide nationwide network maintenance
service.
COMPETITION
The telecommunications service industry is highly competitive. The Company
expects that competition will continue to intensify as customers seek additional
capacity to satisfy the continued growth of the Internet. In addition, numerous
competitors, including major telecommunications carriers, are rapidly expanding
their network capabilities. The Company believes that the primary competitive
factors for the provision of network services are quality of service, network
coverage, reliability, price, and product innovation.
The Company's current and prospective competitors generally may be divided
into two groups: (i) companies that provide Internet dial access services to
ISPs and (ii) companies that provide Internet access (including Internet dial
access and transit), VPN and other value added services to business customers.
ISP Internet Access Service. According to IDC, there are over 4,000 ISPs in
the United States, consisting of national, regional and local providers. The
Company intends to market Internet dial access services to these ISPs. The
Company's competitors in this market will be other companies that provide
Internet access service to ISPs as well as ISPs which possess backbone networks
enabling them to provide capacity to other ISPs. Competitors in this segment
include UUNET, Verio, Concentric, PSINet and Netcom. While the Company believes
that its status as an independent service provider distinguishes it from many of
these competitors, some of these competitors have significantly greater market
presence, brand recognition and financial, technical and personnel resources
than the Company.
Corporate Internet Access and VPN. In the corporate Internet access and VPN
markets, the competitors include Internet service providers (e.g., Verio and
Concentric) as well as traditional telecommunications carriers (e.g., AT&T and
Sprint). Many of these competitors, in addition to their substantially greater
market presence and financial, technical and personnel resources, also have
large existing commercial customer bases. Furthermore, many of these competitors
have the ability to bundle Internet dial access and VPN services with other
services such as Web hosting or long distance services. Such bundling of
services may have a material adverse effect on the Company's ability to compete
effectively and thus could have an adverse effect on the Company's business,
financial condition and results of operations.
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The Company believes that significant new competitors will enter the
network services market. Other companies, including Williams Communications and
Level 3, are in the process of building or expanding networks that will have the
ability to provide services comparable to those of the Company. In addition,
many of the Company's competitors have the financial and operational resources
to construct networks similar to the Splitrock Network. For example, Sprint
recently announced that it is in the process of designing a network which will
contain ATM switches at every core, hub and remote site. There can be no
assurance that the Company will be able to compete effectively with these
companies.
Recent reforms in the federal regulation of the telecommunications industry
have also created greater opportunities for LECs, including the RBOCs, to enter
the Internet network services market and therefore compete with the Company.
Such increased competition could have a material adverse effect on the Company.
The Company believes that there is a trend toward horizontal integration through
acquisitions of, joint ventures with, and the wholesale purchase of connectivity
from, ISPs. The WorldCom/MFS/UUNet/ MCI consolidation, the Netcom/ ICG
Communications Inc. merger, the Intermedia/DIGEX merger and GTE's acquisition of
BBN are indicative of this trend. Such consolidations may result in the Company
competing with larger companies with greater resources to devote to the
development of new competitive products and services and the marketing of
existing competitive products and services.
As a result of increased competition and integration in the industry, the
Company could encounter significant pricing pressure, which in turn could result
in significantly lower average selling prices of the Company's services. There
can be no assurance that the Company will be able to offset the effects of any
such lower prices with an increase in the number of its customers, growth in
sales to its customer base, higher revenue from enhanced services, cost
reductions or otherwise. In addition, the Company believes that the Internet
access and related services industry is likely to undergo further consolidation
in the near future, which could result in increased price and other competition
in these industries and, potentially, other portions of the industry, including
the market for VPN services. Increased price or other competition could have a
material adverse effect on the Company's business, financial condition and
results of operations. There can be no assurance that the Company will have the
financial resources, technical expertise or marketing and support capabilities
to continue to compete successfully.
REGULATION
Overview. Although the Company is not currently subject to direct
regulation by the FCC, it operates in a highly regulated industry and therefore
changes in the regulatory environment relating to Internet related and other
telecommunications services, including regulatory changes which directly or
indirectly affect telecommunications costs or increase the likelihood or scope
of competition from RBOCs or other telecommunication companies, could have a
material adverse effect on the Company's financial position or results of
operations.
Various existing federal and state regulations are currently the subject of
judicial proceedings, legislative hearings and administrative proposals which
could change, in varying degrees, the manner in which the industry operates.
Neither the outcome of these proceedings, nor their impact upon the
telecommunications industry generally, or on the Company particularly, can be
predicted at this time. In addition, over the past several years both the
federal and state governments have adopted new legislation and rules profoundly
affecting the telecommunications industry. No assurance can be given that the
changes in current legislation or new legislation, and the regulations adopted
by the FCC or state regulators pursuant to such legislation, would not have a
material adverse impact on the Company.
Regulation of Internet Communications. In 1980, the FCC created a
distinction between "basic" services, which it regulated as common carriers, and
"enhanced services," which it deregulated. The FCC exempted enhanced service
providers ("ESPs"), from federal and state regulations governing common
carriers, including the obligation to pay access charges and regulatory fees,
such as contributions to the Universal Services Fund. Management believes that
the Company is an ESP and, so far, has remained unregulated.
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The enhanced classification usually applies to any service that transforms
or adds content to end user messages, including protocol conversion that is not
internal to a network. Under this regulatory framework, the FCC generally
refrained from regulating ISPs but was rarely called upon to offer formal
pronouncements on the classification of data communication services. In 1995,
however, the FCC ruled at least one version of packet-switched data
communications, called frame relay, can under certain circumstances be
classified as a basic service and subjected to common carrier regulation.
The Federal Telecommunications Act of 1996 ("FTA") established a
distinction between "telecommunications carriers" and "information services,"
but a combination of a changing technology and other provisions of the FTA have
made it increasingly difficult to discern the boundary between unregulated and
regulated services. The FTA provides that all telecommunications carriers must
contribute to the Universal Service Fund, and it directs the FCC to adopt
regulations that, when fully implemented, will greatly enlarge that fund. This
greatly magnifies the significance of the boundary between regulated and
unregulated services, because it implies that the classification of a company
under this scheme will determine whether or not it will be required to pay a
form of regulatory tax.
Since the FTA was adopted, several companies have begun providing voice
telephony services over Internet-style packet-switched networks, and traditional
long distance telephone companies have announced plans to migrate their services
to packet-switched networks. As a consequence, the regulatory status of
communications services over Internet-style packet-switched networks is
presently uncertain. In an April 10, 1998 Report to Congress regarding Universal
Service (the "Report"), the FCC concluded that the provision of underlying
transmission capacity to ISPs constitutes "telecommunications" under the FTA.
The FCC has also indicated in the Report that it would consider, in an upcoming
proceeding, issues related to whether ISPs that own transmission facilities and
engage in data transport over those facilities in order to provide information
services are providing telecommunications to themselves, and therefore ought to
be required to contribute to the Universal Service Fund. While the Report
containing this conclusion does not have the force of law, it provides a strong
indication of regulatory action that may be taken by the FCC in the future. A
finding by the FCC that ISPs and carriers providing service to ISPs must pay
Universal Service contributions could increase the Company's cost of doing
business and have a material adverse effect on the Company.
To the extent that the Company may provide Internet telephony (i.e., a
service in which a voice transmission is made over a packet-switched interactive
data network), such service is deemed an enhanced service and is not currently
subject to federal or state regulation. There is no guarantee, however, that the
regulatory status of Internet telephony will not change in the future. If
Internet telephony does become subject to federal or state regulation in the
future, such a development could impose substantial new costs on the Company.
Therefore, there can be no assurance that new laws or regulations relating to
these services, or determinations that existing laws are applicable to them,
will not have a material adverse effect on the Company's business.
The Company Operates as an Information Service Provider. The Company
operates as an unregulated information service provider, as that term is defined
in the FTA, and as an ESP, as that term is defined in FCC rules. Because the
regulatory boundaries in this area are unclear and subject to dispute, however,
the Company cannot exclude the possibility that the FCC could choose to classify
some or all of its services as "telecommunications." If that happens, the
Company will be required to contribute directly to the federal Universal Service
Fund.
Unlike most providers of telecommunications, the Company does not offer
services indiscriminately to the public or to a broad class of customers, but
instead negotiates individual service contracts with a small number of select
customers. This could potentially enable the Company to claim status as a
"private carrier" as opposed to a "common carrier," and thereby avoid most
federal and state utility-style regulations. While private carriers are exempt
from most regulations, however, they are nonetheless required to contribute to
the federal Universal Service Fund. The FCC has never rendered a formal
pronouncement on the Company's regulatory status, and the Company cannot predict
with certainty what classification the FCC would apply if it did so. Moreover,
if, in the future, the Company broadens its customer base and/or provides
services according to standardized service arrangements instead of individually
negotiated contracts, it could become
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more vulnerable to classification as a common carrier. If this occurs, the
Company may incur additional regulatory costs to which it is not now subject.
Universal Service Proceeding. If the Company maintains its current
unregulated status, it may contribute indirectly to universal service to the
extent that the Company is billed by telecommunications providers for the
underlying service. Beginning on July 1, 1999, the federal Universal Service
Fund is scheduled to provide subsidy support for service to high-cost areas
served by so-called "non-rural" ILECs. The Company presently is unable to
predict the potential impact of these universal service funding reforms. On
October 28, 1998, the FCC adopted an econometric model incorporating a framework
of fixed assumptions about network design and other basic issues. This model
will be used to estimate non-rural carriers' reimbursable costs for providing
the supported services, but it is dependent upon input values for the cost of
network components and other parameters. The Commission has not yet determined
what those input values should be. In principle, the subsidy increases necessary
to support the scheduled enlargement of the fund should be offset by reductions
in prices that ILECs charge for certain services in urban areas. However, the
Company can provide no assurance that regulators will effectively manage this
transition.
Regulatory Safeguards Affecting Underlying Service Providers. The Company
is heavily dependent upon telecommunications carriers for the transmission
capacity that underlies its enhanced network. To the extent that some of these
carriers have dominant control in certain geographic markets and may compete
with the Company in providing enhanced services, this creates a motive and
potential means for those carriers to discriminate against the Company. At
present, the RBOCs are allowed to provide enhanced information services within
local area transport arrangements ("LATAs") but they are restricted from
providing enhanced services on an inter-LATA basis, except to the extent that
they do so on an unbundled basis that allows end users to choose their own
inter-LATA transmission carriers.
Under Section 271 of the FTA, the RBOCs will be allowed to provide
inter-LATA service, including inter-LATA information services, when they satisfy
a regulatory checklist of local competition requirements. The RBOCs have
resisted compliance with those requirements, and several of them challenged
Section 271 as an unconstitutional bill of attainder. Although the RBOCs
persuaded one federal district court judge to accept their arguments, two U.S.
courts of appeal have turned back that challenge, and the U.S. Supreme Court has
declined to review one of those appeals court rulings. A petition to review the
other appeals court ruling is still pending, but it appears likely that the
Supreme Court will decline it as well. The Company can provide no assurance that
it will be able to compete effectively with the RBOCs it uses if or when
existing restrictions are removed.
Regulations Affecting Competitors Affiliated with Competitive Local
Exchange Carriers. Some of the Company's competitors are affiliated with CLECs,
and the FTA and FCC regulations provide certain advantages to CLECs that are not
available to stand-alone information service providers. The Company cannot
predict whether it will be able to compete effectively with such companies,
either in its current configuration or by creating or affiliating itself with a
CLEC.
Potential Liability of ISPs. The law in the United States relating to the
liability of ISPs and providers of transmission capacity for information carried
on, disseminated through or hosted on their systems is currently unsettled. The
FTA and statutes enacted or under consideration in some states impose civil and
criminal liability upon ISPs, or providers of transmission capacity to ISPs, for
the transmission or dissemination of certain types of information and materials.
The imposition of such liability may require the Company to implement measures
to reduce its exposure to such liability, which may require the expenditure of
substantial resources. Regulations, litigation, or legislation could affect the
demand for the Company's services.
TRADEMARKS AND TRADE NAME
The Company filed federal trademark applications for the marks "Splitrock"
and "A Carrier of Wisdom" on September 18, 1997, and "splitrock.net" on March 6,
1998. The Company also filed separate federal trademark applications for logos
on the above dates, for Splitrock with triangle design on June 16, 1998, for the
mark "splitrock.com" on July 27, 1998, and for the mark "ATM-to-the-Edge" in
March, 1999. These applications are pending and the Company has no assurance
that they will be granted. Trademark applications
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for the marks "Splitrock", "A Carrier of Wisdom" and Splitrock with triangle
design also have been applied for in numerous foreign countries. "Splitrock
Services, Inc." is a trade name of the Company.
INSURANCE
The Company has insurance coverage it believes to be adequate for the risks
of the businesses in which it is engaged. The Company carries property, general
liability and directors and officers liability insurance. In addition, the
Company has an umbrella policy applicable to general liability, auto liability,
and employers liability. Such coverage may not be adequate or available to
compensate the Company for all losses that may occur. The occurrence of a
significant loss not fully covered by insurance could have a material adverse
effect on the Company.
EMPLOYEES
As of December 31, 1998, the Company had 154 full-time employees and 34
independent contract workers. None of the Company's employees are represented by
a union. The Company has experienced no strikes or work stoppages and considers
its relations with its employees to be satisfactory.
The Company believes that its ability to successfully implement its
business strategies will depend on its continued ability to attract and retain
qualified employees. While the Company is expecting to add employees throughout
its organization, the Company will focus on recruiting new technical and sales
and marketing employees. The Company expects to employ over 300 employees and
independent contractors by the end of the second quarter of 1999, and
approximately 400 by the end of 1999. Independent contractors are expected to
continue to represent between 5% and 10% of the Company's total workforce. In
order to attract and retain highly qualified employees, the Company believes
that it is important to provide a competitive compensation program that aligns
employees' interests with the Company's. The Company's noncash benefit programs
are designed to be comparable to those offered by its competitors. There can be
no assurance that the Company will be able to attract and retain the personnel
necessary to implement its strategies.
ITEM 2. PROPERTIES AND FACILITIES
Until June 1998 the Company leased approximately 8,000 square feet of space
in The Woodlands, Texas for its headquarters and administrative facilities. In
July 1998, the Company moved its headquarters and administrative facilities to a
larger facility containing approximately 25,000 square feet in The Woodlands,
Texas. The lease on the current facility expires in 2003. The Woodlands, Texas
NOC is also housed in this facility. In March 1999, the Company entered into a
long-term lease agreement for approximately 69,000 square feet in The Woodlands,
Texas and expects the new facility will be ready for occupancy not later than
August 1999. The new facility will become the Company's headquarters, and the
existing space will continue to be utilized as a NOC, and customer care center.
In addition, the Company was granted an option to lease additional space in a
building which will be constructed adjacent to the new facility and which will
contain approximately 69,000 square feet. If this option is exercised by a
certain date, the Company has the option to terminate the lease of the 25,000
square feet facility before the end of the term. The Company believes the
present lease, the lease of the new facility and the option to lease additional
space in the building which will be built adjacent to the new facility combine
to provide the Company the flexibility and assurance that it will be able to
manage its anticipated growth needs for the foreseeable future.
In addition to the building leases and option, Splitrock has been granted
an additional option to purchase all, or any part greater than 20 acres, of an
approximately 30 acre tract of land in The Woodlands, Texas. After June 30, 2000
and until December 31, 2001, Splitrock has the right of first opportunity to
purchase such land at its fair market value as well as the right of first
refusal to purchase such land on the same terms as the seller is willing to sell
the land to a third party purchaser in a bona fide arms-length transaction. If
Splitrock purchases the land and builds one or more buildings on it, Splitrock
will be permitted to terminate its then existing leases with the landlord
provided that (i) the square footage of the new building or buildings is at
least equal to the square footage of the leases being terminated and (ii) at
least three years has elapsed since the commencement date of each lease being
terminated.
16
<PAGE> 19
The Company also subleases from Prodigy a facility of approximately 12,500
square feet in Yorktown Heights, New York for the Company's Yorktown Heights
office and NOC. This lease expires on February 28, 2001 but is subject to early
termination on December 31, 1999 upon three months written notice. The Company
intends to exercise the early termination provision, and currently plans to move
its Yorktown Heights, New York facility to another location in the New York
metropolitan area.
In connection with its Network operations, the Company leases commercial
space or has collocation agreements for its installed telecommunications
equipment throughout the U.S. for those POPs deployed in the first phase of the
Network Build. These leases and collocation agreements have an average term of
three years and average monthly payments ranging up to several thousand dollars.
In many cases, the Company has the option to renew the commercial leases, and
extend the collocation agreements with the LEC's or CLEC's. The Company
considers these facilities and arrangements to be suitable for its present
needs. The Company did not assume leases related to the Prodigy POPs in
connection with the Prodigy Agreements. As of December 31, 1998, the Company has
entered into a number of additional leases of raw land for the deployment and
placement of its telecommunication shelter facilities for the remaining Network
Build. The Company expects to substantially complete all required site lease
acquisitions for the Network Build in the second quarter of 1999.
ITEM 3. LEGAL PROCEEDINGS
The Company is not currently involved in any legal proceedings.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None
17
<PAGE> 20
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS
There is no established public trading market for the Company's Common
Stock. As of March 19, 1999, there were 27 record holders of the Company's
Common Stock. The Company has not paid any dividends since its inception. The
indenture ("Indenture") governing the Company's 11 3/4% Series B Senior Notes
due 2008 ("New Notes") restricts the Company's ability to pay dividends.
On July 24, 1998, the Company sold 261,000 units consisting of $261.0
million principal amount of 11 3/4% Senior Notes due 2008 ("Original Notes") and
warrants to purchase 2,642,613 shares of Common Stock (the "Senior Notes
Offering"). In November 1998, all of the Original Notes were exchanged for the
New Notes, which were substantially identical with the Original Notes, except
there were no restrictions on transferring such New Notes. At the same time the
warrants and underlying Common Stock were registered under the Securities Act of
1933.
In June 1998, a director of the Company, exercised a stock option
previously granted to him and purchased 1.0 million shares of Common Stock of
the Company for $1.1 million. A former employee of the Company also exercised an
option to purchase 15,000 shares of Common Stock for $0.625 per share in the
fourth quarter of 1998. These sales of stock were made pursuant to the Company's
1997 Incentive Share Plan and were exempt from registration under Section 4(2)
of the Securities Act of 1933 and the rules promulgated thereunder.
On September 14, 1998, a stockholder of the Company and a wholly owned
subsidiary of the controlling stockholder of Prodigy, exercised a warrant to
purchase 5.0 million shares of the Company's Common Stock for $0.625 per share.
This exercise was exempt from registration under Section 4(2) of the Securities
Act of 1933 and the rules promulgated thereunder.
18
<PAGE> 21
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial information set forth below with respect
to the Company's statements of operations for the period from inception (March
5, 1997) to December 31, 1997 and the year ended December 31, 1998, and the
balance sheet data as of December 31, 1997 and 1998, are derived from the
financial statements of the Company audited by PricewaterhouseCoopers LLP,
independent public accountants. The data set forth below should be read in
conjunction with the historical financial statements of the Company and the
notes thereto and "Management's Discussion and Analysis of Financial Condition
and Results of Operations" included elsewhere in this Form 10-K.
<TABLE>
<CAPTION>
PERIOD FROM INCEPTION
(MARCH 5, 1997)
THROUGH YEAR ENDED
DECEMBER 31, 1997 DECEMBER 31, 1998
---------------------- ------------------
(DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER
SHARE AMOUNTS)
<S> <C> <C>
STATEMENT OF OPERATIONS DATA:
Revenue.................................................... $ 22,708 $ 63,611
Operating expenses:
Network personnel costs.................................. 437 4,972
Network operating costs.................................. 1,925 30,055
Legacy Network costs..................................... 25,341 58,271
Severance costs(1)....................................... 463 --
Selling, general and administrative...................... 1,276 4,296
Depreciation and amortization............................ 3,500 13,850
----------- -----------
Total operating expenses......................... 32,942 111,444
----------- -----------
Loss from operations....................................... (10,234) (47,833)
Other income (expense):
Interest income.......................................... 348 5,393
Interest expense......................................... (235) (15,390)
----------- -----------
Loss before income taxes................................... (10,121) (57,830)
Provision for income taxes................................. -- --
----------- -----------
Net loss................................................... $ (10,121) $ (57,830)
=========== ===========
Loss per share -- basic and diluted........................ $ (0.24) $ (0.73)
=========== ===========
Weighted average shares -- basic and diluted............... 42,824,000 78,844,000
=========== ===========
</TABLE>
<TABLE>
<CAPTION>
AS OF
DECEMBER 31,
----------------------
1997 1998
--------- ----------
(DOLLARS IN THOUSANDS)
<S> <C> <C>
BALANCE SHEET DATA:
Cash and cash equivalents................................... $ 7,710 $ 28,330
Restricted investments(2)................................... 3,472 58,477
Unrestricted investments.................................... -- 120,475
Property and equipment, net................................. 38,504 73,899
Total assets................................................ 54,388 296,141
Long term debt and capital lease obligations (including
current portion).......................................... 25,120 275,581
Stockholders' equity (deficit).............................. 20,407 (30,291)
</TABLE>
- ---------------
(1) Prior to January 1998, certain staffing positions were filled by Prodigy
employees who were subcontracted to the Company. In the fourth quarter of
1997, the Company recorded a severance charge related to the elimination of
13 of these positions.
(2) As of December 31, 1997, the Company had an outstanding letter of credit in
the amount of $3.5 million. This letter of credit was secured by the amount
in the restricted cash account. In the first quarter of 1998, the Company
exercised its early purchase option with regard to the related capital lease
and the letter of credit was retired. Restricted investments as of December
31, 1998, represents escrowed funds that, together with interest received
thereon, will be sufficient to pay, when due, the first four semi-annual
interest payments on the New Notes.
19
<PAGE> 22
ITEM 7.MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATION
This section contains certain forward-looking statements within the meaning
of Section 27A of the Securities Act and Section 21E of the Exchange Act which
are intended to be covered by safe harbors created thereby. Stockholders are
cautioned that all forward-looking statements involve risks and uncertainty,
including, without limitation, the ability of the Company to continue its
Network Build, the ability of the Company to diversify its services and
customers, the ability to obtain necessary supplies, the ability to make
projected capital expenditures, and the ability to achieve projected quarterly
results, as well as general market conditions, competition, and pricing. All
statements, other than statements of historical facts, included or incorporated
by reference in this section that address activities, events or developments
that the Company expects or anticipates will or may occur in the future,
including such things as future capital expenditures (including the amount and
nature hereof), business strategy and measures to implement such strategy,
competitive strengths, goals, expansion and growth of the Company's business and
operations, plans, references to future success as well as other statements
which include words such as "anticipate," "believe," "plan," "estimate,"
"expect," and "intend" and other similar expressions, constitute forward-looking
statements. Although the Company believes that the assumptions underlying the
forward-looking statements contained herein are reasonable, any of the
assumptions could be inaccurate, and the inclusion of such information should
not be regarded as a representation by the Company or any other person that the
objectives and plans of the Company will be achieved.
OVERVIEW
Splitrock Services, Inc. is a provider of telecommunications services,
including high speed Internet access services, on its advanced nationwide
network, based on ATM switching technology. The Company is deploying this
advanced technology in every operational POP of its Network. Currently, the
Company is providing Internet dial access and related services to Prodigy for
its subscribers. During the twelve months ended December 31, 1998, Prodigy was
the Company's primary wholesale Internet dial access customer, accounting for
substantially all of the Company's revenue.
In September 1997, the Company began constructing and installing an
advanced nationwide Network designed to give the Company a physical presence in
all 50 states, and targeting 90% of U.S. businesses and households with V.90
modem access local call. The Network POPs are capable of providing Internet
access to businesses and households in every market in the United States with a
population of at least 100,000, as well as many smaller markets. The Company
expects to achieve the planned coverage with approximately 370 POPs upon
completion of the Network Build, which the Company believes will be
substantially completed by the end of the second quarter of 1999. The expanding
Network is supported by two NOCs equipped with state-of-the-art Network
management systems.
Through the combination of a direct sales force and alternative
distribution channels, the Company believes that it will be able to access
markets and increase revenue-producing traffic on the Splitrock Network. To
implement its distribution strategy, the Company is developing an in-house
direct sales force. The Company intends to utilize its direct sales force to
market its products and services directly to ISPs, carriers, value added service
providers, and medium and large businesses. The Company intends to utilize
alternate distribution channels, such as agents, resellers and wholesalers, to
market its products and services to medium and small businesses.
Given the fixed cost nature of the Splitrock Network's infrastructure, the
Company seeks to increase total network utilization primarily by targeting
providers of business services (daytime intensive traffic) and, to a lesser
extent, providers of consumer services (evening intensive traffic) to maximize
Network utilization throughout a 24-hour period. Current Network utilization
peaks in the evening hours to support Prodigy's residential Internet
subscribers. The Company plans to focus on providing VPN services, Internet
dedicated access (transit), Web hosting and Internet dial access services.
Historically, in the telecommunications industry, providing VPN services
increases the length of the sales cycle when compared to providing Internet
dedicated access services. Because the Company is in the early stages of
building its sales force, the Company
20
<PAGE> 23
expects growth in revenues to fluctuate from quarter to quarter depending on the
volume of monthly revenue of its customers and the actual date the service
becomes billable to its customers. The Company cannot assure that it will be
successful in its marketing plan or that it will achieve the balance of
utilization of the Network facilities necessary to attain or maximize
profitability or positive cash flow from operations.
While expanding its services, the Company is also implementing a
comprehensive billing system. The Company expects to modify its systems on a
continuing basis to meet the demands of its customers. The Company anticipates
that additional funds will be required for the continued development of the
billing system and supporting infrastructure needed to absorb increases in both
the number of customers serviced and the nature of services offered.
The Company has incurred net losses and experienced negative cash flow from
operations since its inception in March 1997. The Company anticipates that
losses and negative cash flow from operations will continue while the Company
completes the Network Build, expands its revenue base and improves the
utilization of its Network. The extent to which the Company continues to incur
net losses and negative cash flow from operations is largely dependent upon the
timely deployment of the Network, the rate at which the Company can expand its
customer and revenue base and the Company's ability to maximize use of its
nationwide Network.
PRODIGY TRANSACTIONS
On June 24, 1997, the Company and Prodigy entered into the Prodigy
Agreement, pursuant to which the Company agreed to provide certain Network
services to Prodigy subscribers. The Prodigy Agreement became effective on July
1, 1997. In order to provide services to Prodigy for its subscribers prior to
the completion of the Splitrock Network, on July 1, 1997 the Company acquired
for interim use the Prodigy Legacy Network. This acquisition consisted of
substantially all network assets and related communications equipment owned or
leased by Prodigy. Consideration for the acquisition of the Prodigy Legacy
Network included the assumption of $5.9 million of liabilities.
Prodigy Agreement. Under the Prodigy Agreement, the Company provides
Prodigy with network services, including Internet dial services and other
Network connections, and Prodigy pays the Company monthly usage-based or
subscriber-based service charges equal to the lower of: (i) total subscriber
hours for the month multiplied by the contracted hourly usage rate (the
"Usage-Based Rate") or (ii) total subscribers for the month, as measured by a
"Subscriber Count," as defined in the Prodigy Agreement, multiplied by the fixed
monthly charge per subscriber (the "Subscriber-Based Rate"). The contracted
hourly Usage-Based Rate increased by 9.5% on January 1, 1998 and 8.7% on January
1, 1999. The fixed monthly Subscriber-Based Rate does not increase over time.
The Prodigy Agreement imposes certain minimum monthly service charges on Prodigy
in the event that the lower of the Usage-Based Rate or Subscriber-Based Rate
calculation is below defined levels. The minimum monthly service charges are
$3.5 million through June 30, 1999, and will increase by $500,000 beginning each
subsequent July 1. Additionally, in the event the average monthly hours per
subscriber (calculated as the total subscriber hours for the month divided by
the total subscribers at the month end) exceeds 30 hours, the Prodigy Agreement
provides that Prodigy will be subject to additional fees ("Additional Fees")
equal to (a) $1.00, multiplied by (b) the number of average monthly hours per
subscriber in excess of 30 hours, multiplied by (c) the total subscribers at the
month end. Through March 31, 1998, amounts paid by Prodigy under the Prodigy
Agreement were based on the Usage-Based Rate. Since April 1998, such amounts
have been based on the Subscriber-Based Rate. Over the long term the Company
expects to receive amounts from Prodigy based on the Subscriber-Based Rate. As a
result, amounts received by the Company from Prodigy since April 1998 have been,
and over the long term (except for any Additional Fees) are expected to be, a
function of the total number of Prodigy subscribers as opposed to total
subscriber hours.
The initial term of the Prodigy Agreement expires on June 30, 2001. After
the initial term either party may terminate the Prodigy Agreement upon twelve
months' prior written notice. If no notice is received, the term of the Prodigy
Agreement is automatically extended for successive twelve-month terms. Under the
Prodigy Agreement, the Company is required, among other things, to provide
Prodigy with certain financial
21
<PAGE> 24
and other information and to meet certain network performance standards. The
Company is required to provide certain credits to Prodigy in the event it fails
to meet such network performance standards. Prodigy has the right to terminate
the Prodigy Agreement following a cure period in the event of the Company's
failure to comply with certain provisions of the Prodigy Agreement, including
certain network performance standards. In addition, Prodigy has the right to
terminate the Prodigy Agreement during the initial term without cause by
providing twelve months' prior written notice and paying a termination charge of
$5.0 million until July 1, 1999 and $3.0 million thereafter. In the event of
certain prolonged Network failures, Prodigy also has the right to enter the
Company's premises and cure such failures.
Prodigy Services. Prodigy currently provides two services to its
subscribers: Prodigy Internet and Prodigy Classic. Prodigy Internet subscribers
generally have higher average usage than Prodigy Classic.
Under the terms of the Prodigy Agreement, the Company's services for
Prodigy Classic subscribers was to end not later than December 31, 1998. In
mid-1998, the Company, at Prodigy's request, agreed to extend the date for one
year with termination to occur not later than December 31, 1999. Prodigy has
recently announced its intentions to continue Prodigy Classic service only until
October 1999. As of December 31, 1998, Prodigy Classic subscribers represented
less than 25% of the total subscriber count billed to Prodigy. The Company has
recently agreed, effective January 1, 1999, to lower the Subscriber-Based Rate
for those Prodigy Classic subscribers who are enrolled with Prodigy under a
reduced plan of $9.95 or less per month and are restricted to lower usage. Since
the latter part of 1997, Prodigy has sought to migrate Prodigy Classic
subscribers to Prodigy Internet and other service plans.
22
<PAGE> 25
RESULTS OF OPERATIONS
The following table sets forth selected unaudited quarterly and audited
partial year from inception and audited annual statements of operations data
that are the basis of the following discussion:
<TABLE>
<CAPTION>
THREE MONTHS ENDED (UNAUDITED)
-----------------------------------------------------------------------
DECEMBER 31, MARCH 31, JUNE 30, SEPTEMBER 30, DECEMBER 31,
1997 1998 1998 1998 1998
------------ ----------- ----------- ------------- ------------
(DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
<S> <C> <C> <C> <C> <C>
QUARTERLY STATEMENT OF
OPERATIONS DATA:
Revenue....................... $ 11,979 $ 16,494 $ 15,720 $ 15,378 $ 16,019
Operating expenses:
Network personnel costs...... 342 1,051 1,105 1,176 1,640
Network operating costs...... 1,364 3,127 6,275 10,419 10,234
Legacy Network costs......... 12,222 12,295 14,795 14,641 16,540
Severance costs.............. 463 -- -- -- --
Selling, general and
administrative............. 680 657 971 1,192 1,476
Depreciation and
amortization............... 1,792 2,820 2,087 2,804 6,139
----------- ----------- ----------- ----------- -----------
Total operating
expenses............. 16,863 19,950 25,233 30,232 36,029
----------- ----------- ----------- ----------- -----------
Loss from operations.......... (4,884) (3,456) (9,513) (14,854) (20,010)
Other income (expense):
Interest income.............. 181 107 76 2,664 2,546
Interest expense............. (122) (349) (493) (6,294) (8,254)
----------- ----------- ----------- ----------- -----------
Loss before income tax........ (4,825) (3,698) (9,930) (18,484) (25,718)
Provision for income tax...... -- -- -- -- --
----------- ----------- ----------- ----------- -----------
Net loss...................... $ (4,825) $ (3,698) $ (9,930) $ (18,484) $ (25,718)
=========== =========== =========== =========== ===========
Loss per share -- basic and
diluted...................... $ (0.06) $ (0.05) $ (0.13) $ (0.23) $ (0.31)
=========== =========== =========== =========== ===========
Weighted average
shares -- basic and
diluted...................... 76,800,000 76,800,000 76,976,000 78,724,000 82,810,000
=========== =========== =========== =========== ===========
OTHER QUARTERLY DATA:
EBITDA(1)..................... $ (2,629) $ (636) $ (7,426) $ (12,050) $ (13,871)
=========== =========== =========== =========== ===========
Cash provided by (used in):
Operating activities......... $ (2,333) $ (4,874) $ 1,162 $ 5,895 $ (2,918)
Investing activities......... (2,878) (2,740) (4,974) (13,081) (148,717)
Financing activities......... (3,387) 3,253 5,640 184,331 (2,357)
<CAPTION>
PERIOD FROM
INCEPTION
(MARCH 5, 1997)
THROUGH YEAR ENDED
DECEMBER 31, DECEMBER 31,
1997 1998
--------------- ------------
(DOLLARS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
<S> <C> <C>
QUARTERLY STATEMENT OF
OPERATIONS DATA:
Revenue....................... $ 22,708 $ 63,611
Operating expenses:
Network personnel costs...... 437 4,972
Network operating costs...... 1,925 30,055
Legacy Network costs......... 25,341 58,271
Severance costs.............. 463 --
Selling, general and
administrative............. 1,276 4,296
Depreciation and
amortization............... 3,500 13,850
----------- -----------
Total operating
expenses............. 32,942 111,444
----------- -----------
Loss from operations.......... (10,234) (47,833)
Other income (expense):
Interest income.............. 348 5,393
Interest expense............. (235) (15,390)
----------- -----------
Loss before income tax........ (10,121) (57,830)
Provision for income tax...... -- --
----------- -----------
Net loss...................... $ (10,121) $ (57,830)
=========== ===========
Loss per share -- basic and
diluted...................... $ (0.24) $ (0.73)
=========== ===========
Weighted average
shares -- basic and
diluted...................... 42,824,000 78,844,000
=========== ===========
OTHER QUARTERLY DATA:
EBITDA(1)..................... $ (6,271) $ (33,983)
=========== ===========
Cash provided by (used in):
Operating activities......... $ (2,233) $ (735)
Investing activities......... (17,198) (169,512)
Financing activities......... 27,141 190,867
</TABLE>
- ---------------
(1) EBITDA is defined as net loss plus net interest expense, provision for
income taxes, depreciation and amortization and severance costs.
The Company does not believe historical results are necessarily indicative
of future results. The Company has focused since inception (March 5, 1997) on
designing, constructing and installing a nationwide network and at the same time
operating and decommissioning the Legacy Network. The Company believes the
Network Build will be substantially completed by the end of the second quarter
of 1999. Legacy Network costs and the costs to transition from the Legacy
Network to the Splitrock Network are expected to be substantially eliminated
during the third quarter of 1999. The Network Build entails coordination of many
third party vendors to meet the projected build-out schedule. Delays caused by
any such parties may result in delays of POP installations which would cause a
delay in the Company's ability to reduce its Legacy Network costs. Such a delay
could increase the Company's operating losses.
During 1999, the Company initiated its marketing and sales efforts. In
anticipation of expected utilization for additional customers and services, the
Company may be required to increase network capacity and infrastructure. This
added capacity and infrastructure could require additional financial,
operational and
23
<PAGE> 26
management resources. If demand for Network usage were to increase faster than
projected or were to exceed the Company's current forecasts, the Network could
experience capacity constraints that could adversely affect the performance of
the system. There can be no assurance that the Company will be able to expand or
adapt its Network infrastructure to meet the additional needs on a timely basis
or at a commercially reasonable cost.
YEAR ENDED DECEMBER 31, 1998 COMPARED TO PERIOD FROM INCEPTION (MARCH 5, 1997)
THROUGH DECEMBER 31, 1997
From inception (March 5, 1997) through June 30, 1997, the Company had not
yet begun deploying the Splitrock Network nor had it consummated the Prodigy
Agreement. As a result, it generated no revenue and incurred limited operating
expenses prior to the third quarter of 1997. Thus, a comparison of operations
for the year ended December 31, 1998 to the period from inception (March 5,
1997) through December 31, 1997, effectively results in a comparison of the
twelve months ended December 31, 1998 to the six months ended December 31, 1997.
Since inception, the Company has focused on the Network Build while
maintaining and decommissioning, when appropriate, the Legacy Network. Through
December 31, 1998, the Company had not focused on increasing sales, as the
Splitrock Network had not yet been completed. Prodigy represented the primary
source of revenue for the Company during both 1997 and 1998. In the second
quarter of 1998, the Company began its efforts to raise capital to complete the
Network Build. On July 24, 1998, the Company issued and sold $261.0 million in
Senior Notes and warrants to acquire 2,642,613 shares of Common Stock and began
a campaign to recruit and employ the personnel necessary to complete, operate
and maintain its Network.
To support the Network Build, the Company has been adding employees. At the
end of 1997 and 1998, respectively, the Company had 67 and 188 full time
employees and contractors. Additionally, during 1998, the Company added its
second state of the art NOC in The Woodlands, Texas.
In 1998, the Company entered into an agreement with a contractor to provide
services to and construction of 99 POP sites. This contractor also provided the
Company with a $5.0 million credit facility to be used to pay amounts due under
the agreement, of which $1.5 million was borrowed in early 1998 and was repaid
with proceeds from the Company's offering of Senior Notes. Because of a failure
to meet construction milestones, in November 1998, the Company entered into
agreements with other service providers and suppliers for lease acquisition and
construction management services. In addition, the Company added field and
office personnel for construction management, equipment rack-and-stack of the
fabricated concrete shelters necessary for the POPs, provisioning, and related
project management services. Management believes implementation of these
additional measures, put in place before year-end 1998, was necessary for
completion of the Network Build on a timely basis.
UNAUDITED QUARTERLY OPERATING RESULTS
Revenue. From inception (March 5, 1997) until June 30, 1997, the Company
did not generate any revenue. As discussed above, Prodigy was the primary source
of revenue for the Company in 1997 and 1998. The Company provides certain
network and related services, including Internet dial access services to Prodigy
for its subscribers. The revenue from Prodigy is based on the lower of the
Usage-Based Rate or the Subscriber-Based Rate calculation, and is subject to a
minimum monthly commitment. The Company may receive Additional Fees. See
"Prodigy Transactions."
In 1997 and the first quarter of 1998, the revenue from Prodigy was based
on the Usage-Based Rate. As a result of a change in the mix of services offered
by Prodigy, revenue increases in the first quarter of 1998 resulted from an
increase in total subscriber hours. Total subscriber usage, as compared to the
immediately prior quarter, increased 12.1%, 25.4%, 6.7%, 14.6% and 13.3% in the
fourth quarter of 1997 and the first, second, third and fourth quarters of 1998,
respectively. Additionally, in January 1998, pursuant to contractual terms,
there was a 9.5% increase in the hourly usage rate charged to Prodigy. The
hourly usage rate also increased by 8.7% in January 1999. This increase is not
expected to have an impact on the Company's revenue, as the Company anticipates
it will continue to be subject to the Subscriber-Based Rate calculation, which
is not calculated by reference to usage but by reference to number of
subscribers.
24
<PAGE> 27
Since the second quarter of 1998, revenue from Prodigy has been based on
the Subscriber-Based Rate. The change in the method of calculation was
anticipated by management as Prodigy's mix of Internet service offerings was
migrating from the Prodigy Classic service, which experiences a lower usage per
subscriber, to Prodigy Internet, which experiences a significantly higher usage
per subscriber. The Company anticipates that revenue generated from Prodigy over
the long-term will continue to be based primarily on the total number of Prodigy
subscribers, as opposed to the total number of subscriber hours. Percentage
increases (decreases), as compared to the immediately prior quarter, in total
Prodigy subscriber counts billed to Prodigy during the fourth quarter of 1997
and the first, second, third and fourth quarter of 1998 were (3.3%), 6.4%,
(8.0%), (4.9%), and 3.5%, respectively. Because the Company's current revenues
are almost entirely derived from Prodigy, such revenues are primarily dependent
on Prodigy's growth in subscribers, mix in services and the usage of such
services.
The Company expects the number of Prodigy Internet subscribers to continue
to increase relative to the number of Prodigy Classic subscribers. Average
hourly usage per subscriber is therefore continuing to increase. This increase
could result in Additional Fees owing to the Company. Additional Fees are earned
when average monthly usage per subscriber exceeds 30 hours per month. The
Company is unable to predict when or whether it will receive any Additional Fees
from Prodigy.
Under the terms of the Prodigy Agreement, the Company's services for
Prodigy Classic subscribers was to end not later than December 31, 1998. In
mid-1998, the Company, at Prodigy's request, agreed to extend the date for one
year with termination to occur not later than December 31, 1999. Prodigy has
announced its intentions to continue Prodigy Classic service only until October
1999. As of December 31, 1998, Prodigy Classic subscribers represented less than
25% of the total subscriber count billed to Prodigy. The Company has recently
agreed to lower the Subscriber-Based Rate charged to Prodigy Classic Subscribers
who are enrolled with Prodigy under a reduced plan of $9.95 or less per month
and are restricted to lower usage.
While Internet dial access service provided to Prodigy's subscribers has
been the only significant source of the Company's revenues to date, the Company
has begun to develop and offer other services geared toward business customers.
The Company expects this strategy to increase revenues in 1999 and more fully
utilize the Network during the underused daytime hours without the need to add
significant additional capacity.
Currently, the Company has contracted or implemented Internet dedicated
access services for several companies and smaller ISPs. Internet dedicated
access services require minimal additional costs to provide service and have
short sales cycles. The Company believes that the number of companies for which
it provides this service will increase.
The Company intends to provide VPN services for business customers to use
the Splitrock Network to connect its remote locations and to provide dial access
to remote employees. This type of service has a longer sales lead-time and is
expected to require higher customer care cost. However, minimal additional
capital investment is required. The Company expects that the provision of VPN
(both dedicated and dial) services will be a major focus of its future business.
Network Costs -- Overview. Network related operating expenses include all
of the direct costs incurred in connection with designing, deploying and
operating the Splitrock Network. These costs also include operating the Legacy
Network, which includes both the Prodigy Legacy Network and the IBM Network. The
Company's Network-related operating expenses are principally comprised of three
categories: Network personnel costs, Network operating costs and Legacy Network
costs.
The Company anticipates its efforts and resources through mid-1999 will be
substantially devoted to completing the Network Build. These construction
efforts have caused and will continue to cause fluctuations in expenses from
period to period, in terms of total dollars and as a percentage of revenue.
Additionally, the nature and amount of expenses are expected to fluctuate as the
Company completes the Network Build and transitions its focus to maintaining and
improving operations and adding customers in new service lines.
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<PAGE> 28
Network Personnel Costs. Network personnel costs include all internal
personnel expenses incurred in connection with designing, deploying and
operating the Splitrock Network. Network personnel have steadily increased as
the Company continues to build the Network infrastructure necessary to support
the Network facilities and the services offered. The large increase in the last
quarter of 1998 was the result of an increase in recruiting and hiring, as
funding was available. At December 31, 1997 and 1998, the Company had 67 and 188
employees and contractors, respectively. The Company expects increases in
Network personnel to continue as the Company adds additional employees to
develop and improve operations for new services.
Network Operating Costs. Network operating costs include all expenses,
other than personnel costs, incurred in connection with designing, deploying and
operating the Splitrock Network. These costs primarily include leased
telecommunication line charges for both access and transmission and operating
expenses related to the Network operations, customer support, engineering,
information technology, field operations and facility management. Steady
increases in operating costs relate to the rise in Network facilities and in
line charges incurred in connection with the growth in total subscriber usage.
As of December 31, 1998, the Company had 107 operational POPs and expects to
have approximately 370 operational POPs at the completion of its Network Build.
During construction of new POP sites, access and transmission lines are
installed and charges are incurred as a POP site becomes operational. This
results in a duplication of expenses on both the new Splitrock POP and the
associated Legacy Network POP until the new Splitrock POP is operational and the
associated Legacy Network POP is decommissioned.
The Company anticipates continued increases in Network operating costs as
lines and facilities are deployed in connection with the Network Build. To date,
the Company has performed its own maintenance of equipment and has relied on
initial warranties at no costs from its vendors. During March 1999, the Company
finalized a contract with Lucent to provide equipment maintenance for field
operations. Maintenance contract costs will increase with the expansion of the
Network.
While the Company is targeting providers of business services, with the
intent of optimizing its Network utilization throughout a 24-hour period, there
is no assurance that its marketing efforts will be successful. The Company may
be required to add additional capacity to meet the demands for the mix of
services actually provided, and there could be periods with underutilized
capacity. The occurrence of such circumstances would increase Network costs and
decrease operating margins.
Legacy Network Costs. Legacy Network costs, currently representing the
largest cost component of total Network costs, include all expenses incurred in
connection with operating and decommissioning the Prodigy Legacy Network. This
includes facility leases, line charges for Prodigy Legacy Network POPs, certain
personnel costs, occupancy costs, equipment maintenance costs and access fees
for the IBM Network. Legacy Network costs are expected to decline, as more
coverage becomes available on the Splitrock Network. As the Network Build
progresses, the Prodigy Legacy Network is being decommissioned and usage of the
IBM Network is declining. As of December 31, 1998, the Company had fully
decommissioned 75% of the original Prodigy Legacy Network POPs. At any given POP
site, operating costs are incurred on both the Splitrock POP and the Legacy
Network POP until the Splitrock POP is operational and the Legacy Network POP is
decommissioned. Although duplicate costs will never be totally eliminated during
the Network Build, the Company is decreasing the time period during which
duplicate costs are incurred.
The largest component of Legacy Network costs are paid to IBM for usage
incurred on the IBM Network. The Company has incurred quarterly costs of $6.3
million, $7.3 million, $11.0 million, $12.0 million, and $12.6 million,
respectively, for the five quarters from October 1, 1997 through December 31,
1998. The increase in costs relates to a continued quarterly increase in total
subscriber usage coupled with an increase in the hourly usage rate, pursuant to
a contract implemented at the beginning of the second quarter of 1998. Prior to
April 1, 1998, the Company accessed the IBM Network under Prodigy's contract
with IBM. Effective April 1, 1998, the Company entered into a new contract with
IBM to continue to provide these access services. The implementation of this new
contract between the Company and IBM resulted in an increase in rates. This new
contract provides for significantly higher hourly usage charges due to the
Company's expected short-term use of the IBM Network, as well as the Company's
lack of a long-term relationship with IBM.
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<PAGE> 29
The Company anticipates the IBM Network costs to decline in the first half
of 1999 and such usage is expected to be substantially eliminated during the
third quarter of 1999. The Company's ability to meet the Network Build schedule
and remove the associated IBM Network cost on a timely basis has a direct impact
on costs and the Company's losses.
Severance Costs. In connection with the Prodigy Agreement the Company
agreed to assume the costs associated with certain of Prodigy's Network
employees. In the fourth quarter of 1997 the Company eliminated certain of these
employees and recorded a $463,000 severance charge.
Selling, General and Administrative Expenses. Selling, general and
administrative expenses consist of personnel and operating costs relating to
executive management, accounting and finance, human resources, sales and
marketing and administrative employees. The Company has experienced steady
increases in these costs as it has added employees to support the Company's
growth. Additionally, in the third quarter of 1998, the Company moved into a
25,000 square foot office facility in The Woodlands, Texas, which significantly
increased its occupancy costs.
The Company expects its selling, general and administrative costs to
increase significantly primarily as a result of the development of the sales and
marketing programs expected to be implemented throughout 1999. Through 1998, the
Company had limited staff in the sales and marketing area. The Company intends
to expand its direct sales force and customer service to attract ISPs, carriers,
value-added service providers and medium and large-sized businesses. The Company
also intends to use alternative distribution channels, including agents,
resellers and wholesalers, to gain access to a substantially larger base of
potential customers than the Company could otherwise initially address through
its direct sales force. In March 1999, the Company signed an agent agreement
with a company to identify and develop qualified opportunities for the sale of
services in the specific regions of Europe. The Company anticipates increases in
the costs associated with the infrastructure necessary to support international
sales. The Company believes that utilizing a range of distribution channels will
enable it to reach a broad base of potential customers in a cost effective
manner. However, the Company may initially incur sales and marketing costs
without realizing offsetting revenue.
In addition to the expanded sales force, the Company anticipates continued
back-office expansion, including the continued implementation of a new customer
care and billing system. The Company has signed a lease for 69,000 square feet
of additional office space, which the Company expects to be available for
occupancy by August 1999. This office lease will increase selling, general and
administrative costs and will also require additional capital expenditures for
furniture and fixtures and leasehold improvements.
Depreciation and Amortization. The steady increase in depreciation results
from the Company's increase in its Network facilities. In the fourth quarter of
1998, the Company revised its estimate of the useful life of certain Network
equipment supporting Prodigy Classic Service. This charge resulted in an
increase in depreciation expense of approximately $2.2 million in the fourth
quarter of 1998.
Interest Expense. Historical interest expense is related to capital leases
on equipment and loans from Linsang Partners, L.L.C. ("Linsang"), a stockholder
of the Company, prior to completion of the Senior Notes Offering in July 1998.
Interest expense increased significantly in the third quarter of 1998, due to
the interest on the $261.0 million of Senior Notes issued on July 24, 1998. The
Company anticipates that interest expense will remain fairly constant unless
additional debt financing is obtained.
Interest Income. Interest income relates to the interest earned on
investments of cash on hand in investment grade commercial paper and money
market accounts. The increase in the third and fourth quarter of 1998 relates to
interest earned on the proceeds from the sale of the Original Notes. The Company
anticipates a continued decline in interest income as the Company uses such
funds to complete its Network Build and to fund operations.
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<PAGE> 30
Income Taxes. No provision for income taxes has been recognized as the
Company had operating losses for both tax and financial reporting purposes in
all periods.
At December 31, 1998 the Company had approximately $26.2 million of gross
deferred tax assets comprised primarily of net operating loss carryforwards. The
Company believes that based on a number of factors, the available objective
evidence creates sufficient uncertainty regarding the ability to realize the
deferred tax assets such that a full valuation has been recorded. These factors
include the Company's history of net losses since its inception and the fact
that the market is intensely competitive and characterized by rapidly changing
technology. The Company believes that, based on the current evidence, it is more
likely than not that the Company will generate net losses through 1999. The
Company will continue to assess the ability to realize the deferred tax assets
based on actual and forecasted results.
LIQUIDITY AND CAPITAL RESOURCES
The Company's principal capital and liquidity needs have been related
primarily to costs incurred to install the nationwide Network and to fund
operating losses while the Company builds its infrastructure to support the
Network in advance of offering services for which the Network was designed. In
1997 the majority of the equipment needed for the Network Build was financed
through vendor equipment leasing programs and other needs were financed through
equity infusions from shareholders. In 1998, the Company's cash requirements
were funded from the proceeds of the Company's issuance and sale of $261.0
million of Senior Notes. The Company expects to continue to incur substantial
operating losses through the scheduled completion of its Network Build in
mid-1999, and until its revenue base is broadened. The Company expects to rely
on the proceeds from the Senior Notes Offering to meet its anticipated cash
needs for working capital, purchases of additional capital equipment, lease
obligations and debt service requirements for at least the next twelve months.
If the Company's sales program does not increase the revenue base to provide
positive working capital and to fund additional capital requirements, if any,
the Company may need to raise additional capital.
Cash Flow Related to Operations. Cash flow used in operating activities can
vary significantly from period to period depending upon the timing of operating
cash receipts from Prodigy and large payments to vendors. The Company expects
this variation to continue until the Network Build is completed and the
Company's base of customers and revenue has increased.
Cash Flow Related to Financings. Since its inception, the Company has
raised approximately $263.3 million (excluding a $10.0 million convertible note
that was converted into equity) through debt financings (of which $2.3 million
has been repaid) and $34.8 million through private sales of equity (including
the conversion into equity of the $10.0 million convertible note).
In addition, the Company has arranged $30.6 million in equipment financing,
including $29.1 million for Network-related equipment primarily from equipment
vendors and $1.5 million for office equipment from vendors and leasing
companies. This financing includes $3.5 million of equipment leases subsequently
liquidated through an early purchase option and approximately $5.3 million in
lease obligations assumed pursuant to the Prodigy Agreement. The Company does
not anticipate the use of leasing to fund a significant portion of capital
purchases, as the Company anticipates that the proceeds from the sale of the
Senior Notes will be adequate to cover such purchases for the Network Build and
its business support systems.
On July 24, 1998, the Company issued and sold $261.0 million aggregate
principal amount of 11 3/4% Senior Notes due in 2008, with interest to be paid
semi-annually each January 15 and July 15 commencing with the January 15, 1999
payment. Of the total outstanding principal amount of $261.0 million of Original
Notes, $11.0 million of the Original Notes were sold to Linsang in connection
with the refinancing of Linsang's outstanding notes to the Company. In November
1998 the Company completed, through a registered offering, an exchange
("Exchange Offering") of New Notes with substantially the same terms as the
Original Notes. The New Notes are senior obligations of the Company ranking pari
passu with all existing and future senior indebtedness of the Company and rank
senior to all future subordinated obligations of the Company. The New Notes are
unsecured (except that the Trustee has a security interest in an escrow account
for the benefit of the holders) and therefore are subordinate to all secured
indebtedness. An amount has been escrowed from the proceeds, that together with
the interest received thereon, will be sufficient to pay the first
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<PAGE> 31
four semi-annual payments of interest beginning with the January 15, 1999
payment. In connection with the Senior Notes Offering and the Exchange Offering,
the Company incurred $9.5 million of related costs, including underwriting fees.
The Company is subject to certain covenants and restrictions pursuant to and
defined in the indenture governing the New Notes. The Company was in compliance
with such covenants as of December 31, 1998.
Cash Flow Related to Investing. As of December 31, 1998, the Company's
investing activities were almost entirely composed of purchases of capital
equipment and installation costs incurred in connection with the Network Build.
As of December 31, 1998, the Company had recorded assets (exclusive of
depreciation) of approximately $91.1 million, of which $5.9 million represents
assets acquired from Prodigy. The following table sets forth such capital
expenditures by category:
<TABLE>
<CAPTION>
(MILLIONS)
<S> <C>
Telecommunications Network Equipment and Shelters........... $79.8
Furniture, Fixtures and Office Equipment.................... 3.2
Software.................................................... 2.2
Assets Acquired from Prodigy................................ 5.9
-----
$91.1
=====
</TABLE>
Of this amount, approximately $30.6 million was financed through capital
leases (including $5.3 million of equipment leases assumed from Prodigy and $3.5
million of equipment leases subsequently liquidated through an early purchase
option). Additionally, the Company has expended approximately $2.2 million in
deposits and other intangibles, including capitalized installation costs and
leasehold improvements, in connection with the Network Build.
Commitments. The Company has utilized contractual pricing in exchange for
volume commitments on certain Network activities, lease lines and equipment.
The Company has an agreement with a telecommunication supplier to provide
certain installation services for the Company. The minimum amount of services
for which the Company is required to pay is $1.3 million. The Company estimates
that as of February 1999, it had incurred approximately $0.7 million of such
amount in connection with this agreement. The Company expects that it will
continue to utilize the services of this provider as the need arises.
The Company has commitments to certain telecommunication vendors to meet
certain minimum usage volumes over periods of two to three years. Additionally,
the Company is subject to certain cancellation penalties should the Company need
to terminate its line contracts. The cancellation penalties typically require a
payment of a certain percentage of the remaining amounts due under the contract,
depending on the year in which the cancellation may occur.
In addition, as of December 31, 1998, the Company had aggregate operating
and capital lease payments of $11.6 million, $8.0 million, $1.5 million, $0.5
million and $0.3 million due in each of the next five years.
Future. The Company's future liquidity and capital requirements are
expected to relate primarily to its debt service and principal repayment
obligations, lease obligations, capital expenditures and other expenses to be
incurred in connection with the Splitrock Network, acquisitions and joint
ventures and general working capital purposes. The Company had originally
anticipated reaching 90% of U.S. household and businesses through approximately
400 POPs at a cost of $85.1 million. Through expanded coverage of its CLEC
providers, the Company believes the planned coverage can be obtained through 370
POPs for an estimated cost of $80.8 million. As of December 31, 1998, the
Company had incurred approximately $63.0 million of the cost of the original
Network design, as revised, and anticipates the remaining amount will be
incurred in the first half of 1999. In addition to the initial capital required
to build the Network, the Company has incurred and will incur additional capital
expenditures to increase Network capacity. The Company may incur additional
capital expenditures to enhance the Network to provide additional value added
products and
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<PAGE> 32
services. The Company has begun to research, and in some cases such as VPN and
Web hosting, has begun to implement the infrastructure for value added services
in the future. Additionally, the Company installed its Network management system
in mid-1998 and its billing system in December 1998. The Company expects to
provide refinements during 1999 to improve its billing and Network management
capabilities for new services. The Company will also incur approximately $4.5
million of additional capital expenditures in connection with its new office
facility in mid-1999. The Company currently believes that the net proceeds
received from the Senior Notes Offering will be sufficient to fund the Company's
expected capital expenditures, working capital, lease obligations and debt
service requirements for at least the next twelve months.
The Company is highly leveraged. As of December 31, 1998, the Company had
$275.6 million of total indebtedness, representing over 100% of the Company's
total capitalization. While there can be no assurance that the Company will have
sufficient cash flow to pay the interest expense or the principal associated
with the New Notes or its other indebtedness, the Company has placed funds in
escrow that, together with the interest received thereon, will be sufficient to
pay, when due, the first four semi-annual interest payments on the New Notes.
The amount and nature of indebtedness is restricted under the Indenture until
the Company is able to maintain less than a 6.0 to 1.0 debt to annualized
operating cash flow ratio. As of December 31, 1998, the Company had negative
annualized operating cash flow, and the type and amount of indebtedness the
Company can incur therefore remains restricted. The highly leveraged position of
the Company could have a material adverse effect on its ability to obtain
financing for acquisitions, joint ventures or other purposes and the Company's
ability to borrow is also restricted by covenants contained in the New Notes.
The Company recorded EBITDA, as defined, of approximately $(6.3) million
and $(34.0) million for the period from inception, March 5, 1997 to December 31,
1997 and the year ended December 31, 1998, respectively. During the same
periods, net losses amounted to $10.1 million and $57.8 million. The Company
expects such net losses to continue as the Company focuses on increasing its
customer base, implementing its business strategy and developing new services.
The historical earnings of the Company were insufficient to cover its fixed
charges for the period from inception to December 31, 1997 and the year ended
December 31, 1998 by approximately $10.1 million and $57.8 million,
respectively.
The Company's ability to meet its debt service obligations, to finance
planned capital expenditures, lease payments or acquisitions or to comply with
certain covenants contained in the Indenture will depend upon the Company's
future performance, which will be subject to general economic conditions and to
financial, business, competitive, legislative, regulatory and other factors
affecting its operations, many of which are beyond the Company's control. In
addition, for the near term, the Company's financial performance will be
dependent on Prodigy. There can be no assurance that the Company's business will
be able to generate cash flow at levels sufficient to satisfy its debt service
and other requirements. If, in the future, the Company is unable to generate
sufficient cash from its operations to make scheduled interest payments on the
New Notes, to pay the New Notes at maturity, or to meet other obligations and
commitments, the Company may be required to adopt one or more alternatives, such
as refinancing or restructuring its indebtedness, reducing or delaying planned
expansion, selling assets or raising additional debt or equity. There can be no
assurance that the Company will be able to implement any of these alternatives
on satisfactory terms, or at all. In addition, the terms of existing or future
debt agreements, including the Indenture governing the New Notes, may prohibit
the Company from adopting some of these alternatives. The Company may, subject
to the limitations provided in the indenture to the New Notes, engage in
acquisitions, investments, joint ventures, strategic partnerships, or other
business combinations, which, in the view of management, present significant
business opportunities. Such activities may require additional financing.
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<PAGE> 33
YEAR 2000
The year-2000 issue is the result of computer programs being written using
two digits, rather than four digits, to define the applicable year. Programs
that have time-sensitive software may recognize a date using "00" as the year
1900 rather than the year 2000 (the "year-2000 issue"). This could result in a
major system failure or miscalculations, including an inability to process
transactions, send invoices or engage in similar normal business activities. Due
to its reliance on computer hardware and software, the Internet and related
service industries are highly susceptible to the year-2000 issue. If the
year-2000 issue should cause widespread problems across the Internet, usage can
be expected to decline dramatically. Such an event would have a material adverse
effect on the Company's financial condition and results of operations, the
nature and extent of which cannot reasonably be determined by the Company on the
basis of information currently available to it.
Splitrock's Approach to the Year 2000 Issue
The Company established a program during 1998 (Y2K Program") to ensure
that, to the extent reasonably possible, all systems are or will be year-2000
compliant prior to the end of 1999. The Y2K Program, designed with the
assistance of an outside consultant, consists of five phases: (I) inventory of
the Company's assets, including significant third-party supplier and customer
relationships, (II) analysis of the assets to determine compliance or
non-compliance, (III) remediation and contingency plan development, (IV)
remediation, and (V) testing of affected systems.
A team consisting of the Company's managers from Information Technology,
Finance and Operations has been established as the Y2K Readiness Team. With the
assistance of its outside consultant, the Y2K Readiness Team has designed an
aggressive schedule to identify information technology ("IT") and non-IT assets
requiring compliance upgrades and a timetable for performance and testing of the
affected systems. In addition, the Y2K Program calls for validation of
compliance by significant Splitrock suppliers and customers.
Once identified, detailed remediation steps will be scheduled to ensure
that internal systems and significant external suppliers and customers meet Y2K
Program compatibility requirements, or that sufficient contingency plans are in
place. Remediation and compliance validation are estimated for completion during
the second quarter of 1999.
Current Status
The Company's year-2000 assessment is approaching final completion. An
inventory of computing, communications and facility systems has been prepared
and validated. Significant suppliers, including CLECs, have also been identified
for validation.
The Company has completed the inventory for both its IT and non-IT systems
and has completed most of the analysis phase for these systems. The Company
anticipates that it will complete the analysis phases for these systems during
the early part of the second quarter of 1999. The Y2K Program calls for the
completion of all phases for both IT and non-IT Systems by the end of the second
quarter of 1999.
The Company has performed a technical review of significant third party
suppliers and customers and, if available, has surveyed the public year-2000
statements issued by them. Additionally, the Company has sent inquiry letters to
certain third party suppliers and customers requesting information regarding
their vulnerability to year-2000 issues. The Company will respond to these
inquiries and evaluate the responses it receives to determine if alternate
business actions will be necessary.
To date, the Company has not incurred and does not anticipate incurring a
significant amount of costs to implement remedial actions required for year-2000
compliance.
Contingency Plans
If any significant systems, customers or suppliers are determined to have
questionable remediation potential, the Y2K Readiness Team will establish a
contingency plan to address the at-risk area during the analysis phase of the
overall project now underway. The Company is unable at this time to determine
what
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<PAGE> 34
contingency plans, if any, may need to be implemented. As the Company progresses
through the Y2K Program and identifies specific risk areas, it will take such
steps to implement remedial actions and contingency plans as may be appropriate
under the circumstances.
Risks
The failure to correct a year-2000 issue could result in the interruption
or failure of certain normal business activities or operations. The Company
believes that the most reasonably likely worst-case scenario would result from
interruption or failure of third party services. Because the Company is
dependent on a number of third party vendors to provide network services, a
significant year-2000-related disruption of these Network services could cause
customers to consider seeking alternate service providers or cause a significant
burden on customer service and technical support.
The Company is not presently aware of any vendor-related year-2000 issue
that is likely to result in any disruption of this type. Although there is
inherent uncertainty in the year-2000 issue, the Company expects that as it
progresses in its Y2K Program, the level of uncertainty about the impact of the
year-2000 issue will be reduced significantly.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company is exposed to a variety of risks, including changes in the
market value of its investments. In the normal course of business, the Company
employs established policies and procedures to manage its exposure to changes in
the market value of its investments.
Short-term Investments. The fair value of the Company's investments in
unrestricted and restricted marketable securities at December 31, 1998 was
$179.0 million. The Company's investment policy is to manage its investment
portfolio to preserve principal and liquidity while maximizing the return on the
investment portfolio through the full investment of available funds. The Company
diversifies the marketable securities portfolio by investing in multiple types
of investment-grade securities. The Company's investment portfolio is primarily
invested in short-term securities with at least an investment grade rating to
minimize interest rate and credit risk as well as to provide for an immediate
source of funds. Although changes in interest rates may affect the fair value of
the investment portfolio and cause unrealized gains or losses, such gains or
losses would not be realized unless the investments are sold.
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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements required in response to this section are submitted
as part of Item 14 of this report and can be found beginning on page F-1.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
Not applicable.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The Company's Board of Directors is divided into three classes of
directors, each class consisting of two directors elected for a term of three
years. Class 1 consists of Messrs. Kwok L. Li and Samer Salameh, whose terms
expire at the annual shareholders meeting to be held in 1999. Mr. Clark McLeod
is one of the Class 2 directors, and his term will expire at the annual
shareholders meeting to be held in 2000. The other Class 2 directorship is
currently vacant. Class 3 consists of Messrs. William R. Wilson and Roy A.
Wilkens, whose terms expire at the annual shareholders meeting to be held in
2001. Directors hold office for three years unless removed because of death,
disability or removal from the Board of Directors in conformance with the
provisions of the Company's Certificate of Incorporation or bylaws. All officers
are elected by the Board of Directors and serve until removed by the Board of
Directors. The following is information concerning the Board of Directors,
executive officers and other key employees of the Company:
<TABLE>
<CAPTION>
NAME AGE PRINCIPAL POSITION WITH THE COMPANY
- ---- --- -----------------------------------
<S> <C> <C>
Kwok L. Li............................ 41 Chairman of the Board of Directors and
Chief Technical Officer
William R. Wilson..................... 51 President, Chief Executive Officer and
Director
Patrick J. McGettigan, Jr............. 46 Senior Vice President, Secretary and
General Counsel
Clark McLeod.......................... 51 Director
Samer Salameh......................... 34 Director
Roy A. Wilkens........................ 55 Director
J. Robert Fugate...................... 38 Executive Vice President and Chief
Financial Officer
David Boatner......................... 50 Executive Vice President and Chief
Marketing Officer
</TABLE>
Kwok L. Li has served as a Chairman of the Board since July 1997 and has
served as Chief Technical Officer of the Company since April 1998. Mr. Li is a
co-founder of the Company. Mr. Li has also been the Chairman and managing member
of Linsang since July 1997. Linsang is a technology investment company in which
Mr. Li owns a controlling interest. Mr. Li was a director of Yurie from 1995
until the consummation of the sale of Yurie to Lucent in 1998. Mr. Li also
served as Vice Chairman of Yurie from June 1997 until its sale to Lucent, as
President and Chief Operating Officer of Yurie from March 1996 to June 1997, and
as Executive Vice President and Chief Technical Officer of Yurie from August
1994 through March 1996. From 1991 to 1994, Mr. Li was Director of Strategic
Planning at WilTel an interexchange carrier. From 1988 to 1991, he was Manager
of Fiber Access Systems Development for Bell Northern Research, Inc., a
subsidiary conducting technological research and development for Northern
Telecom Limited. Mr. Li is the primary technical architect of the Lucent AC120
switch technology. Mr. Li received a B.E.S. in electrical engineering from The
Johns Hopkins University in 1979.
William R. Wilson has served as President of the Company since its
inception and as Chief Executive Officer since April 1998. Mr. Wilson is a
co-founder of the Company. Prior to assuming his position at the
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<PAGE> 36
Company, Mr. Wilson was the Chief Executive Officer of OneLine Management, a
telecommunications consulting firm specializing in strategic positioning founded
by Mr. Wilson in 1995. In that capacity, Mr. Wilson advised Carso and Telmex on
strategic matters. From 1988 to 1995, Mr. Wilson was Vice President of Strategic
Planning at WilTel. Previously, Mr. Wilson taught at Rice University, The
University of Texas at Austin, and The University of Michigan. Mr. Wilson holds
a Ph.D. in Social Psychology from The University of Michigan and an MBA from The
University of Texas at Austin.
Patrick J. McGettigan, Jr., has served as General Counsel of the Company
since September 1997, as Secretary since March 1998, and as Senior Vice
President since April 1998. Prior to joining the Company, Mr. McGettigan was in
the private practice of law, having been a partner in the firm he founded in the
early 1980s. Mr. McGettigan served as outside counsel to the Company when it was
formed in March 1997. Mr. McGettigan received a Bachelor of Arts degree from The
University of Texas and his JD degree from South Texas College of Law, and is a
member of the State Bar of Texas.
Clark McLeod has served as a director of the Company since May 1998. Mr.
McLeod founded McLeodUSA, and has served as its Chairman of the Board and Chief
Executive Officer since its inception in 1991. McLeodUSA is a fully integrated
provider of telecommunications services in the Midwest region. Mr. McLeod's
previous business venture, Teleconnect, a long distance telecommunications
company, was founded in January 1980. This company later merged with
SouthernNet, Inc., forming Telecom*USA. The company grew to become the fourth
largest long distance telecommunications company in the U.S., and was purchased
by MCI in 1990 for $1.3 billion.
Samer Salameh has served as a director of the Company since April 1998. Mr.
Salameh has served as Chief Executive Officer and a director of Prodigy since
September 1997, as Chairman of the Board since August 1998, and served as
President from September 1997 to December 1998. From July 1994 until joining
Prodigy, Mr. Salameh served as Director, Long Distance Division of SBC
Communications (formerly Southwestern Bell), responsible for marketing,
strategy, positioning, product management and product development for Telmex,
the leading provider of local and long distance telephone services in Mexico.
Before that, Mr. Salameh was employed by MCI as a Product Manager in 1994 and as
a Strategic Marketing Manager from 1991 to 1993, and he was employed by Merl
Industries, a management consulting firm, as Vice President of Finance during
1993. Mr. Salameh holds a Masters degree from the Fletcher School of Law and
Diplomacy, a B.S. degree in Management and Technology Transfer from Polytechnic
University of New York and a Baccalaureate degree with concentration in Math and
Physics from Lycee Fenelon in Paris.
Roy A. Wilkens has served as a director of the Company since April 1998.
Mr. Wilkens was President of The Williams Pipeline Company when he founded
WilTel Network Services as an operating unit of The Williams Companies, Inc. in
1985. He was Founder/Chief Executive Officer of WilTel Network Services from
1985 to 1997. In 1995, WilTel Network Services was acquired by LDDS
Communications, which now operates under the name WorldCom. Mr. Wilkens served
as Vice Chairman of WorldCom until his retirement in 1997. In 1992, Mr. Wilkens
was appointed by President George Bush to the National Security
Telecommunications Advisory Council. He has also served as chairman of both the
Competitive Telecommunications Association (CompTel) and the National
Telecommunications Network. Mr. Wilkens is a member of the board of directors of
Paging Network, Inc., UniDial Inc., Invensys Corporation Inc., and Qwest. Mr.
Wilkens is the father of Todd Wilkens, the Company's Vice President of
Engineering.
J. Robert Fugate joined the Company as Executive Vice President and Chief
Financial Officer in March, 1999. From 1997 to 1999, Mr. Fugate served as
Executive Vice President and Chief Financial Officer of Fuego Technology
Corporation, a privately held software development company based in Dallas,
Texas. From 1996 to 1997 Mr. Fugate was Vice President, Corporate Development
for General Wireless Inc., a private Dallas-based company with licenses to
develop personal communications services. In addition, Mr. Fugate served as
Senior Vice President, Finance and Chief Financial Officer of Mobile
Telecommunication Technologies Corp. (since renamed SkyTel Communications, Inc.)
from 1988 to 1996, a publicly traded nationwide and international provider of
personal messaging services. Mr. Fugate received an MBA from Harvard University
and a BBA from The University of Mississippi.
34
<PAGE> 37
David M. Boatner joined the Company in March 1999 as Executive Vice
President and Chief Marketing Officer. Prior to joining Splitrock, Mr. Boatner
was the President of Business Services for McLeodUSA, an integrated
telecommunications provider in the Midwest. At McLeodUSA, Mr. Boatner was
responsible for sales, marketing and customer support for all business
subscribers. From January 1995 to February 1996, Mr. Boatner served as Regional
Vice President of Sales for LDDS-Worldcom, where he was responsible for business
telecommunications sales in the central, southwest and western US. In December
1985, Mr. Boatner was employed as Vice President of Sales for Wiltel until
Wiltel was acquired by LDDS-Worldcom in 1995. In this capacity he managed the
nationwide data and long distance sales for Wiltel. Prior to joining Wiltel, Mr.
Boatner held numerous sales and marketing positions at Southwestern Bell and
AT&T.
CERTAIN OTHER SIGNIFICANT EMPLOYEES
Todd Wilkens has served as Vice President of Engineering of the Company
since July 1997. From 1996 to 1997, Mr. Wilkens was Vice President, Engineering
and Operations, at Gridnet International, where he helped Gridnet, a start-up
Internet services company, implement a nationwide frame relay/ATM network. From
1993 to 1996, Mr. Wilkens was Senior Manager, Advanced Products Support, at
WorldCom where he helped build the Internet Support Organization which
specialized in building and operating ISP backbones. Prior to that, Mr. Wilkens
supported offshore communications in the Gulf of Mexico for Conoco/Dupont. Mr.
Wilkens holds a BSEE from Oklahoma State University. Mr. Wilkens is the son of
Roy A. Wilkens, a director of the Company.
Tracy Hammond joined the Company as Controller in September 1997. In
October of 1998, Ms. Hammond was named Vice-President and Controller. From 1995
to 1997, Ms. Hammond served as Vice President -- Finance and Administration of
Comsul, Ltd., a privately held national communications consulting firm. From
1992 to 1995, Ms. Hammond was Principal Financial Officer at Optex Biomedical, a
high-tech biomedical start-up company. Previously, Ms. Hammond worked for seven
years in Arthur Andersen's emerging business practice group, achieving the level
of audit manager. Ms. Hammond is a CPA, and holds a BS in Accountancy from The
University of Missouri.
Frank W. Williams joined the Company in December of 1998 as Vice President
of Operations. Prior to joining Splitrock, Mr. Williams held several management
and senior executive positions with WilTel, later known as Williams
Communications Solutions LLC. His most recent position was as Senior Operations
Executive where he directed and developed the National Technical Resource
Center. This Center supported 2,500 field technicians servicing digital
communications products manufactured by Nortel, NEC, Octel, Cisco, Bay Networks
and 3Com. He also established a new 130-seat call center from Wiltel NTRC and
Nortel Customer Service Centers. Mr. Williams received a BA in Business from
Trinity University and an Associate of Arts from the Marion Institute in Marion,
Alabama.
Ralph Freeman joined the Company as Vice President of Information Services
in February 1999. From 1996 to June 1998, Dr. Freeman was Chief Information
Officer at American Telco. In June 1998, he became Vice President of Information
Systems at Logix Communications Enterprises, one of the largest CLECs in the
country, which acquired American Telco. During this tenure, he helped build a
new multi-state network architecture. From 1991 to 1994, Dr. Freeman was the
manager in the electronics and software departments of Walt Disney Imagineering.
From 1989 to 1991, Dr. Freeman managed his own consulting firm where he led
senior executives in a simulated business environment on conceptual design and
post-production support. Dr. Freeman holds a BS in Engineering Management from
the Air Force Academy; a MS in Business Administration, Computer Methods from
the University of California at Los Angeles; and a PhD in Information Technology
from George Mason University.
35
<PAGE> 38
ITEM 11. EXECUTIVE COMPENSATION
The following table sets forth certain information regarding the
compensation earned by or awarded to the chief executive officer of the Company
and certain other executive officers of the Company during the period from
inception (March 5, 1997) through Dec. 31, 1997 and for the year ended December
31, 1998.
SUMMARY COMPENSATION TABLE
<TABLE>
<CAPTION>
LONG-TERM
COMPENSATION
ANNUAL COMPENSATION AWARDS
---------------------------------- ------------
OTHER SECURITIES
ANNUAL UNDERLYING
NAME AND PRINCIPAL POSITION YEAR SALARY($) COMPENSATION($) OPTIONS(#)
--------------------------- ---- --------- --------------- ------------
<S> <C> <C> <C> <C>
Kwok L. Li, Chairman of the Board and
Chief Technical Officer...................... 1998 -- -- --
1997 -- $10,600(1) --
William R. Wilson, President and Chief
Executive Officer............................ 1998 $151,440 -- --
1997 62,980 $16,400(1) --
Patrick J. McGettigan, Jr., Senior Vice
President,
Secretary and General Counsel(2)............. 1998 $150,833 -- --
1997 46,933 $65,000(3) 250,000
</TABLE>
- ---------------
(1) The compensation for services rendered was paid in the form of shares of
Common Stock in May 1997.
(2) Mr. McGettigan became an employee of the Company in September 1997. Prior to
being employed by the Company, Mr. McGettigan, performed legal services on
behalf of the Company. In 1997, Mr. McGettigan's former law firm received
approximately $18,000 from the Company.
(3) Granted as a bonus upon Mr. McGettigan becoming an employee of the Company.
OPTION GRANTS IN FISCAL YEAR 1998
There were no stock options granted during 1998, to the executive officers
named in the Summary Compensation Table.
AGGREGATED FISCAL YEAR-END OPTION VALUES
The following table shows information with respect to unexercised options
held by the executive officers named in the Summary Compensation Table as of
December 31, 1998. No stock options were exercised by any executive officers
during the year ended December 31, 1998.
<TABLE>
<CAPTION>
NUMBER OF SECURITIES
UNDERLYING UNEXERCISED VALUE OF UNEXERCISED
OPTIONS HELD AT IN-THE-MONEY OPTIONS
DECEMBER 31, 1998(#) AT DECEMBER 31, 1998(1)($)
--------------------------- ---------------------------
NAME EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
---- ----------- ------------- ----------- -------------
<S> <C> <C> <C> <C>
Kwok L. Li.................................... * * * *
William R. Wilson............................. * * * *
Patrick J. McGettigan, Jr..................... 122,500 127,500 $333,813 $347,438
</TABLE>
- ---------------
* Not applicable.
(1) Options are "in-the-money" if the price of the Company's Common Stock
exceeds the exercise price of the options. The value of unexercised options
represents the difference between the exercise price of such options and the
value of the Company's Common Stock on December 31, 1998, which is based on
a valuation made by an independent firm and which was determined to be $3.35
per share.
36
<PAGE> 39
1997 INCENTIVE SHARE PLAN
On June 16, 1997, the Company's 1997 Incentive Share Plan (the "Plan")
became effective. On April 1, 1998, the Board of Directors of the Company
approved and adopted an amendment and restatement of the Plan which was
subsequently approved and adopted by the stockholders of the Company on April
27, 1998. The purpose of the Plan is to provide employees, and certain
non-employee directors, and consultants with additional incentives by increasing
their ownership interests in the Company.
Individual awards under the Plan may take the form of one or more of (i)
either incentive or non-qualified stock options, (ii) stock appreciation rights,
(iii) restricted stock and (iv) other awards, the value of which is based in
whole or in part upon the value of the Common Stock. Options under the Plan have
a term of ten years and are generally granted with an exercise price equivalent
to market value at the date of grant. Individual option grants vest over time,
based upon a schedule approved by the Board of Directors, which is generally
four years. All of the Company's Common Stock options vest automatically upon a
change in control of the Company, as defined.
The Compensation Committee administers the Plan, determines the persons who
will receive awards and establishes the terms and conditions of those awards.
The President of the Company is also authorized, subject to certain limitations,
to grant awards to other employees. The maximum number of shares of Common Stock
that may be subject to outstanding awards is 20.0 million. As of December 31,
1998, options for 4,443,500 shares had been granted, of which (i) options to
purchase 1,015,000 shares had been exercised, including an option to purchase
1,000,000 shares granted to Mr. McLeod (ii) options to purchase 3,200,500 shares
were outstanding and (iii) options to purchase 228,000 shares, which were
previously granted, had been cancelled or forfeited. Shares of Common Stock
which are attributable to awards which have expired, terminated or been canceled
or forfeited are available for issuance or use in connection with future awards.
Awards under the Plan may be made until January 1, 2007. The Plan may be
amended by the Board of Directors without the consent of the stockholders of the
Company.
DIRECTOR COMPENSATION
The directors of the Company who are not also employees of the Company are
entitled to receive an annual fee of $10,000 and a fee of $500 for attending
each committee meeting not held on the same date as a regular meeting of
directors (Mr. Wilkens and Mr. Salameh have waived all such cash compensation
for 1998), plus reimbursement for reasonable expenses incurred in conjunction
with attending meetings. The Company did not make any cash compensation payments
to the Directors in 1998, except for reimbursement of reasonable expenses
incurred in conjunction with attending meetings. Directors are also eligible for
grants of awards under the Plan. On May 28, 1998, each of the three outside
directors was granted options to purchase 80,000 shares of the Common Stock at
$1.10 per share, with options to purchase 20,000 of such shares vesting on each
of the first four anniversaries of the date of grant.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
In 1997, the compensation of the Company's executive officers was
determined by the Board of Directors. In April 1998, the Board of Directors of
the Company appointed a Compensation Committee consisting of Kwok L. Li, William
R. Wilson, Samer Salameh and Roy Wilkens, who will determine the compensation of
the Company's executive officers consistent with guidelines established by the
Board of Directors. Mr. Li and Mr. Wilson are executive officers of the Company.
Kwok L. Li, the Chairman and Chief Technical Officer of the Company, was
also the Vice Chairman and a Director of Yurie, a principal supplier of the
Company, until its acquisition by Lucent. Mr. Li acts as a consultant to Lucent.
As of February 28, 1999, the Company had purchased approximately $11.4 million
of products and services from Lucent.
Samer Salameh, a Director of the Company, is Chairman of the Board of
Directors of Prodigy, the principal customer of the Company. The Company has,
effective July 1, 1997, entered into an agreement to
37
<PAGE> 40
provide certain network services to Prodigy for its subscribers. Prodigy pays
the Company a monthly service charge for such services. During the fiscal year
ended December 31, 1998, the Company's revenue from Prodigy was approximately
$63.6 million, under the Prodigy Agreement.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table sets forth certain information with respect to the
beneficial ownership of the Company's Common Stock as of February 28, 1999 by
(i) each executive officer and director of the Company, (ii) each stockholder
known by the Company to own beneficially 5% or more of the Company's Common
Stock and (iii) all directors and executive officers of the Company as a group.
As of February 28, 1999, the Company had approximately 82.9 million shares of
Common Stock outstanding. The Company effected a 100-for-1 stock split on June
3, 1997 and a 10-for-1 stock split on August 8, 1997. All share amounts included
herein have been adjusted to reflect the effect of these stock splits.
<TABLE>
<CAPTION>
NUMBER OF
SHARES PERCENTAGE
-------- ----------
<S> <C> <C>
Kwok L. Li.................................................. 39,000,000(1) 47.1%
Linsang Partners, L.L.C..................................... 28,000,000(2) 33.8%
William R. Wilson........................................... 17,000,000 20.5%
Clark McLeod................................................ 1,000,000 1.2%
Samer Salameh............................................... --(3) --
Roy A. Wilkens.............................................. 800,000(4) 1.0%
Patrick J. McGettigan, Jr................................... 122,500(5) *
Orient Star Holdings........................................ 25,000,000(6) 30.2%
Paseo de las Palmas #736
Col Lomas de Chapultepec
Mexico DF CP 11000
Directors and executive officers as a group (6 people)...... 57,922,500(6) 69.9%
</TABLE>
- ---------------
* Less than 1%.
(1) Includes 28.0 million shares owned beneficially and of record by Linsang, a
limited liability company controlled by Mr. Li, and certain members of Mr.
Li's family. Excludes 111,375 shares issuable upon exercise of Warrants
included as part of units purchased by Linsang in the Senior Note Offering.
(2) Such shares are included in the shares shown as beneficially owned by Kwok
L. Li. Excludes 111,375 shares issuable upon exercise of Warrants included
as part of Units purchased by Linsang in the Senior Note Offering.
(3) Excludes stock owned by Orient Star Holdings, a wholly owned subsidiary of
Carso Global Telecom, S.A. de C.V. ("Carso"). Carso is a controlling
shareholder of Prodigy and Mr. Salameh is Chairman of the Board of Directors
of Prodigy. Mr. Carlos Slim Helu, a Mexican citizen, and certain members of
his immediate family, directly and through their ownership of a majority of
the voting and economic interests in two trusts, own a majority of the
outstanding voting equity securities of Carso.
(4) Such shares are held by Mr. Wilkens and Sandra L. Wilkens in joint tenancy.
(5) Consists of shares subject to stock options granted under the Plan that are
exercisable within 60 days of February 28, 1999.
(6) See notes 1 through 5 above.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Employment Agreements. The Company has entered into employment agreements
with William R. Wilson (the "Wilson Agreement") and Patrick J. McGettigan, Jr.
(the "McGettigan Agreement"). The Wilson Agreement terminates on March 15, 2002,
and provides for the payment of an initial base salary at an annual rate of not
less than $150,000 and entitles him to participate in employee benefit plans
offered to senior executives. The McGettigan Agreement terminates on August 31,
1999, and provides for the payment of an
38
<PAGE> 41
initial base salary at an annual rate of not less than $140,000 and entitles him
to participate in employee benefit plans offered to senior executives. The base
salaries are subject to adjustment by the Board of Directors or the Compensation
Committee.
The Wilson Agreement contains confidentiality provisions and provides for
termination (a) for cause (i.e., final conviction of a felony or crime involving
moral turpitude or willful or grossly negligent violation of the terms regarding
confidentiality), (b) upon death or disability or (c) without cause. If Mr.
Wilson is terminated upon death or disability or without cause, the Company is
required to pay the base salary for the remaining term of the Wilson Agreement.
The Company has also indemnified Mr. Wilson pursuant to the Wilson Agreement for
actions taken as an officer and director. The Wilson Agreement further provides
that Mr. Wilson may engage in other business endeavors without violating any of
provisions of the agreement and allows Mr. Wilson to terminate all obligations
under the agreement with 30 days written notice.
The McGettigan Agreement provides for termination for cause (i.e., willful
and material breach of the McGettigan Agreement, intentional nonperformance,
willful dishonesty, fraud or misconduct with respect to the business or
conviction of a felony). If Mr. McGettigan is terminated by the Company for any
reason other than cause, the Company is required to pay the base salary for the
remaining term of the McGettigan Agreement. In addition, Mr. McGettigan can
terminate all obligations under the McGettigan Agreement upon 60 days written
notice.
Financings. In March 1997, the Company issued to its founders, Kwok L. Li
and William R. Wilson, 400,000 and 600,000 shares, respectively, of its Common
Stock for $0.00167 per share. In May 1997, the Company approved the issuance to
Mr. Li and Mr. Wilson of 10.6 million and 16.4 million shares, respectively, of
the Company's Common Stock in consideration of services performed since March
1997.
On June 6, 1997, Mr. Li advanced $3.0 million to the Company and on June
19, 1997, Mr. Li advanced an additional $7.0 million to the Company. Such
advances were evidenced by a $10.0 million convertible note. On August 9, 1997,
Linsang, the assignee of Mr. Li, converted such note into 16.0 million shares of
the Common Stock of the Company.
In December 1997, Linsang loaned $1.0 million to the Company. Such loan was
repayable 30 days after written demand or, if no demand was made, on December 1,
2002 and bore interest at the rate of 9.75% per annum beginning in February
1998. In January, March and June 1998, Linsang advanced an additional $3.0
million, $2.0 million and $5.0 million, respectively, to the Company on similar
terms. Such indebtedness was refinanced in connection with the Senior Note
Offering. In connection with such refinancing, Linsang purchased 11,000 Units in
the Senior Note Offering.
In August 1997, Roy Wilkens and Sandra Wilkens purchased 800,000 shares of
the Common Stock of the Company for $0.5 million. Mr. Wilkens became a member of
the Board of Directors of the Company in April 1998.
In September 1997, Orient Star, a wholly owned subsidiary of Carso,
purchased 20.0 million shares of Common Stock of the Company for $12.5 million.
Orient Star subsequently acquired, pursuant to an option, an additional 5.0
million shares for $3.1 million. Orient Star currently holds approximately 30.2%
of the Common Stock of the Company. Samer Salameh, the Chairman of Prodigy, an
affiliate of Carso, became a member of the Board of Directors of the Company in
April 1998. Carso is a controlling stockholder of Prodigy and a significant
stockholder of TelMex. As a result of Mr. Salameh's relationship with Prodigy,
conflicts of interest may arise, including conflicts relating to potential
corporate opportunities. If any such conflict arises, the Company will have the
non-interested members of the Board of Directors pass on the appropriateness of
any particular matter.
In June 1998, Clark McLeod, CEO of McLeodUSA, a regional telecommunications
firm in the Midwest, exercised in full a stock option previously granted to him
and purchased 1.0 million shares of Common Stock of the Company for $1.1
million. Mr. McLeod became a member of the Board of Directors of the Company in
May 1998.
39
<PAGE> 42
On July 24, 1998, the Company offered and sold 261,000 Units pursuant to
the Senior Note Offering, of which 250,000 units were resold to "qualified
institutional buyers" (as defined in Rule 144A under the Securities Act) and
11,000 units to Linsang, as stated above. As a result, the Company received
$261.0 million.
Other. Kwok L. Li, the Chairman and Chief Technical Officer of the Company,
was also the Vice Chairman and a Director of Yurie, a principal supplier of the
Company, until its acquisition by Lucent. Mr. Li acts as a consultant to Lucent.
As of February 28, 1999, the Company had purchased approximately $11.4 million
of products and services from Lucent. As a result of Mr. Li's relationship with
Lucent and with Linsang, each of which has business relationships with the
Company, there may be conflicts of interest that arise including conflicts
relating to potential corporate opportunities. If any such possible conflict
arises the Company will have the non-interested members of the Board of
Directors pass on the appropriateness of any particular matter.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) Exhibits filed as a part of this Report are set forth below. Unless
preceded by an asterisk, the following exhibits have been previously filed with
the Company's Registration Statement on Form S-4 Registration No. 333-61293
pursuant to the Securities Act of 1933, as amended, under the same exhibit
number set forth herein, and is incorporated herein by this reference:
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
------- -----------
<C> <S>
1.1 -- Purchase Agreement dated July 21, 1998 between the
Company and Chase Securities Inc.
2.1 -- Plan of Merger effective May 8, 1998 between the Company
and Splitrock Services, Inc., a Texas corporation.
3.1 -- Certificate of Incorporation of the Company filed with
the Secretary of State of the State of Delaware on April
15, 1998.
3.2 -- Bylaws of the Company, adopted April 27, 1998.
4.1 -- Specimen 11 3/4% Series B Senior Note due 2008.
4.2 -- Escrow and Disbursement Agreement dated as of July 24,
1998, among The Chase Manhattan Bank (as escrow agent),
Bank of Montreal Trust Company, and the Company.
4.3 -- Indenture dated as of July 24, 1998, between Bank of
Montreal Trust Company (as trustee) and the Company,
including table of contents and cross-reference sheet.
4.4 -- Exchange and Registration Rights Agreement dated as of
July 24, 1998 between Chase Securities Inc. and the
Company.
4.5 -- Warrant Agreement dated as of July 29, 1998 between the
Company and Bank of Montreal Trust Company.
</TABLE>
40
<PAGE> 43
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
------- -----------
<C> <S>
10.1 -- Splitrock Full Service Agreement dated as of June 24,
1997 between the Company and Prodigy Services Corporation
(certain portions omitted based on a grant of
confidential treatment and filed separately with the
Commission).
10.2 -- Definitive Agreement dated as of June 24, 1997 by and
between Prodigy Services Corporation and the Company.
10.3 -- Transition Services Agreement dated as of June 24, 1997
between Prodigy Services Corporation and the Company.
10.4 -- Network Implementation Agreement effective as of April
23, 1998 by and between the Company and Ericsson, Inc.
10.5 -- Security Agreement dated as of April 30, 1998 by and
between the Company and Ericsson.
10.6 -- Yurie Equipment Purchase Agreement effective July 1, 1997
between the Company and Yurie.
10.7 -- Customer Service Agreement effective April 1, 1998
between the Company and IBM Global Services Network.
10.8 -- IBM Customer Agreement effective April 1, 1998 between
the Company and International Business Machines
Corporation.
10.9 -- Product Support Services Agreement dated February 27,
1998, together with Addendum effective March 1, 1998.
10.10 -- Option Agreement dated May 28, 1998 between the Company
and Clark McLeod.
10.11 -- Form of Notes between the Company and Linsang.
10.12 -- Warrant Agreement dated as of July 24, 1998 between the
Company and Bank of Montreal Trust Company, as Warrant
Agent.
10.13 -- 1997 Incentive Share Plan.
10.14 -- Employment Agreement effective March 15, 1997 between
William R. Wilson and the Company.
10.15 -- Employment Agreement effective September 1, 1997 between
Patrick J. McGettigan, Jr. and the Company.
10.16 -- Option to subscribe to purchase 5,000,000 shares of
common stock of the Company for $3.1 million, registered
in the name of Orient Star.
10.17 -- ATM Backbone Services Agreement effective April 28, 1998
between the Company and Network Two Communications Group.
*12 -- Statement re computation of ratios.
*24 -- Powers of Attorney.
*27 -- Financial Data Schedule.
</TABLE>
- ---------------
* Filed herewith.
(b) Financial Statement Schedule
(1) Financial Statements are set forth on pages F-2 through F-15 hereto.
The index to the Financial Statements is found on page F-1.
41
<PAGE> 44
(2) Financial Statement Schedule:
Schedule II: Valuation and Qualifying Accounts (in thousands)
<TABLE>
<CAPTION>
BALANCE AT CHARGED TO BALANCE AT
BEGINNING COSTS AND END
OF PERIOD EXPENSES DEDUCTIONS OF PERIOD
---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Tax Valuation Allowance:
Period from inception (March 5, 1997)
to December 31, 1997.............. $ -- $ 3,436 $ -- $ 3,436
Year ended December 31, 1998......... $3,436 $22,309 $ -- $25,745
Allowance for Doubtful Accounts:
Period from inception (March 5, 1997)
to December 31, 1997.............. $ -- $ -- $ -- $ --
Year ended December 31, 1998......... $ -- $ 537 $ -- $ 537
</TABLE>
All other schedules are omitted because they are not required, are not
applicable, or the information is included in the consolidated financial
statements or notes thereto.
(c) Reports on Form 8-K:
No reports on Form 8-K were filed by the Company during the fourth
quarter of 1998.
42
<PAGE> 45
SPLITROCK SERVICES, INC.
INDEX TO FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
FINANCIAL STATEMENTS:
Report of Independent Accountants......................... F-2
Balance Sheets as of December 31, 1997 and 1998........... F-3
Statements of Operations for the Period from Inception
(March 5, 1997) Through December 31, 1997 and the year
ended December 31, 1998................................ F-4
Statements of Stockholders' Equity(Deficit) for the Period
from Inception (March 5, 1997) Through December 31,
1998................................................... F-5
Statements of Cash Flows for the Period from Inception
(March 5, 1997) Through December 31, 1997 and the year
ended December 31, 1998................................ F-6
Notes to Financial Statements............................. F-7
FINANCIAL STATEMENT SCHEDULE:
Schedule II -- Valuation and Qualifying Accounts.......... 42
</TABLE>
F-1
<PAGE> 46
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders of
Splitrock Services, Inc.
In our opinion, the financial statements listed in the index appearing on
page F-1, present fairly, in all material respects, the financial position of
Splitrock Services, Inc. at December 31, 1997 and 1998, and the results of its
operations and its cash flows for the period from inception (March 5, 1997) to
December 31, 1997 and the year ended December 31, 1998, in conformity with
generally accepted accounting principles. In addition, in our opinion, the
financial statement schedule listed in the index appearing on page F-1, presents
fairly, in all material respects, the information set forth therein when read in
conjunction with the related financial statements. These financial statements
and financial statement schedule are the responsibility of the Company's
management; our responsibility is to express an opinion on these financial
statements and financial statement schedule based on our audits. We conducted
our audits of these statements in accordance with generally accepted auditing
standards which require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements, assessing the
accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for the opinion expressed above.
PRICEWATERHOUSECOOPERS LLP
Houston, Texas
March 24, 1999
F-2
<PAGE> 47
SPLITROCK SERVICES, INC.
BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
ASSETS
<TABLE>
<CAPTION>
DECEMBER 31,
-------------------
1997 1998
-------- --------
<S> <C> <C>
Current assets:
Cash and cash equivalents................................. $ 7,710 $ 28,330
Unrestricted investments -- short term.................... -- 120,475
Restricted investments -- short term...................... 3,472 39,476
Accounts receivable, net of $0 and $537 allowance in 1997
and 1998, respectively................................. 4,252 3,205
Prepaid expenses and other current assets................. 221 480
-------- --------
Total current assets.............................. 15,655 191,966
Property and equipment, net................................. 38,504 73,899
Restricted investments -- long term......................... -- 19,001
Other assets, net........................................... 229 11,275
-------- --------
$ 54,388 $296,141
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current liabilities:
Current maturities of capital lease obligations........... $ 11,010 $ 9,121
Accounts payable.......................................... 3,086 21,582
Accrued interest payable.................................. -- 13,375
Accrued liabilities and other current liabilities......... 5,775 15,894
-------- --------
Total current liabilities......................... 19,871 59,972
Senior notes payable ($261,000 face value net of $2,783
unamortized discount (Note 5))............................ -- 258,217
Capital lease obligations................................... 13,110 8,243
Note payable to stockholder................................. 1,000 --
-------- --------
Total liabilities................................. 33,981 326,432
Commitments and contingencies (Note 7)
Stockholders' equity (deficit):
Preferred stock, $.001 par value, 25,000,000 shares
authorized, no shares issued........................... -- --
Common stock, $.001 par value, 150,000,000 shares
authorized, 76,800,000 and 82,815,000 shares issued and
outstanding as of December 31, 1997 and 1998,
respectively........................................... 77 83
Common stock warrants..................................... -- 2,849
Additional paid-in capital................................ 30,451 34,681
Accumulated other comprehensive income.................... -- 47
Accumulated deficit....................................... (10,121) (67,951)
-------- --------
Total stockholders' equity (deficit).............. 20,407 (30,291)
-------- --------
$ 54,388 $296,141
======== ========
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-3
<PAGE> 48
SPLITROCK SERVICES, INC.
STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
PERIOD FROM
INCEPTION
(MARCH 5, 1997) TO YEAR ENDED
DECEMBER 31, 1997 DECEMBER 31, 1998
------------------ -----------------
<S> <C> <C>
Revenue..................................................... $ 22,708 $ 63,611
Operating expenses:
Network personnel costs................................... 437 4,972
Network operating costs................................... 1,925 30,055
Legacy Network costs...................................... 25,341 58,271
Severance costs........................................... 463 --
Selling, general and administrative....................... 1,276 4,296
Depreciation and amortization............................. 3,500 13,850
----------- -----------
32,942 111,444
----------- -----------
Loss from operations........................................ (10,234) (47,833)
Other income (expense):
Interest income........................................... 348 5,393
Interest expense.......................................... (235) (15,390)
----------- -----------
Loss before income taxes.................................... (10,121) (57,830)
Provision for income taxes.................................. -- --
----------- -----------
Net loss.................................................... (10,121) (57,830)
Other comprehensive income:
Unrealized gain on securities............................. -- 47
----------- -----------
Comprehensive net loss...................................... $ (10,121) $ (57,783)
=========== ===========
Net loss per share -- basic and diluted..................... $ (0.24) $ (0.73)
=========== ===========
Weighted average shares -- basic and diluted................ 42,824,000 78,844,000
=========== ===========
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-4
<PAGE> 49
SPLITROCK SERVICES, INC.
STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
PERIOD FROM INCEPTION (MARCH 5, 1997) THROUGH DECEMBER 31, 1998
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
COMMON STOCK ACCUMULATED
------------------ ADDITIONAL COMMON OTHER
PAR PAID-IN STOCK COMPREHENSIVE ACCUMULATED
SHARES VALUE CAPITAL WARRANTS INCOME DEFICIT TOTAL
---------- ----- ---------- -------- ------------- ----------- --------
<S> <C> <C> <C> <C> <C> <C> <C>
Initial capitalization.......... 28,000,000 $28 -- -- -- -- $ 28
Issuances of Common Stock for
cash of $0.625 per share and
warrant..................... 32,800,000 33 $20,467 -- -- -- 20,500
Conversion of note payable to
Common Stock at $0.625 per
share....................... 16,000,000 16 9,984 -- -- -- 10,000
Net loss...................... -- -- -- -- -- $(10,121) (10,121)
---------- --- ------- ------ --- -------- --------
Balance at December 31, 1997.... 76,800,000 77 30,451 -- -- (10,121) 20,407
Unrealized gain on
securities.................. -- -- -- -- $47 -- 47
Issuance of warrants to
purchase 2,643,000 shares of
Common Stock in connection
with Senior Notes (Note
5).......................... -- -- -- $2,849 -- -- 2,849
Exercise of stock options and
Warrant..................... 6,015,000 6 4,230 -- -- -- 4,236
Net loss...................... -- -- -- -- -- (57,830) (57,830)
---------- --- ------- ------ --- -------- --------
Balance at December 31, 1998.... 82,815,000 $83 $34,681 $2,849 $47 $(67,951) $(30,291)
========== === ======= ====== === ======== ========
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-5
<PAGE> 50
SPLITROCK SERVICES, INC.
STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
<TABLE>
<CAPTION>
PERIOD FROM
INCEPTION
(MARCH 5, 1997)
THROUGH YEAR ENDED
DECEMBER 31, 1997 DECEMBER 31, 1998
----------------- -----------------
<S> <C> <C>
Cash flows from operating activities:
Net loss.................................................. $(10,121) $ (57,830)
Adjustments to reconcile net loss to net cash used by
operating activities:
Depreciation and amortization........................... 3,500 13,850
Amortization of debt discount and deferred financing
costs................................................. -- 467
Changes in assets and liabilities:
(Increase) decrease in accounts receivable.............. (4,252) 1,047
Increase in prepaid and other current assets............ (221) (259)
Increase in accounts payable and accrued liabilities.... 8,861 28,615
Increase in accrued interest payable.................... -- 13,375
-------- ---------
Net cash used in operating activities................... (2,233) (735)
-------- ---------
Cash flows from investing activities:
Purchase of equipment..................................... (16,969) (45,261)
Increase in unrestricted investments...................... -- (119,462)
Reinvestment of interest earned on unrestricted
investments............................................. -- (966)
Reinvestment of interest earned on restricted
investments............................................. -- (1,725)
Increase in other assets.................................. (229) (2,098)
-------- ---------
Net cash used by investing activities.............. (17,198) (169,512)
-------- ---------
Cash flows from financing activities:
Proceeds from senior notes payable and warrants issued.... -- 261,000
Proceeds from notes payable to stockholder................ 11,750 10,000
Repayments of notes payable to stockholder................ (750) (11,000)
Proceeds from notes payable............................... -- 1,477
Repayments of notes payable............................... -- (1,477)
Financing costs incurred.................................. -- (9,501)
Restriction of cash under senior note agreement........... -- (56,752)
Sale of common stock and exercise of stock options........ 20,528 4,236
Proceeds from sale-leaseback of equipment................. 1,152 960
Principal payments on capital lease obligations........... (2,067) (11,548)
Restriction of cash under credit agreement................ (3,472) 3,472
-------- ---------
Net cash provided by financing activities.......... 27,141 190,867
-------- ---------
Increase in cash and cash equivalents....................... 7,710 20,620
Cash and cash equivalents:
Beginning of period....................................... -- 7,710
-------- ---------
End of period............................................. $ 7,710 $ 28,330
======== =========
Supplemental cash flow information:
Cash paid for interest.................................... $ 235 $ 1,536
======== =========
Approximately $18,400 of the increase in accounts payable
and accrued liabilities at December 31, 1998, were
related to equipment purchases.
Noncash investing and financing activities:
Assumption of capital lease obligations and other
liabilities (Note 2).................................... $ 5,900 $ --
======== =========
Capital lease obligations incurred........................ $ 20,916 $ 4,792
======== =========
Conversion of note payable to stockholder into common
stock................................................... $ 10,000 $ --
======== =========
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-6
<PAGE> 51
SPLITROCK SERVICES, INC.
NOTES TO FINANCIAL STATEMENTS
(AMOUNTS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Splitrock Services, Inc. ("the Company") was formed on March 5, 1997 as a
Texas corporation and was reincorporated in Delaware on April 15, 1998. The
Company was formed to build a nationwide, facilities-based telecommunications
network with the goal of providing telecommunications services. The Company has
designed and is in the process of deploying a network based on Asynchronous
Transfer Mode ("ATM") switching technology which it believes will provide
high-quality communications services on a flexible multi-service platform. On
June 24, 1997, the Company entered into a four-year service agreement to provide
Internet dial access services to Prodigy (Note 2).
During 1997, the Company began building its "ATM-to-the-Edge"(TM) network.
The Company expects to have approximately 370 points of presence operational in
the United States upon completion of its Network Build in mid-1999. This network
is currently supported by two network operating centers equipped with state-
of-the-art network management systems. In July 1998 the Company issued Senior
Notes (Note 5) in order to finance the expansion of the network. Upon completion
of the network build, the Company expects to offer value-added data, video and
voice products to business customers.
The following is a summary of the Company's significant accounting
policies:
Use of Estimates. The preparation of the Company's financial statements in
conformity with generally accepted accounting principles requires management to
make estimates and assumptions that affect the reported amounts of assets,
liabilities, revenues and expenses, as well as disclosures of contingent assets
and liabilities. Because of inherent uncertainties in this process, actual
future results could differ from those expected at the reporting date.
Management believes the estimates are reasonable.
Cash and Cash Equivalents and Short-term Investments. The Company considers
highly liquid investments with an original maturity of three months or less from
the date of purchase to be classified as cash and cash equivalents. Cash and
cash equivalents are stated at cost, which approximates fair value.
Short-term investments have original maturities greater than three months
at the date of purchase. At December 31, 1998, cash equivalents and short-term
investments consisted primarily of money market funds and securities of the
highest grade. All short-term investments have been classified as available for
sale under the provisions of Statement of Financial Accounting Standards No.
("SFAS") 115, Accounting for Certain Investments in Debt and Equity Securities,
and have various maturity dates which do not exceed one year. Available for sale
securities are carried at fair value, with the unrealized gains and losses, net
of tax, reported as a separate component of stockholders' equity. The cost of
investments sold is determined on the specific identification or the first-in,
first-out method.
The following is a summary of the investments classified as restricted and
unrestricted as of December 31, 1998:
<TABLE>
<CAPTION>
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE
--------- ---------- ---------- --------
<S> <C> <C> <C> <C>
Available for sale securities:
Money market funds....................... $ 23,557 $ -- $ -- $ 23,557
Corporate notes.......................... 108,496 3 (80) 108,419
Municipal securities..................... 12,061 -- (6) 12,055
U.S. Treasury notes...................... 34,791 181 (51) 34,921
-------- ---- ----- --------
$178,905 $184 $(137) $178,952
======== ==== ===== ========
</TABLE>
F-7
<PAGE> 52
SPLITROCK SERVICES, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
(AMOUNTS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
The restricted investment at December 31, 1997 was a three-month time
deposit held as collateral on a letter of credit. In the first quarter of 1998,
the letter of credit was retired with the Company's exercise of its early
purchase option with regard to the related capital lease. The restricted
investments at December 31, 1998, relates to funds held in escrow to pay future
semi-annual interest payments due under the terms of the Senior Note obligation
(Note 5).
Concentration of Credit Risk. Financial instruments which potentially
subject the Company to concentration of credit risk are primarily cash and cash
equivalents, investments and receivables. The Company's cash investment policies
limit investments to short-term, investment grade instruments with quality
financial institutions. The Company's revenues and its trade receivable balances
for the periods ended December 31, 1997 and 1998, were derived primarily from
services provided to Prodigy, the Company's major customer during the periods.
Any interruption of this relationship could adversely affect the Company.
Management believes that the risk of incurring material losses related to credit
risks are remote.
Fair Values of Financial Instruments. Due to the short-term nature of the
Company's financial instruments, management believes the carrying values of the
Company's assets, short-term liabilities and lease obligations approximate their
fair values. The fair value of the Company's Senior Notes (Note 5) at December
31, 1998, approximates $227,000, based upon quoted market prices.
Property and Equipment. Property and equipment are stated at cost.
Depreciation and amortization of telecommunications network equipment, including
assets under capital leases, is provided when placed into service using the
straight-line method over the estimated useful lives of three years from the
date of installation. Shelters are depreciated using the straight-line method
over its estimated useful life of twenty years. Software, furniture, fixtures
and office equipment is depreciated using the straight-line method over the
useful lives of the assets, which range from three to ten years. Equipment
acquired from Prodigy is depreciated over its estimated useful life of nine
months to three years.
Long-Lived Assets. The Company reviews for the impairment of long-lived
assets whenever events or changes in circumstances indicate that the carrying
amount of an asset may not be recoverable. The carrying amount of a long-lived
asset is considered impaired when anticipated undiscounted cash flows expected
to result from the use of the asset and its eventual disposition are less than
its carrying amount. The Company believes that no material impairment exists at
December 31, 1998.
Income Taxes. Deferred tax assets and liabilities are determined based on
the temporary differences between the financial statement carrying amounts and
the tax bases of assets and liabilities using the enacted tax rates in effect in
the years in which the differences are expected to reverse. In estimating future
tax consequences, all expected future events are considered with the exception
of enacted changes in the tax law or rates.
Stock-Based Compensation. The Company has adopted SFAS No. 123, Accounting
for Stock-Based Compensation, for disclosure purposes. Under SFAS No. 123, the
Company measures compensation expense for its stock-based employee compensation
plan using the intrinsic value method prescribed in Accounting Principles Board
("APB") No. 25, Accounting for Stock Issued to Employees. The Company provides
disclosure of the effect on net income as if the fair value-based method
prescribed in SFAS No. 123 has been applied in measuring compensation expense.
Revenue Recognition. The Company recognizes revenue when services are
provided and collectibility is deemed probable under its agreement with the
customer. Prodigy was the Company's only customer through December 31, 1997 and
the Company's major customer (99% of revenue for the year ended December 31,
1998) through December 31, 1998.
F-8
<PAGE> 53
SPLITROCK SERVICES, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
(AMOUNTS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
Legacy Network Costs. The Legacy Network refers to the operations related
to certain assets which the Company acquired from Prodigy on July 1, 1997
related to Prodigy's existing network infrastructure, in order to provide
services to Prodigy while the Splitrock Network is being deployed (Note 2).
These costs contain all expenses incurred in connection with operating and
decommissioning of the Legacy Network. This includes facility fees, line charges
for Prodigy Legacy Network POPs, certain personnel costs, occupancy costs,
equipment maintenance costs and access fees for the IBM Global Services Network.
Comprehensive Income. Effective January 1, 1998, the Company adopted SFAS
No. 130, Reporting Comprehensive Income, as displayed in its Statements of
Operations for all periods presented. This SFAS establishes standards for
reporting and display of comprehensive income and its components. The Company's
comprehensive income is comprised of net income and unrealized gains on
available for sale securities.
Net Loss Per Share. Basic and diluted net loss per share have been computed
in accordance with SFAS No. 128, Earnings Per Share. SFAS No. 128 requires the
Company to report both basic earnings per share, which is based on the weighted
average number of common shares outstanding, and diluted earnings per share,
which is based on the weighted average number of common shares outstanding and
all dilutive potential common shares outstanding. At December 31, 1997, options
to acquire 1,880,000 shares of Common Stock at the exercise price of $0.625 and
a warrant to purchase 5,000,000 shares of Common Stock at $0.625 and at December
31, 1998, options to acquire 3,200,500 shares of Common Stock at the
weighted-average exercise price of $1.30 and warrants to acquire 2,642,613
shares of Common Stock at an exercise price of $0.01 were not included in the
computation of diluted earnings per share because their effect is anti-dilutive.
Basis of Presentation. The Company conducts its business within one
industry segment. The Company presents its financial statements to reflect how
the "key operating decision maker" views the business and has made the
appropriate enterprise-wide disclosures in accordance with SFAS No. 131,
Disclosures About Segments of an Enterprise and Related Information.
New Accounting Pronouncements. In June 1998, the Financial Accounting
Standards Board ("FASB") issued SFAS No. 133 Accounting for Derivative
Instruments and Hedging Activities, which is effective for fiscal years
beginning after June 15, 1999, and establishing accounting and reporting
standards for derivative instruments. The Company has historically not engaged
in derivative instrument activity. The adoption of this standard is not expected
to have a material effect on the Company's financial position or results of
operations.
In March 1998, the American Institute of Certified Public Accountants
("AICPA") issued Statement of Position ("SOP") 98-1, Accounting for the Costs of
Computer Software Developed or Obtained for Internal Use. This standard requires
that certain costs related to the development or purchase of internal-use
software be capitalized and amortized over the estimated useful life of the
software. This SOP also requires that costs related to the preliminary project
stage, data conversion and the post-implementation/operation stage of an
internal-use computer software development project be expensed as incurred. SOP
98-1 is effective for financial statements issued for fiscal years beginning
after December 31, 1998. The adoption of this Statement is not expected to have
a material effect on the Company's financial position or results of operations.
2. PRODIGY TRANSACTIONS
On June 24, 1997, the Company entered a four-year Full Service Agreement
with Prodigy, in which the Company agreed to provide certain network services to
Prodigy from July 1, 1997 through June 30, 2001 for the lower of a price per
hour of usage or a price per subscriber as stipulated. Monthly minimum service
commitments set each year under this four-year contract range from $3,000 to
$4,500. Monthly maximum service commitments are based on average usage per
subscriber and the number of subscribers. Prodigy may terminate the Full Service
Agreement without termination charges in an event of default by the Company;
such defaults include documented failures (without cure) to meet certain network
performance standards.
F-9
<PAGE> 54
SPLITROCK SERVICES, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
(AMOUNTS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
The agreement also allows Prodigy to terminate its arrangement with the Company
at any time upon the payment of a termination charge.
The Company also entered into a transition agreement with Prodigy in which
Prodigy agreed to provide certain network infrastructure support for the Company
for the period July 1, 1997 through December 31, 1997. The infrastructure
support included the services of selected Prodigy employees and services
provided under vendor arrangements related to the Prodigy network
infrastructure. The costs of these services and other reasonable and customary
charges incurred by Prodigy in connection with the continued operations of the
network during this transition period are included in Legacy Network costs. The
Company assumed no contractual liabilities of any services related to Prodigy's
existing network infrastructure as part of the transition agreement.
Also on June 24, 1997, the Company entered into a Definitive Agreement with
Prodigy pursuant to which the Company acquired selected data transmission
equipment from Prodigy. In consideration for the equipment, the Company assumed
approximately $5,900 in equipment lease obligations and other liabilities.
3. PROPERTY AND EQUIPMENT
Property and equipment consisted of the following:
<TABLE>
<CAPTION>
DECEMBER 31,
------------------
1997 1998
------- --------
<S> <C> <C>
Telecommunications network equipment and shelters........... $ 3,464 $ 43,275
Software.................................................... 94 2,186
Furniture, fixtures and office equipment.................... -- 1,749
Telecommunications network equipment under construction..... 12,248 13,289
------- --------
15,806 60,499
Less -- accumulated depreciation............................ (103) (10,392)
------- --------
Purchased property and equipment, net..................... 15,703 50,107
------- --------
Leased telecommunications network equipment................. 13,648 29,102
Leased office equipment..................................... 388 1,496
Leased telecommunications network equipment under
construction.............................................. 12,162 --
------- --------
26,198 30,598
Less -- accumulated amortization............................ (3,397) (6,806)
------- --------
Leased property and equipment, net........................ 22,801 23,792
------- --------
Property and equipment, net................................. $38,504 $ 73,899
======= ========
</TABLE>
4. ACCRUED LIABILITIES
Accrued liabilities consisted of the following:
<TABLE>
<CAPTION>
DECEMBER 31,
----------------
1997 1998
------ -------
<S> <C> <C>
Telecommunications network equipment and shelters........... $ -- $ 9,900
Access and transmission telecommunications line costs (Note
7)........................................................ 41 3,172
Other....................................................... 5,734 2,822
------ -------
Accrued liabilities............................... $5,775 $15,894
====== =======
</TABLE>
F-10
<PAGE> 55
SPLITROCK SERVICES, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
(AMOUNTS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
5. INDEBTEDNESS
The components of indebtedness are summarized as follows:
<TABLE>
<CAPTION>
DECEMBER 31,
-------------------
1997 1998
-------- --------
<S> <C> <C>
Senior Notes................................................ $ -- $258,217
Capital lease obligations................................... 24,120 17,364
Note payable to stockholder................................. 1,000 --
-------- --------
25,120 275,581
Less -- current maturities.................................. (11,010) (9,121)
-------- --------
$ 14,110 $266,460
======== ========
</TABLE>
On July 24, 1998, the Company sold 261 units consisting of $261,000
principal amount of 11 3/4% Senior Notes due 2008 ("Senior Notes") and warrants
to purchase 2,642,613 shares of common stock ("the Senior Notes Offering"). Upon
issuance, the Senior Notes were recorded in the Company's financial statements
net of a $2,849 discount. The discount was attributable to the Company's
estimate of the value of the warrants based on an independent third party
valuation. The discount is amortized as a component of interest expense over the
life of the Senior Notes. This amortization will result in an increase in the
financial statement balance of the Senior Notes to a $261,000 face value by
2008.
In connection with the Senior Notes Offering, the Company repaid $1,477
outstanding under a credit facility and refinanced $11,000 of indebtedness owed
to Linsang Partners L.L.C. ("Linsang"), a stockholder of the Company. In
connection with the refinancing, Linsang acquired 11,000 units in the Senior
Notes Offering. The net proceeds to the Company, after the Senior Notes Offering
expenses and retirement and refinancing of debt, approximated $239,000.
In November 1998, the Senior Notes were exchanged in an offering registered
under the Securities Act of 1933 for $261,000 in principal amount of Series B
Senior Notes, which have substantially the same terms as the Senior Notes,
except that there is no restriction on transferability.
Capital leases require payments on a monthly basis over periods ranging
from 24 to 48 months, with implicit interest rates of 9% to 12%.
In December 1997, the Company borrowed $1,000 from Linsang. The unsecured
note had a stated rate of interest of 9.75% and provided for monthly interest
payments beginning February 1, 1998, with the principal due on demand after
December 31, 1998, and maturing December 31, 2002. During 1998, the Company
borrowed $10,000 from Linsang on terms substantially the same as the previous
note. The Linsang notes were refinanced in July 1998, in connection with the
Senior Notes offering, as stated above.
6. INCOME TAXES
A provision for income taxes for the periods ended December 31, 1997 and
1998 has not been recognized as the Company had operating losses for both tax
and financial reporting purposes. Due to the uncertainty surrounding the timing
of realizing the benefits of its favorable tax attributes in future tax returns,
the Company has recorded a full valuation allowance against its otherwise
recognizable net deferred tax asset.
F-11
<PAGE> 56
SPLITROCK SERVICES, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
(AMOUNTS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
Deferred tax assets consist of the following:
<TABLE>
<CAPTION>
DECEMBER 31,
------------------
1997 1998
------- --------
<S> <C> <C>
Net operating loss carryforward............................. $ 3,248 $ 22,465
Depreciation................................................ 167 3,325
Other....................................................... 21 429
------- --------
Deferred tax assets....................................... 3,436 26,219
------- --------
Leases...................................................... -- (474)
------- --------
Deferred tax liabilities.................................. -- (474)
------- --------
Net deferred tax assets..................................... 3,436 25,745
Valuation allowance......................................... (3,436) (25,745)
------- --------
Net deferred tax assets..................................... $ -- $ --
------- --------
</TABLE>
The Company's net operating loss carryforward totals approximately $59,000
of which approximately $9,500 expires in 2012 and the remainder in 2013. Certain
changes in ownership of the Company could result in limitations on the Company's
ability to utilize the losses.
7. COMMITMENTS AND CONTINGENCIES
The Company leases office space, equipment facilities and equipment under
noncancelable operating and capital leases expiring through the year 2003. Rent
expense for noncancelable operating leases amounted to $218 in 1997 and $663 in
1998.
Future minimum payments by year and in the aggregate related to
noncancelable operating and capital leases at December 31, 1998 are:
<TABLE>
<CAPTION>
CAPITAL OPERATING
LEASES LEASES TOTAL
------- --------- -------
<S> <C> <C> <C>
1999.................................................... $10,576 $1,049 $11,625
2000.................................................... 7,101 903 8,004
2001.................................................... 746 801 1,547
2002.................................................... 37 422 459
2003.................................................... -- 265 265
------- ------ -------
Total minimum lease payments.................. 18,460 $3,440 $21,900
------- ====== =======
Less amount representing interest............. (1,096)
-------
Present value of minimum capital lease payments......... $17,364
=======
</TABLE>
The Company leases telephone lines from competitive local exchange
suppliers, interexchange carriers and long distance telephone companies
primarily for access and transport purposes ("line costs"). These line costs are
leased under both cancelable and noncancelable operating leases over periods
ranging from month-to-month to five years and are included in Network operating
costs on the statement of operations. The Company has commitments to certain of
these telecommunication vendors to meet certain minimum usage volumes.
Additionally, the Company is subject to certain cancellation penalties which
could become applicable upon termination of a number of these agreements. The
cancellation penalties typically require a payment of certain percentage of the
remaining amounts due under the contract, depending on the year in which
cancellation may occur.
F-12
<PAGE> 57
SPLITROCK SERVICES, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
(AMOUNTS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
Line costs included in the Splitrock Network operating costs were $547 and
$22,617 during the period from inception (March 5, 1997) to December 31, 1997
and the year ended December 31, 1998, respectively. Line costs incurred during
the period from inception (March 5, 1997) to December 31, 1997 and the year
ended December 31, 1998, comprise a substantial portion of the Network operating
costs.
The Company is in the process of resolving certain issues related to the
collection and remittance of certain taxes. The Company believes resolution of
these issues will not have a material adverse effect on the Company's financial
condition or results of operations.
The Company had an outstanding letter of credit in the amount of $3,472 as
of December 31, 1997. This letter of credit was maintained as security for
performance under a certain capital lease obligation and was retired in the
first quarter of 1998 with the Company's exercise of its early purchase option
on the related capital lease.
The Company has an agreement with a telecommunication supplier to provide
certain installation services for the Company. The minimum amount of services
for which the Company is required to pay is approximately $1,300. As of December
31, 1998, the Company has incurred approximately $700 of such amount in
connection with this agreement.
8. EQUITY TRANSACTIONS
The Company effected a 1-for-100 stock exchange on June 3, 1997 and a
1-for-10 stock exchange on August 8, 1997. All share amounts included in these
financial statements have been adjusted to reflect the effect of the stock
exchanges.
Warrants issued in connection with the Company's Senior Note Offering are
exercisable at $.01 per share at any time on or after July 24, 1999 through July
15, 2008 for 2,642,613 shares of Common Stock.
9. STOCK OPTIONS
The Company's 1997 Incentive Share Plan (the "Plan") provides that options
to purchase up to 20,000,000 shares of common stock may be granted to certain
directors, employees or consultants of the Company. Options under the Plan have
a term of ten years and are granted with an exercise price equivalent to market
value at the date of grant which has been determined by the Board of Directors
for periodic intervals based upon actual issuances of shares in exchange for
cash, third party appraisals and significant events effecting the value of the
Company. Individual option grants vest over time, based upon a schedule approved
by the Board of Directors, which is generally four years. All of the Company's
common stock options vest automatically upon a change in control of the Company,
as defined.
F-13
<PAGE> 58
SPLITROCK SERVICES, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
(AMOUNTS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
The following summarizes the activity for the Plan:
<TABLE>
<CAPTION>
1997 1998
-------------------- --------------------
WEIGHTED WEIGHTED
AVERAGE AVERAGE
EXERCISE EXERCISE
SHARES PRICE SHARES PRICE
--------- -------- --------- --------
<S> <C> <C> <C> <C>
Options outstanding at beginning of fiscal
year...................................... -- -- 1,880,000 $0.625
Granted................................... 1,880,000 $0.625 2,563,500 $1.670
Exercised................................. -- -- 1,015,000 $1.093
Canceled.................................. -- -- 228,000 $0.840
--------- ---------
Options outstanding at end of year.......... 1,880,000 $0.625 3,200,500 $1.298
</TABLE>
The following table summarizes information about the Company's stock
options outstanding at December 31, 1998:
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
-------------------------------------- -----------------------
NUMBER WEIGHTED- NUMBER
OUTSTANDING AVERAGE WEIGHTED EXERCISABLE WEIGHTED
RANGE OF AT REMAINING AVERAGE AT AVERAGE
EXERCISE DECEMBER 31, CONTRACTUAL EXERCISE DECEMBER 31, EXERCISE
PRICES 1998 LIFE (YEARS) PRICE 1998 PRICE
-------- ------------ ------------ -------- ------------ --------
<S> <C> <C> <C> <C> <C>
$0.625....................... 2,120,500 8.71 $0.625 793,375 $0.625
1.10........................ 350,000 9.37 1.100 1,250 1.10
3.35........................ 730,000 9.75 3.350 -- --
--------- -------
$0.625 - $3.35............... 3,200,500 9.02 $1.298 794,625 $0.626
</TABLE>
In October 1996, the FASB issued SFAS No. 123, "Accounting for Stock-Based
Compensation," which allows the Company to account for its employee stock-based
compensation plans under APB No. 25 and the related interpretations. According
to APB No. 25, deferred compensation is recorded for stock-based compensation
grants based on the excess of the market value of the common stock on the
measurement date over the exercise price. The deferred compensation is amortized
over the vesting period of each unit of stock-based compensation grant. If the
exercise of the stock-based compensation grants is equal to the market price of
the Company's stock on the date of grant, no compensation expense is recorded.
During the year ended December 31, 1998, the Company recognized
compensation expense of $46 for options granted at a discount from the then
estimated fair market value of the Company's Common Stock.
Had compensation cost for the Company's stock option plan been determined
based on the estimated fair market value at the grant date, consistent with the
provisions of SFAS No. 123, the Company's pro forma net loss would have been as
follows:
<TABLE>
<CAPTION>
PRO FORMA
PERIOD FROM
INCEPTION
(MARCH 5,
1997) PRO FORMA
THROUGH YEAR ENDED
DECEMBER 31, DECEMBER 31,
1997 1998
------------- -------------
<S> <C> <C>
Net loss.................................................... $(10,141) $(58,254)
Net loss per share -- basic and diluted..................... (0.24) (0.74)
</TABLE>
Options granted in 1997 and 1998 had weighted-average fair values of $0.077
and $1.00, respectively. For purposes of estimating the fair value of options
granted, the Company used no future dividends, used average U.S. government
security interest rates for its risk-free interest rates of 5.80% and 4.39%,
assumed no volatility
F-14
<PAGE> 59
SPLITROCK SERVICES, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
(AMOUNTS IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
and 70.5% volatility, and assumed expected life of the options of five and four
years in 1997 and 1998, respectively.
10. RELATED PARTY TRANSACTIONS
The Company's chairman of the Board of Directors (the "Chairman"), who is
also a shareholder of the Company, is the Chief Technical Officer of Lucent
Technologies, Inc. (the "Vendor") from which the Company purchased approximately
$11,000 in equipment through December 31, 1997 and $427 during the year ended
December 31, 1998.
The Company also retained the Vendor to perform assembly services related
to the deployment of network equipment to the field during 1997. The Company
incurred approximately $1,500 for these services of which approximately $990
were expensed in 1997. As of December 31, 1997 and 1998, the Company owed $1,461
and $0 to the Vendor, respectively.
Linsang, an affiliate of the Chairman, loaned $1,000 to the Company for the
purchase of certain network equipment in December 31, 1997. During 1998, the
affiliate made further advances of $10,000 under this agreement. The unsecured
notes had a stated rate of interest of 9.75% and provided for monthly interest
payments beginning February 1, 1998, with the principal due on demand after
December 31, 1998, and maturing December 31, 2002. The Notes were refinanced in
July 1998, in connection with the Senior Notes offering (Note 5).
A director of the Company exercised an option to purchase 1,000,000 shares
of the Company Common Stock for $1,100 in June 1998.
In September 1997, Orient Star Holdings, a wholly-owned subsidiary of Carso
Global Telecom, S.A. de C.V. (the controlling stockholder of Prodigy) purchased
20,000,000 shares of the Company for $0.625 per share and paid $0.1, for a
warrant to purchase an additional 5,000,000 shares of the Company through
September 18, 1998 for $0.625 per share. The warrants were exercised in
September 1998 (Note 8).
11. SUBSEQUENT EVENTS
In March 1999, the Company signed a lease for sixty-nine thousand square
feet of additional office space, which the Company expects to be available for
occupancy in August 1999. In connection with this lease, the Company issued a
$850 letter of credit.
F-15
<PAGE> 60
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf of the undersigned, thereunder duly authorized, in the City of The
Woodlands, State of Texas on the 30th day of March, 1999.
SPLITROCK SERVICES, INC.
By: /s/ WILLIAM R. WILSON
----------------------------------
William R. Wilson
President and Chief Executive
Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed by the following persons on behalf of the registrant and
in the capacities and on the dates indicated.
<TABLE>
<CAPTION>
SIGNATURE TITLE DATE
--------- ----- ----
<C> <S> <C>
/s/ WILLIAM R. WILSON President, Chief Executive March 30, 1999
- ----------------------------------------------------- Officer and Director
William R. Wilson (Principal Executive
Officer)
/s/ KWOK L. LI Chairman of the Board, March 30, 1999
- ----------------------------------------------------- Director
Kwok L. Li
/s/ CLARK MCLEOD Director March 30, 1999
- -----------------------------------------------------
Clark McLeod
* /s/ SAMER SALAMEH Director March 30, 1999
- -----------------------------------------------------
Samer Salameh
/s/ ROY A. WILKENS Director March 30, 1999
- -----------------------------------------------------
Roy A. Wilkens
/s/ TRACY E. HAMMOND Vice President and Controller March 30, 1999
- ----------------------------------------------------- (Chief Accounting Officer)
Tracy E. Hammond
*By: /s/ PATRICK J. MCGETTIGAN, JR. March 30, 1999
------------------------------------------------
Patrick J. McGettigan, Jr.
Attorney-in-fact
</TABLE>
S-1
<PAGE> 61
SUPPLEMENTAL INFORMATION TO BE FURNISHED WITH REPORTS
FILED PURSUANT TO SECTION 15(d) OF THE ACT
BY REGISTRANTS WHICH HAVE NOT REGISTERED SECURITIES
PURSUANT TO SECTION 12 OF THE ACT
The Company has not sent and does not plan to send an annual report or
proxy material to its security holders.
S-2
<PAGE> 62
INDEX TO EXHIBITS
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
------- -----------
<C> <S>
1.1 -- Purchase Agreement dated July 21, 1998 between the
Company and Chase Securities Inc.
2.1 -- Plan of Merger effective May 8, 1998 between the Company
and Splitrock Services, Inc., a Texas corporation.
3.1 -- Certificate of Incorporation of the Company filed with
the Secretary of State of the State of Delaware on April
15, 1998.
3.2 -- Bylaws of the Company, adopted April 27, 1998.
4.1 -- Specimen 11 3/4% Series B Senior Note due 2008.
4.2 -- Escrow and Disbursement Agreement dated as of July 24,
1998, among The Chase Manhattan Bank (as escrow agent),
Bank of Montreal Trust Company, and the Company.
4.3 -- Indenture dated as of July 24, 1998, between Bank of
Montreal Trust Company (as trustee) and the Company,
including table of contents and cross-reference sheet.
4.4 -- Exchange and Registration Rights Agreement dated as of
July 24, 1998 between Chase Securities Inc. and the
Company.
4.5 -- Warrant Agreement dated as of July 29, 1998 between the
Company and Bank of Montreal Trust Company.
10.1 -- Splitrock Full Service Agreement dated as of June 24,
1997 between the Company and Prodigy Services Corporation
(certain portions omitted based on a grant of
confidential treatment and filed separately with the
Commission).
10.2 -- Definitive Agreement dated as of June 24, 1997 by and
between Prodigy Services Corporation and the Company.
10.3 -- Transition Services Agreement dated as of June 24, 1997
between Prodigy Services Corporation and the Company.
10.4 -- Network Implementation Agreement effective as of April
23, 1998 by and between the Company and Ericsson, Inc.
10.5 -- Security Agreement dated as of April 30, 1998 by and
between the Company and Ericsson.
10.6 -- Yurie Equipment Purchase Agreement effective July 1, 1997
between the Company and Yurie.
10.7 -- Customer Service Agreement effective April 1, 1998
between the Company and IBM Global Services Network.
10.8 -- IBM Customer Agreement effective April 1, 1998 between
the Company and International Business Machines
Corporation.
10.9 -- Product Support Services Agreement dated February 27,
1998, together with Addendum effective March 1, 1998.
10.10 -- Option Agreement dated May 28, 1998 between the Company
and Clark McLeod.
10.11 -- Form of Notes between the Company and Linsang.
10.12 -- Warrant Agreement dated as of July 24, 1998 between the
Company and Bank of Montreal Trust Company, as Warrant
Agent.
10.13 -- 1997 Incentive Share Plan.
10.14 -- Employment Agreement effective March 15, 1997 between
William R. Wilson and the Company.
10.15 -- Employment Agreement effective September 1, 1997 between
Patrick J. McGettigan, Jr. and the Company.
</TABLE>
<PAGE> 63
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
------- -----------
<C> <S>
10.16 -- Option to subscribe to purchase 5,000,000 shares of
common stock of the Company for $3.1 million, registered
in the name of Orient Star.
10.17 -- ATM Backbone Services Agreement effective April 28, 1998
between the Company and Network Two Communications Group.
*12 -- Statement re computation of ratios.
*24 -- Powers of Attorney.
*27 -- Financial Data Schedule.
</TABLE>
- ---------------
* Filed herewith.
<PAGE> 1
EXHIBIT 12
SPLITROCK SERVICES, INC.
COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES
(Amounts in thousands of dollars)
December 31, December 31,
1997 1998
------------ ------------
Pre-tax loss from continuing operations $(10,121) $(57,830)
Fixed charges:
Interest expense and amortization
of debt discount and premium on
all indebtedness 235 15,390
Rentals:
Facilities - 33% 72 219
-------- --------
Total fixed charges 307 15,609
-------- --------
Loss before income taxes and fixed charges $ (9,814) $(42,221)
Ratio of earnings to fixed charges (A) (A)
-------- --------
(A) As a result of the losses incurred in the period from inception (March 5)
to December 31, 1997 and the year ended 1998, the Company was unable to
fully cover the indicated fixed charges.
<PAGE> 1
EXHIBIT 24
POWER OF ATTORNEY
The undersigned, Clark McLeod, constitutes and appoints Patrick J.
McGettigan, Jr. his true and lawful attorney-in-fact and agent, with full power
of substitution and resubstitution, for him and in his name, place and stead,
in any and all capacities to sign on his behalf individually and in his
capacity as Director, this Report and any amendment to this Report on Form 10-K
under the Securities Exchange Act of 1934, as amended, and to file the same,
with all exhibits thereto and other documents in connection therewith with the
Securities and Exchange Commission, granting unto said attorney-in-fact and
agent, full power and authority to do and perform each and every act and thing
requisite and necessary to be done in and about the premises, as fully to all
intents and purposes as he might or could do in person, hereby ratifying and
confirming all that said attorney-in-fact and agent may lawfully do or cause to
be done by virtue hereof.
/s/ CLARK MCLEOD
------------------------------------
Clark McLeod
<PAGE> 2
POWER OF ATTORNEY
The undersigned, Samer Salameh, constitutes and appoints Patrick J.
McGettigan, Jr. his true and lawful attorney-in-fact and agent, with full power
of substitution and resubstitution, for him and in his name, place and stead,
in any and all capacities to sign on his behalf individually and in his
capacity as Director, this Report and any amendment to this Report on Form 10-K
under the Securities Exchange Act of 1934, as amended, and to file the same,
with all exhibits thereto and other documents in connection therewith with the
Securities and Exchange Commission, granting unto said attorney-in-fact and
agent, full power and authority to do and perform each and every act and thing
requisite and necessary to be done in and about the premises, as fully to all
intents and purposes as he might or could do in person, hereby ratifying and
confirming all that said attorney-in-fact and agent may lawfully do or cause to
be done by virtue hereof.
/s/ SAMER SALAMEH
------------------------------------
Samer Salameh
<PAGE> 3
POWER OF ATTORNEY
The undersigned, Roy A Wilkens, constitutes and appoints Patrick J.
McGettigan, Jr. his true and lawful attorney-in-fact and agent, with full power
of substitution and resubstitution, for him and in his name, place and stead,
in any and all capacities to sign on his behalf individually and in his
capacity as Director, this Report and any amendment to this Report on Form 10-K
under the Securities Exchange Act of 1934, as amended, and to file the same,
with all exhibits thereto and other documents in connection therewith with the
Securities and Exchange Commission, granting unto said attorney-in-fact and
agent, full power and authority to do and perform each and every act and thing
requisite and necessary to be done in and about the premises, as fully to all
intents and purposes as he might or could do in person, hereby ratifying and
confirming all that said attorney-in-fact and agent may lawfully do or cause to
be done by virtue hereof.
/s/ ROY A. WILKENS
------------------------------------
Roy A. Wilkens
<PAGE> 4
POWER OF ATTORNEY
The undersigned, Kwok Li, constitutes and appoints Patrick J.
McGettigan, Jr. his true and lawful attorney-in- fact and agent, with full
power of substitution and resubstitution, for him and in his name, place and
stead, in any and all capacities to sign on his behalf individually and in his
capacity as Director, this Report and any amendment to this Report on Form 10-K
under the Securities Exchange Act of 1934, as amended, and to file the same,
with all exhibits thereto and other documents in connection therewith with the
Securities and Exchange Commission, granting unto said attorney-in-fact and
agent, full power and authority to do and perform each and every act and thing
requisite and necessary to be done in and about the premises, as fully to all
intents and purposes as he might or could do in person, hereby ratifying and
confirming all that said attorney-in-fact and agent may lawfully do or cause to
be done by virtue hereof.
/s/ KWOK L. LI
-------------------------------------
Kwok L. Li
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
COMPANY'S AUDITED FINANCIAL STATEMENTS FOR THE YEAR ENDED DECEMBER 31, 1998 AND
IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> DEC-31-1998
<CASH> 28,330
<SECURITIES> 120,475
<RECEIVABLES> 3,742
<ALLOWANCES> (537)
<INVENTORY> 0
<CURRENT-ASSETS> 191,966
<PP&E> 91,097
<DEPRECIATION> (17,198)
<TOTAL-ASSETS> 296,141
<CURRENT-LIABILITIES> 59,972
<BONDS> 258,217
0
0
<COMMON> 83
<OTHER-SE> (30,374)
<TOTAL-LIABILITY-AND-EQUITY> 296,141
<SALES> 63,611
<TOTAL-REVENUES> 63,611
<CGS> 93,298
<TOTAL-COSTS> 111,444
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 15,390
<INCOME-PRETAX> (57,830)
<INCOME-TAX> 0
<INCOME-CONTINUING> (57,830)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (57,830)
<EPS-PRIMARY> (0.73)<F1>
<EPS-DILUTED> (0.73)
<FN>
<F1>EPS-PRIMARY REFERS TO BASIC EARNINGS PER SHARE, AS DEFINED IN STATEMENT OF
FINANCIAL ACCOUNTING STANDARDS NO. 128, "EARNINGS PER SHARE."
</FN>
</TABLE>
