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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, 1999
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 000-26827
Splitrock Services, Inc.
(Exact name of registrant as specified in its charter)
Delaware 76-0529757
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification No.)
9012 New Trails Drive
The Woodlands, Texas 77381
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (281) 465-1200
8665 New Trail Dr.
The Woodlands, Texas 77381
(Former address of principal executive (Zip Code)
Offices
If changed from last report)
Securities registered pursuant to Section 12(b) of the Act:
None
(Title of Class)
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $0.001 par value
(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. [ ]
The aggregate market value of the voting stock held by non-affiliates of the
registrants, based upon the closing sale price of the Common Stock on March 6,
2000 as reported on the Nasdaq Stock Market, was approximately $2,019,729,589.
As of March 6, 2000 registrant had outstanding 57,259,677 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
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Item 1. Business............................................................................
Item 2. Properties and Facilities...........................................................
Item 3. Legal Proceedings...................................................................
Item 4. Submission of Matters to a Vote of Security Holders.................................
PART II
Item 5. Market For Registrant's Common Equity and Related Stockholder Matters...............
Item 6. Selected Financial Data.............................................................
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operation......................................................................
Item 7A. Quantitative and Qualitative Disclosures About Market Risk..........................
Item 8. Financial Statements and Supplementary Data.........................................
Item 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure..........................................................
PART III
Item 10. Directors and Executive Officers of the Registrant..................................
Item 11. Executive Compensation..............................................................
Item 12. Security Ownership of Certain Beneficial Owners and Management......................
Item 13. Certain Relationships and Related Transactions......................................
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K.....................
Index to Financial Statements....................................................... F-1
Signatures.......................................................................... S-1
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PART I.
Item 1. Business
We make many forward-looking statements in this filing that are not based on
historical facts, but discuss our future expectations. You can identify these
statements by our use of forward-looking terms, such as "anticipates,"
"believes," "plans," "expects," "future," "intends" and similar expressions.
Because these forward-looking statements involve risks and uncertainties, there
are important factors that may cause our actual results to differ materially
from those expressed or implied in our forward-looking statements, including
those discussed under this section and elsewhere in this filing. 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.
Our Company
We are a facilities-based provider of advanced data communications services.
We market our services to Internet service providers, telecommunications
carriers and other businesses throughout the United States. We own and operate a
state-of-the-art, broadband access network that:
. currently handles more than 2.5 billion minutes of use per month,
. reaches businesses and households in every U.S. market with a population of
at least 100,000 as well as several smaller markets,
. employs asynchronous transfer mode (ATM) switches at every POP.
In 1999, we agreed to acquire indefeasible rights to use four dark fiber optic
strands, with an option to use up to 12 additional fibers, in a nationwide
network that will cover approximately 15,000 route miles. The combination of our
existing broadband access network with our acquisition of significant fiber
optic facilities positions us to deliver a broad array of end-to-end data
communications services on our own network, including:
. dial and dedicated Internet access
. Internet access for higher bandwidth services, such as digital subscriber
line and cable modem
. value-added services, such as virtual Internet services, virtual private
networks and web hosting
. bandwidth leasing and colocation services.
We continued to provide nationwide Internet dial access and related services
to Prodigy Communications Corporation in 1999, which is our primary customer and
one of the largest Internet service providers in the United States. We are
Prodigy's primary provider of dial access services. In 1999, we also began
offering dial and dedicated access for virtual private network services on a
test basis to businesses nationwide, and plan to begin offering web hosting and
other value-added services in 2000. We believe that our relationship with
Prodigy and our high network performance have demonstrated our strength as a
network operator and positioned us to expand our customer base and service
offerings. Leveraging our demonstrated network capabilities, we have entered
into significant new customer relationships with a number of other leading
Internet service providers.
Recent Developments
Splitrock and its wholly-owned subsidiaries, Splitrock Holdings, Inc., and
Splitrock Merger Sub, Inc., entered into an amended and restated agreement and
plan of merger, dated as of February 11, 2000, with McLeodUSA, Inc., and its
wholly-owned subsidiary, Southside Acquisition Corporation. The merger
agreement provides for two distinct but related transactions:
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. a holding company reorganization, in which Splitrock Merger Sub, Inc., a
wholly owned subsidiary of Splitrock Holdings, Inc., will merge with and
into Splitrock Services, Inc. and Splitrock Services will become a wholly
owned subsidiary of Splitrock Holdings, Inc.; and
. a merger in which Splitrock Holdings will become a wholly owned subsidiary
of McLeodUSA.
As a result of the reorganization and the merger, each share of Splitrock
common stock, including the warrant shares offered in this registration
statement, will be converted into the right to receive 0.5347 of a share of
McLeodUSA Class A Common Stock. The reorganization and the merger are intended
to be tax-free to the stockholders of Splitrock. Holders of Splitrock's common
stock will vote on a proposal to approve the merger agreement at a meeting to be
held on March 30, 2000. Stockholders of Splitrock holding approximately 52.3%
of the outstanding shares of Splitrock common stock have agreed to vote in favor
of the approval of the merger agreement. We have entered into excise tax
agreements with some of our executive officers and may enter into excise tax
agreements with additional directors, officers and employees who may be affected
by certain excise taxes imposed on "parachute payments" as a result of the
merger. For more information, see - "Executive Compensation - Excise Tax
Agreements Related to the Merger."
In connection with the merger agreement, Splitrock and Citicorp USA, Inc., as
administrative agent, entered into a credit agreement as of January 6, 2000 for
a revolving credit facility up to $115 million. Up to $75 million of the
facility is secured by a guarantee by Splitrock Leasing, LLC, a wholly-owned
subsidiary of Splitrock, a pledge of the stock of Splitrock Leasing and a
security agreement covering substantially all of Splitrock's available assets.
The credit agreement includes restrictive covenants that in large part mirror
the covenants contained in the indenture governing the notes.
In February 2000, we amended our master services agreement with Prodigy in
order to extend the term of the agreement to December 31, 2001 from June 30,
2001 and to convert the pricing formula from a subscriber based fee to a fixed
hourly fee for usage.
Industry Overview
Data communications services, including Internet and other network services,
is one of the fastest growing segments of the global telecommunications market
place. Businesses of all sizes are demanding advanced, highly reliable solutions
for their data transmission needs that enhance productivity, improve efficiency
and reduce operating expenses. As a result, businesses are seeking
communications providers that can securely and efficiently connect
geographically-dispersed locations uniformly and offer a full range of value-
added services that meet their data networking needs. Businesses have begun to
utilize value-added data communications services such as web hosting, e-mail,
file transfer and, more recently, intranet and extranet services, e-mail
outsourcing, e-mail broadcast and security. High speed data communications
access services link businesses or individual consumers to the Internet's
resources or to corporate intranets and extranets. Access services include dial-
up access for individuals and small businesses and the high-speed dedicated
access services used primarily by mid-sized and larger organizations.
Businesses have also rapidly established corporate websites as a means to
expand customer reach and improve communications efficiency. Many businesses are
currently using the Internet as a lower cost alternative to building expensive
private data communications networks. For example, many corporations are
connecting their remote locations using intranets to enable efficient
communications with employees, customers and suppliers, reducing
telecommunications costs by using IP-based faxing and migrating legacy database
applications to run over IP-based networks.
Market Size and Growth
According to industry reports, data communications services is one of the
fastest growing segments of the global telecommunications market. For example,
according to International Data Corporation (IDC):
. business Internet access services are projected to grow at a compound annual
growth rate of 23.1% from $5.2 billion in 1999 to $14.8 billion in 2004;
. consumer Internet access spending will increase at a compound annual growth
rate of 9% from approximately $7.4 billion in 1999 to approximately $11.4
billion in 2004;
. value-added services, led by web hosting are projected to grow at a compound
annual growth rate of 47.1% from $4.9 billion in 1999 to $34.1 billion in
2004;
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. frame relay services are projected to grow at a compound annual growth rate
of 15.8% from $5.6 billion in 1999 to $11.7 billion in 2004; and
. ATM services are projected to grow at a compound annual growth rate of 30%
from $0.7 billion in 1999 to $2.7 billion in 2004.
Since we are a new company and operate in a new and rapidly changing market,
we have included market data from industry publications, including reports
produced by Forrester Research, Inc. and International Data Corporation. The
reliability of these data cannot be assured. These industry publications
generally indicate that they have obtained information from sources believed to
be reliable, but do not guarantee the accuracy and completeness of their
information. While we believe these industry publications to be reliable, we
have not independently verified their data. We also have not sought the consent
of these organizations to refer to their reports in this document.
Our Strategy
Our mission is to strengthen our position as a leading facilities-based
provider of advanced data communications services. To achieve this objective,
our business strategy focuses on the following key principles:
Exploit the Capabilities of Our Advanced Nationwide Communications Network
We have substantially completed deployment of our advanced, high-capacity,
facilities-based nationwide broadband access network. We believe that our ATM-
to-the-Edge (TM) network results in:
. an easily scalable network architecture;
. the ability to efficiently add new services and integrate further
technological innovations at a lower incremental investment than that
required by other communications service providers with legacy systems that
have separate networks for voice and data;
. interoperability with other network platforms; and
. improved network manageability.
To enhance our broadband access network, we have agreed to acquire
indefeasible rights to use four dark fiber strands, with options to acquire
indefeasible rights to use up to 12 additional fibers, in a state-of-the-art
nationwide fiber optic network currently under construction by Level 3. We
believe that the combination of this fiber optic backbone with our broadband
access network positions us to:
. deliver, on our own facilities, a broad array of end-to-end data
communications services at the high level of quality and reliability
increasingly demanded by customers;
. reduce significantly our network costs as a percentage of revenues as we
substitute the acquired bandwidth for existing leased circuit arrangements
with various telecommunications carriers;
. expand our service offerings by providing bandwidth leasing services on a
stand-alone basis or bundled with our other services;
. increase the reliability and redundancy of our network; and
. increase the variety of service options and speeds available to customers.
Build Strong Customer Loyalty Through Superior Customer Service
We believe that superior customer service is a critical element in attracting
and retaining customers. Our broadband access network is designed to provide
uniform quality and consistent service offerings at every point nationwide. We
have also made significant investments in personnel and our scalable operating
support systems. We believe that these systems give us a competitive
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advantage relative to traditional network service providers because we can
better meet new customer demands and accommodate new service offerings. We
oversee our network operations from our network operating center 24 hours a day,
seven days a week. With our integrated web-based network management tools we can
monitor every POP in our network for quick and efficient problem resolution from
our network operations center.
Increase and Optimize Network Utilization
Given the nature of our network costs and the fact that our current network
utilization peaks in the evening hours to support our customer's residential
Internet subscribers, we seek to increase and optimize total network utilization
primarily by targeting providers of business services with daytime intensive
traffic as well as providers of consumer services with evening intensive
traffic. By pursuing this strategy, we believe that we will be able to optimize
network utilization throughout a 24-hour period by offering both business-
oriented services, such as dial virtual private networks and dedicated and dial
Internet access services, during the day, and consumer-oriented services, such
as Internet dial access services in the evening.
Broaden Our Portfolio of Service Offerings
We are broadening our portfolio of value-added services to address business
customers who are increasingly outsourcing their critical applications and
integrating web-based services as part of their core data networking strategy.
We are positioned to offer a number of value-added services, including virtual
private networks with a wide range of access options and speeds, web hosting and
colocation on our nationwide broadband access network. These services can be
bundled with Internet access services to provide complete, turnkey solutions. We
have secured leased facilities for four web hosting data centers, which are
strategically located across the United States and plan to begin construction on
each of the data centers during 2000. In addition, the enhanced capacity
resulting from our recent acquisition of dark fiber capacity will enable us to
offer a wider variety of data services on our own network, including bandwidth
leasing. We believe that providing value-added services not only improves
customer loyalty by making our services more attractive as a package but also
improves profitability, as value-added services often provide higher margins.
Expand Our Marketing Activities to Capitalize on Expected Demand
We intend to capitalize on the expected growth in demand for network services
from businesses by aggressively marketing our services through a variety of
distribution channels. We believe that utilizing a range of distribution
channels will enable us to cost-effectively reach a broad base of potential
customers. We are significantly expanding our direct sales force to attract
Internet service providers, telecommunications carriers, value-added service
providers and medium and large businesses. We are hiring highly motivated
personnel who have a background in or experience with the data communications
industry. In addition, we seek to use alternative distribution channels,
including agents, resellers and wholesalers, to gain access to a substantially
larger base of potential customers than we could otherwise initially address
through our direct sales force. Through the combination of a direct sales force
and alternative distribution channels, we will seek to rapidly increase network
traffic, market penetration and customer base.
Evaluate Strategic Alliances and Acquisitions That Increase Our Network Traffic
We also intend to evaluate strategic alliances and acquisitions that could
provide additional traffic over our network. We are primarily focused on the
domestic services market and we believe that many opportunities for strategic
alliances and acquisitions will be available to us in the future. For example,
we may enter into joint marketing relationships with other companies that offer
complementary services to business customers. We may also acquire companies that
would increase traffic on our network without corresponding cost increases.
Our Services
We provided Internet dial access services and Internet dedicated access
services, as well as value-added services such as dial and dedicated virtual
private networks on a test basis in 1999. During 2000, we plan to focus on
providing Internet dial and dedicated access, virtual Internet service, virtual
private networks, and web hosting. The addition of the fiber optic backbone to
our network and acquisition of dark fiber will allow us to offer bandwidth
capacity and related colocation services as well.
Internet Access Services
Dial Access. Our Internet dial access services offer a cost effective Internet
solution with V.90 modem access to our advanced network via ordinary telephone
lines. Regional Internet service providers using our Internet dial service can
rapidly scale their service
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from regional or local coverage to national coverage. National Internet service
providers can expand their market share by using our extensive local dial and
800 services to reach more customers. We are primarily targeting Internet
service providers with business as well as residential customers to maximize
traffic throughout our network.
Our largest Internet dial access service customer is Prodigy. In addition, we
serve a number of other fast-growing Internet service providers, including Juno
Online Services, 1st Up.com/Alta Vista, and FreeI.net, as well as InfiNet, a
consortium sponsored by Knight-Ridder, Gannett and Landmark Communications.
Dedicated Access. We offer high speed dedicated connectivity to the Internet
for both business users and Internet service providers. Our Internet dedicated
access services provide connectivity at access speeds ranging from 1.54 Mbps to
155 Mbps. We are targeting corporate users and carriers, including Internet
service providers, local exchange companies, regional long distance providers
and wireless providers as potential customers for this service.
In the future, we believe that our fiber optic backbone will position us to
support Internet access for higher bandwidth services, such as DSL and cable
modem. These high-speed access methods will enable new Internet services such as
video and high quality audio services.
Value-Added Services
We believe that business customers will continue to increase their use of the
Internet and other data services. Customers increasingly rely on a range of
value-added services, including virtual private networks and web hosting. We
will continue to develop new services to meet these business needs that
capitalize on our technologically advanced, high-speed broadband access network
and our fiber optic backbone.
Virtual Internet Service (VIS). This service combines nationwide Internet
dial access with comprehensive customer care and billing to the end user. The
VIS program provides the network, technical expertise and back office
management, enabling VIS customers to concentrate on providing the best content
or service to their subscribers. VIS is an easy-to-develop outsourcing solution
that allows Internet service providers to generate new revenue streams without
capital outlays for equipment, space, billing systems or support staff.
VIS offers a number of important advantages to affinity groups and other
businesses who wish to offer Internet service provider(s) services while
focusing on their core strengths of marketing and content:
. easy user signup via brandable CD;
. comprehensive direct billing service;
. reliable, high-speed network; and
. customer service available 24 hours, seven days a week.
Virtual Private Network Services. Many companies today have private data
communication networks built on expensive leased lines designed to transfer data
between office locations. Private data networks are expensive to set up, operate
and maintain, requiring the use of leased lines and the purchase of networking
hardware and software. Our virtual private network services can provide
businesses with a lower-cost alternative to private data networks.
Virtual private network services are valuable to business customers because
they:
. eliminate the need to invest significant amounts in proprietary equipment
and software;
. securely and efficiently connect multiple, geographically dispersed
locations;
. provide remote access capabilities; and
. allow businesses to add, delete or move company locations to meet changing
needs.
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We began offering on a test basis both dial and dedicated access virtual
private network services to businesses, Internet service providers, competitive
local exchange carriers and others in 1999. We expect that the provision of
virtual private network services will be an important focus of our future
business.
Web Hosting. In 1999, we began to offer, on a limited basis, web hosting
services bundled with our Internet access services that permit companies to
market themselves and their products on the Internet without having to invest in
technology, infrastructure and operations staff. We are developing a web hosting
service that will be marketed on a stand-alone basis or bundled with our
Internet access and virtual private network services. Web hosting is an ideal
solution for customers who want to "publish" web pages on the Internet without
purchasing, configuring, maintaining and administering the necessary
sophisticated hardware and software. Due to economies of scale, we can generally
offer more sophisticated web hosting solutions than our customers can provide
for themselves. Our data centers are strategically located at four selected core
POP sites and will make use of multiple high bandwidth connections to the
Internet. File structure directories, domain name registration and security
privileges can be set up for customers on our hosting servers, thus enabling
customers to remotely "publish" their content for distribution over the
Internet. In addition, we can provide network and systems administration and
maintenance, tape back-ups and security. In the future, we may also offer
applications hosting and other e-commerce services.
Bandwidth Leasing Services
With control over our fiber optic backbone network, we expect to offer
bandwidth leasing services that allow Internet service providers and other
business customers to transfer their traffic through our network. Bandwidth
leasing services will enable customers to reduce their data communications
expense by leasing network utilization from us in lieu of leasing point-to-point
circuits from other communications providers. We expect to be able to offer high
volume transmission capacity at a variety of speeds over our fiber optic
network. We may also target large capacity users who want to augment their own
networks or provide diverse routing alternatives in strategic areas of their
systems. Our potential customers for these services include interexchange
carriers, cable, data and transmission companies, the regional Bell operating
companies, Internet service providers, and local exchange carriers. We expect to
offer a variety of pricing and system options to meet the specific needs of each
customer. For instance, a customer may lease the bandwidth capacity on a short
or long term basis for extensive or minimal coverage.
Colocation Services
We plan to house business-critical servers and other electrical, networking
and communications equipment in our secure network facilities on behalf of our
customers. The demand for these colocation services has increased as companies
expand into geographic areas in which they do not have appropriate space or
technical personnel to support their equipment and operations. Colocation
customers are typically larger enterprises employing more sophisticated Internet
hardware, software, and web servers, and have the expertise to maintain their
own web sites and related equipment. We plan to offer customers, including
Internet service providers, the opportunity to colocate their web-server
computers at our sites.
Our Network
We own and operate a state-of-the-art, broadband access network that employs
ATM technology at every core, hub and remote POP site. As of December 31, 1999,
our broadband access network was substantially completed and we had installed
339 broadband access POPs, giving us a physical presence in all 50 states, and
targeting over 90% of U.S. businesses and 87% of U.S. households with a local
call.
Our network is managed and supported by our state-of-the-art network
operations center in The Woodlands, Texas. We have deployed ATM switches at
every core, hub and remote POP of our network. This network architecture,
called "ATM-to-the-EdgeTM," enables Splitrock to serve as a broad-based provider
of data communications services through the creation of a platform that
efficiently delivers multiple services, such as Internet access, virtual private
networks and web hosting, across multiple protocols, including Internet
Protocol, frame relay and ATM. The flexibility inherent to our network design
allows it to expand its service offerings to provide fully integrated data,
video and voice services. This flexibility also allows us to incorporate future
technological innovations into its network architecture with a lower incremental
investment than that required by other communications service providers with
legacy systems that have separate networks for voice and data.
In 1999, we agreed to acquire indefeasible rights to use four dark fiber
strands, with an option to acquire indefeasible rights to use up to 12
additional fibers, in an approximately 15,000 route mile nationwide fiber optic
network. Combining our existing broadband access network with our pending
acquisition of significant fiber optic facilities will allow us to:
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. deliver, on our own facilities, a broad array of end-to-end data
communications services at the high level of quality and reliability
increasingly demanded by customers
. reduce significantly our network costs as a percentage of revenues as we
substitute the acquired bandwidth for existing leased circuit arrangements
with various telecommunications carriers
. expand our service offerings by providing bandwidth leasing services on a
stand-alone basis or bundled with our other services
. increase the reliability and redundancy of our network
. increase the variety of service options and speeds available to customers
Through its ATM-to-the-Edge(TM) architecture, our broadband access network
allows us to concurrently provide multiple services such as data, video and
voice to customers and to incorporate future technology changes at relatively
low incremental investments. As a result, we believe that we have created a more
efficient network than our competitors, thereby reducing future operating costs
and improving reliability to the end user. 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
switching only along the core sites in the backbone, our broadband access
network deploys ATM switching at every POP site--core, hub and remote. Our
management believes that our network contains more ATM-based switches than any
other commercial network.
Our network was designed to meet the following strategic goals:
. provide uniform service nationwide that is reliable, fast, efficient and
easy to access;
. build high capacity to move data more quickly, more efficiently and at
greater traffic volumes;
. provide better quality service than our competitors at a lower cost;
. provide broad coverage to points not served by other networks;
. use the industry's best suppliers for network components; and
. build redundancy into the network for better reliability.
Network Infrastructure
We believe that we have provided for future growth by ensuring that our
network is:
. scalable;
. flexible;
. fault tolerant;
. based on open standards and interoperable; and
. manageable from remote locations.
Scalable. Our flexible, multi-layer network architecture utilizes a high-speed
switching fabric that enables us to increase the number of POPs and the number
of users served in an incremental manner that matches investment with demand.
Our network's scalability extends beyond the currently installed base of POPs to
allow for growth without fundamental design changes or loss of service quality.
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Flexible. We believe that our network will enable us to adapt to new services
and manage network resources according to each service's needs, permitting us to
efficiently offer data, video and voice services concurrently.
Fault Tolerant. Redundancy and adaptive technology in our 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 switches, routers and workstations are configured to search for
alternate paths if an individual component or transmission line fails. We also
have an uninterruptible power supply at each POP, limiting the impact of local
power outages on our network.
Open Standards and Interoperable. Our entire network supports various
protocols, including IP, ATM, frame relay, ISDN, video and SS7. This
architecture allows us to interconnect freely with other carrier networks or
customer networks. As a result, we can extend services of another carrier
outside of that carrier's own region. In addition, potential virtual private
network clients that use standards-based protocols can easily access our network
without having to purchase special equipment that would otherwise be necessary
with a proprietary network.
Manageable. From our network operations center, we are able to monitor our
network remotely, perform network diagnostics and equipment surveillance, and
inform customers when a network problem occurs. Our network operations center is
open 24-hours a day, seven days a week. As a result of our network architecture,
these tasks may be performed remotely regardless of POP location or network
status. This capability allows us to control costs associated with on-site
network configuration and repair.
Broadband Access Network
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. 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 and 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, benefit from highly intelligent terminals
at the end-user that 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 communication networks 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 communication service
networks often have unpredictable performance.
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 for older networks to
provide multiple services. 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.
Our network was designed to address constraints facing older networks by not
requiring the separation of bandwidth for different types of services. In the
process of designing our network we sought to create a network infrastructure
which could:
. efficiently offer data, video, and voice services concurrently;
. reduce operating costs by more efficient utilization of network resources;
and
. provide high quality service for all services offered on the network.
We believe that three features distinguish our network from other data
communications networks. First, we use the Lucent ATM switch platform, which
supports multiple services at every POP of the network. We believe 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, including IP, frame
relay, ATM, Ethernet, T-1, T-3, OC-3, OC-12, OC-48 and many other digital as
well as analog interfaces. Also, the Lucent switches are scalable with up to 14
interface module slots designed to house
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interface cards supporting these various services. The Lucent switches translate
these native service protocols into standard ATM format and transports any
service as an ATM connection. In addition, the Lucent switches implement a
patented queuing algorithm that eliminates the need for bandwidth allocation to
different kinds of services and simultaneously supports data, video and voice
services on a unified platform without loss of quality of service even during
periods of high network utilization.
Second, to manage the large number of ATM switches in our network, we
organized the network architecture into classes and regions. This architecture
allows us to introduce new services more quickly 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. Our 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 traditional IP-based network. Therefore, to introduce
a new service, we only need 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 permits better
management and typically faster throughput than other networks.
Third, most modern networks achieve transmission efficiencies by deploying ATM
switching engines in three to 20 access sites only in the core backbone of their
network. In contrast, ATM switches are located in all POPs throughout the
network. At December 31, 1999, we had approximately 339 installed POPs. The ATM-
to-the-Edge(TM) network forms the basic platform for us to offer multiple
services to all users on the network.
We began a major upgrade and expansion of our dial access platform in late
1999 with the deployment of Nortel Networks' CVX 1800 dial access modem, which
replaces the Bay Networks' dial modem equipment previously in place. The new
equipment, when fully deployed, will represent a four-fold increase in capacity,
as measured in dial ports, over the capacity in place in late 1999. The CVX
1800 dial access modem will provide us with a carrier-class, secure dial-in
solution for seamless remote access. In addition, the CVX 1800 is designed for
ultimate reliability, with the ability to swap out cards easily without
incurring downtime for ease of servicing and support. In addition to these
performance enhancements, the ability of the CVX 1800 to control costs,
including lower operations costs, smaller footprint, decreased power consumption
and ease of administration, was a factor in its selection.
Network Organization
Our 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 network, with the hub and remote access sites extending
the reach of the backbone.
Our 21 core sites are logically and fully meshed to allow 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, OC-3 or OC-12. We
can purchase bandwidth on an actual need basis between each site and upgrade
these links as the bandwidth demand increases because the Lucent switches
conform to standard transmission specifications.
In addition, each core site is equipped with special protocol processors to
enable our network to accommodate demand for a wide variety of services. IP
protocol, for instance is supported by routers at each core site as compared to
other networks that must install routers at each POP. As a result of our design,
each of our routers is directly connected to every other router in the network
and can forward packets from region to region efficiently via simple routing
tables.
Hub sites service the major cities within a region and 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.
Our network has a large number of remote sites to reach the smaller cities
within a region. These sites 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.
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Fiber Optic Backbone
As part of our ongoing efforts to further expand and enhance our network, we
entered into an agreement to acquire long-term indefeasible rights to use four
dark fiber strands in 1999, with an option to use up to 12 additional fibers, in
the nationwide fiber optic network currently under construction by Level 3
Communications.
Fiber optic technology uses light to transport information from one point to
another. Fiber optic strands are thin filaments of glass through which light
beams are transmitted over long distances carrying large amounts of data.
Modulating light on thin strands of glass produces major benefits including high
bandwidth, relatively low cost, low power consumption, small space needs and
total insensitivity to electromagnetic interference.
The optical fiber strands that will comprise our fiber backbone network are
designed to accommodate dense wave division multiplexing transmission
technology. As a result, we can deploy equipment which transmits signals on 32
or more individual wavelengths of light per strand. This capability will
significantly increase the potential capacity of our fiber optic backbone
relative to older networks which generally use fiber optic strands that transmit
fewer wavelengths per strand. In addition, we believe that the installation of
newer optical fibers will allow a combination of greater wavelengths of light
per strand, higher digital transmission speeds, and greater spacing of network
electronics.
In the fourth quarter of 1999 we announced the selection of Nortel Networks as
our primary supplier of fiber optic network equipment. Splitrock will use
OPTeraTM LH, Nortel Networks' advanced optical networking equipment, to provide
the capacity and flexibility needed to deliver additional network services such
as bandwidth leasing and private line service. The OPTera LH open optical
equipment can carry Internet, data, multimedia and voice traffic in its native
formats across long-haul networks. Nortel Networks' OPTera portfolio maximizes
capacity per fiber using Dense-Wavelength Division Multiplexing (D-WDM)
equipment, and will be scalable as high as 1.6 Terabits per second on a single
fiber.
Network Management and Customer Service
We believe that superior customer service is a critical element in attracting
and retaining new customers and expanding value-added services to existing
customers. Historically, we have maintained two network operations centers:
the initial one located near Prodigy's headquarters location in Yorktown
Heights, New York and originally associated with Prodigy's legacy network and
the second, a newer, updated facility located in The Woodlands, Texas. At the
end of 1999, we consolidated the two network operations centers into the Texas
facility, where we operate a 24-hours per day, seven days per week, network
operations center facility. This network operations center permits us to manage
traffic, monitor system status and remotely implement solutions to system
interruptions.
We have implemented a number of new systems and procedures to provide superior
customer service. We have installed a leading customer support trouble ticketing
and workflow management system to track, route and report on customer service
issues. We also implemented a new industry-standard billing system. We expect to
offer wholesale customers a system that generates invoices tailored to the
client's service mix and, for retail customers, a system that authenticates and
bills through credit cards. To support anticipated growth in customers on our
network, we have established a customer call center to provide customer support
24 hours per day, seven days a week.
Through the development of scalable operating support systems, we believe that
we have the opportunity to establish a competitive advantage relative to
traditional network service providers. Traditional network service providers
typically operate extensive legacy operating support systems with
compartmentalized architectures that limit their ability to scale rapidly and
introduce enhanced services and features. In connection with the expansion of
our network, we are creating operating support systems with an architecture
designed to maximize both reliability and scalability. Furthermore, in
establishing our operating support systems, we have 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. Operating support systems are, or will be, distributed
throughout our network, which improves network performance, recovery and
reliability, while also providing real-time capture of statistical and
accounting data. We utilize, when available, industry-standard software systems
developed and maintained by third party vendors but customized for our specific
needs.
We believe that an up-to-date management platform is critical for us to be
competitive and provide customers with quality services. We have put in place a
modern management platform to manage our extensive network. The new management
platform
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performs operations, administration and management tasks. We have customized
most of these platforms to ensure maximum network flexibility and efficiency.
Peering and Interconnection
Peering and interconnection agreements with other carriers enable us to
exchange traffic destined for other networks and allow external traffic access
to our network. We interconnect with other networks from a core site through an
industry standard Cisco router, which promotes proper protocol exchange between
us and other Internet service providers. We currently maintain over 60 peering
and interconnection agreements with third parties.
Transmission Services
We lease long distance connections of various bandwidths to connect sites in
our network. The choice of long distance carriers is based on their network
reliability, bandwidth availability, responsiveness and pricing. We currently
lease a majority of our long distance connections from MCI WorldCom and
periodically review the capability and costs of these services by other
suppliers, such as AT&T, Sprint and Qwest. Prior to the completion of our fiber
optic network, we will utilize interim fiber optic backbone transmission
services from Level 3 to connect our core sites. These interim fiber optic
services will become available in the fourth quarter of 1999. When all of the
interim fiber optic backbone services are fully operational, backbone
transmission services we utilize from other third parties to connect our core
sites will be disconnected. As segments of our fiber optic backbone network are
completed, we will migrate our network traffic from interim backbone
transmission services from Level 3 and onto our own fiber optic facilities.
We lease 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, we have existing relationships with many
competitive local exchange carriers and all major incumbent local exchange
carriers in the country.
Sales and Marketing
We are deploying multiple distribution sales channels to rapidly increase our
market penetration and customer base. The primary sales distribution channel
will be a direct sales force. Additional channels will include agents,
wholesalers and resellers.
Our focus on multiple, leading-edge offerings makes it essential to create a
sophisticated sales organization. We began developing our direct sales force in
the first quarter of 1999 and have been actively recruiting highly experienced
data communications sales professionals. This nationwide sales force markets our
services directly to Internet service providers, telecommunications carriers,
value-added service providers, and medium and large businesses. To support our
direct sales force, we are developing web-based tools, such as sales automation
and sales tracking systems, that will integrate pricing, order management,
provisioning and billing systems. Additionally, the sales force is equipped with
customer-tailored marketing material. As of December 31, 1999 we employed 75
professionals in our sales and marketing group, most of which are devoted to
direct sales.
We also utilize alternate distribution channels, which include agents,
resellers and wholesalers, to market our products and services to medium and
small businesses. As independent entities, agents sell our services under our
brand name to end-users in exchange for revenue based commissions. We intend to
identify agents that generally focus on specific market segments, such as medium
and small businesses, and have existing customer bases. Resellers are
independent companies that would purchase our services and then "repackage"
under their own brand name these services for sale to their customers. Finally,
wholesalers are independent companies that will purchase network service
capabilities in large quantities from us in order to market their own services
under a brand name other than Splitrock. These alternative channels are expected
to optimize revenue growth and market penetration.
We are creating a marketing infrastructure with three primary areas of
responsibility: marketing communications, marketing management and product
development.
Marketing communications builds Splitrock's image and provides communications
interface to customers on services. Marketing communications will also promote
Splitrock's services at industry conferences, trade shows and other events.
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Marketing management develops service literature, price positioning, sales
support materials, service revenue forecasts, competitive industry and service
analysis for our suite of service offerings.
Product development will work with internal organizations such as information
technology, engineering, operations and billing to develop and enhance our
services.
Relationship with Level 3 Communications
On April 26, 1999, we entered into a Cost Sharing National IRU Agreement with
Level 3 Communications, LLC, a subsidiary of Level 3 Communications, Inc. Under
this agreement, Level 3 has granted to us indefeasible rights to use four dark
fibers, with an option expiring on April 26, 2000, to use up to 12 additional
fibers, in the nationwide multiconduit fiber optic communications system
currently under construction by Level 3. The fiber will be delivered in segments
that are expected to become available from the first quarter of 2000 through the
first quarter of 2001. When completed, the fiber network will cover
approximately 15,000 route miles. If Level 3 expands its nationwide fiber optic
network by adding additional routes or otherwise enhances its network, Level 3
has agreed to give us the opportunity to participate in that expansion or
enhancement, subject to Level 3's own business needs and subject to our agreeing
on the allocation of costs in the expansion or enhancement. Our agreement with
Level 3 relates to dark fiber only and does not include the electronic equipment
necessary to allow the fiber to transmit communications.
Under our agreement, we have made a down payment of $11.2 million to Level 3
and we are required to make additional payments as we accept delivery of
segments of the four dark fibers. The total amount we will be required to pay
Level 3 is dependent on the number of fibers we acquire and the number of actual
route miles. In addition to IRU payments, we are required to make payments to
Level 3 for facilities, maintenance and utilities charges.
We anticipate that the acquisition of the right to use the four dark fiber
strands and the related electronics equipment to utilize a portion of the fiber,
will require capital expenditures (including purchases to be funded with capital
leases) of approximately $139 million and $13 million in 2000 and 2001,
respectively.
We have agreed that prior to the fourth anniversary of the agreement, we will
not grant any dark fiber IRU or assign or transfer any IRU or other similar
right or interest in any IRU to anyone other than an affiliate of ours. However,
the agreement allows us to sell or lease capacity over the fibers.
Our agreement with Level 3 has an initial term of 20 years and may be
extended. If we default in any payments due to Level 3 under the agreement,
Level 3 may terminate the agreement, provided that Level 3 may not terminate the
agreement or our rights to use fiber in segments for which we have paid in full.
Level 3 has agreed to provide interim fiber optic backbone transmission
services at capacities ranging from DS-3 to OC-48 for a monthly charge per DS-0
mile, subject to an aggregate monthly minimum of $0.5 million. We began
utilizing some of these interim services in the fourth quarter of 1999. When
all of the interim fiber optic backbone services are fully operational, backbone
transmission services we utilize from other third parties to connect our core
sites will be disconnected.
Suppliers
We depend on third parties for key components of our network infrastructure,
including leased lines, transmission services and networking equipment, such as
routers, switches and modems. The quantities and quality of such networking
equipment that we require are available only from sole or limited sources. We
currently utilize Lucent for ATM switching products, Nortel Networks for our
Internet dial access platform, Cisco for routers and Sun Microsystems and Compaq
for servers. In October 1999, we agreed to purchase $64.1 million in dial access
equipment from Nortel Networks to support our future access demand. The
agreement allows us to exchange our old modems for newly introduced dial access
modems in 2000, which offer greater capacity and improved call reliability. We
also depend upon a variety of local exchange carriers and interexchange carriers
to provide telecommunication services, including leased line and colocation
facilities. For long distance connections and backbone long distance
transmission facilities, we currently use MCI WorldCom. We will utilize interim
fiber backbone transmission services from Level 3 to connect our core sites
until our own fiber optic backbone is operational. In addition, we obtain
bandwidth capacity under leased line connection agreements with local exchange
carriers, including regional Bell operating companies. We also obtain
telecommunications services and lease physical space under local
access/colocation agreements with various competitive local exchange carriers.
We continue to monitor our needs for greater bandwidth and may enter into
agreements to enlarge our bandwidth capability.
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In 1999, we entered into an agreement with Lucent to provide us with
maintenance on our broadband access network in order to maintain the quality and
reliability of our network performance. Prior to entering into this maintenance
arrangement with Lucent, we had performed our own maintenance of equipment and
have relied on warranties from our vendors.
We rely upon Level 3 to construct and install the fiber optic strands and
related facilities that we have acquired. Additionally, we have retained Nortel
Networks to provide the engineering and installation of our fiber optic network
equipment.
Competition
The data communications service industry is highly competitive. We expect that
competition will continue to intensify as customers seek additional capacity to
satisfy the continued growth of data communications and the Internet. In
addition, numerous companies are rapidly expanding their data network
capabilities. We believe that the primary competitive factors for the provision
of data network services are quality of service, network coverage, reliability,
price, and service innovation.
Network Service Providers. We believe that our principal competitors are
generally classified as network service providerswho operate and maintain a
national backbone network. Customers of network service providers typically
include other Internet service providers, regional Bell operating companies,
cable television companies and a variety of network operators entering the
Internet service provider business. In addition, network service providers may
also compete with us by providing retail services such as Internet access,
virtual private networks, and web hosting services directly to businesses and
consumers. We believe our network service provider competitors include UUNet,
Cable & Wireless, Sprint, PSINet, GTE Internetworking, AT&T, and Qwest.
In addition, we believe that the following may also represent sources of
competition:
Internet Service Providers. According to IDC, there are over 5,000 Internet
service providers in the United States, consisting of business access, consumer
access, value-added services, and wholesale providers. We currently market
Internet dial access services to these Internet service providers. Our
competitors in this market include other companies that provide Internet access
service to Internet service providers as well as Internet service providers that
possess national backbone networks enabling them to provide capacity to other
Internet service providers. While we believe that our status as an independent
service provider distinguishes us from many of these competitors, some of these
competitors have significantly greater market presence, brand recognition and
financial, technical and personnel resources than we do.
Corporate Internet Access and Virtual Private Networks. In the corporate
Internet access and virtual private network markets, the competitors include
Internet service providers as well as traditional telecommunications carriers.
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 virtual private network services
with other services such as web hosting or long distance services. This bundling
of services may have a material adverse effect on our ability to compete
effectively and thus could have an adverse effect on our business, financial
condition and results of operations.
Other Value Added Services. We believe that significant new competitors will
enter the data network services market. Other companies are in the process of
building or expanding networks that will have the ability to provide services
comparable to ours. In addition, many of our competitors have the financial and
operational resources to construct networks similar to our own. For example,
Sprint is in the process of designing a network which will contain ATM switches
at every core, hub and remote site. We cannot assure you that we will be able to
compete effectively with these companies. The market for the colocation of web-
servers is extremely competitive. In this market, we would compete with Internet
service providers and network providers as well as others, including inter
exchange carriers, companies that provide only web hosting and IP colocation
services and a number of companies in the computer industry.
Bandwidth Lease Providers. There are currently three principal facilities-
based long distance fiber optic networks, as well as numerous incumbent local
exchange carrier and competitive local exchange carrier networks. Others,
including Level 3, Qwest, Broadwing (IXC Communications) and Williams, are
building additional networks that employ advanced technology and offer
significantly more capacity to the marketplace. There are also companies like
Splitrock that have contracted to obtain rights to use portions of nationwide
fiber networks from companies such as Qwest, Williams and Level 3 and that may
have excess bandwidth capacity available for sale on a wholesale or retail basis
to customers. The additional capacity that is expected to become available in
the next several years may cause significant decreases in the prices for
services. Our ability to compete effectively in this market will
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depend upon our ability to maintain high quality services at prices equal to or
below those charged by our competitors. Interexchange carriers and competitive
local exchange carriers with excess fiber optic strands may be competitors in
the dark fiber business.
Regulation
Overview. Although we are not currently subject to direct regulation by the
FCC, the telecommunications industry is highly regulated. As a result, changes
in the regulatory environment relating to the Internet and telecommunications
services, including regulatory changes which directly or indirectly affect
telecommunications costs or increase the likelihood or scope of competition from
regional Bell operating companies or other telecommunication companies, could
have a material adverse effect on our 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. We
cannot predict the outcome of these proceedings, or the impact they may have on
the telecommunications or Internet services industries generally, or on us
particularly. In addition, over the past several years both the federal and
state governments have adopted new legislation and rules profoundly affecting
the telecommunications and Internet services industries. We cannot assure you
that the changes in current legislation or new legislation, and the regulations
adopted by the FCC or state regulators pursuant to that legislation, would not
have a material adverse impact on our business.
Regulation of Internet Communications. In 1980, the FCC created a
distinction between "basic" services, which it regulated as common carrier
services, and "enhanced services," which it deregulated. The FCC exempted
enhanced service providers from federal regulations governing common carriers,
including the obligation to pay access charges and contribute to universal
services.
The Federal Telecommunications Act of 1996 established a similar distinction
between "telecommunications services" and "information services," but a
combination of changing technology and other provisions of the Federal
Telecommunications Act have made it increasingly difficult to discern the
boundary between unregulated and regulated services. The act directs the FCC to
adopt regulations requiring all telecommunications service providers to
contribute to the federal Universal Service Fund. As of the first quarter of the
year 2000, telecommunications carriers must contribute 5.9 percent of their
retail interstate and international revenues to the FCC's universal service
fund. Information service providers are exempt. This distinction magnifies the
significance of the boundary between regulated and unregulated services.
Since the Federal Telecommunications Act 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 FCC concluded that the provision of
underlying transmission capacity to Internet service providers constitutes
"telecommunications" under the Federal Telecommunications Act. The FCC has also
indicated in the report that it would consider, in an upcoming proceeding,
issues related to whether Internet service providers 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 universal service. While the
report containing this conclusion does not have the force of law, it raises the
possibility that regulatory action could be taken by the FCC in the future. A
finding by the FCC that Internet service providers and carriers providing
service to Internet service providers must make universal service contributions
could increase our cost of doing business and have a material adverse effect on
our business.
We operate as an Information Services Provider. We operate as an unregulated
provider of information services, as that term is defined in the Federal
Telecommunications Act, and as an enhanced service provider, as that term is
defined in FCC rules. Because the regulatory boundaries in this area are unclear
and subject to dispute, however, the FCC could seek to characterize some or all
of our services as "telecommunications services." If that happens, we will be
required to contribute directly to universal service.
Our status as a reseller of underlying telecommunications services provided by
others has reinforced our status as an unregulated information service provider.
A longstanding FCC policy holds that, when a reseller enhances some of the
transmission capacity that it obtains from an unaffiliated facilities- based
common carrier by modifying or adding content to transmitted messages, the
entire package of resold services will be classified as an unregulated enhanced
service, even if much of the resold transmission capacity is not being modified
by the reseller. By contrast, the FCC has required some enhanced service
providers that use their own facilities to
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segregate those facilities and subscribe to them as regulated common carrier
offerings. To the extent that we begin to provide our own transmission
facilities, parts of our company could thus become exposed to common carrier
regulation.
In 1999, we obtained rights to use several strands of unlit fiber, referred to
as "dark fiber," on another company's nationwide fiber network. The FCC and at
least one federal district court have taken the position that provision of dark
fiber is a form of "wire communications," not a sale of facilities. On that
basis, we believe that our acquisition of previously installed dark fiber
capacity does not transform us into a facilities-based provider of
telecommunications, and that we remain a reseller and provider of unregulated,
enhanced services. The treatment of dark fiber under these circumstances is an
unsettled area of the law, however, and we cannot predict with certainty whether
the FCC, or state regulatory commissions, will regulate this kind of service.
Under current FCC policy, enhanced service providers are exempted from having
to pay access charges to local telephone companies. Without this exemption, the
local telephone companies could charge enhanced service providers for connecting
the customer to the enhanced service provider. Recently, the FCC has determined
that both dedicated access and dial-up calls from a customer to an Internet
service provider are interstate, not local, calls, and, therefore, are subject
to the FCC's jurisdiction. The FCC determined that, for the time being, it will
allow states to continue taraffing dial-up Internet access as a local business
line service. However, it did not require states to do so. If the access charge
exemption for enhanced service providers is eliminated, our costs of providing
service may increase substantially, which could have a detrimental effect on our
business.
Universal Service Proceeding. If we maintain our current unregulated status,
we may nonetheless be required to contribute indirectly to universal service to
the extent that we are billed by telecommunications providers for underlying
service. Beginning on January 1, 2000, the federal universal service fund began
providing subsidy support for service to high-cost areas served by so-called
"non-rural" incumbent local exchange carriers. Contributions required of
telecommunications carriers supplying service to Splitrock were increased. As
of the first quarter of the year 2000, they were required to contribute 5.9
percent of their interstate and international revenues to the FCC's universal
service fund. Because Congress has granted the FCC substantial discretion to
determine the size of that fund and the assessment rate applied to carriers, it
is impossible to predict how high the contribution factor may rise in the
future.
Regulatory Safeguards Affecting Underlying Service Providers. We are heavily
dependent upon telecommunications carriers for the transmission capacity that
underlies our enhanced network. Some of these carriers are considered dominant
in their geographic markets and may compete with us in providing enhanced
services. This creates an incentive and potential means for those carriers to
discriminate against us. At present, the regional Bell operating companies are
allowed to provide information services within local access and transport areas
(LATAs) but they are restricted from providing information services on an inter-
LATA basis.
Under Section 271 of the Federal Telecommunications Act, the regional Bell
operating companies will be allowed to provide inter-LATA service, including
inter-LATA information services, when the FCC determines that they satisfy a
regulatory checklist of local competition requirements. These reviews are
conducted on a state-by-state, carrier-by-carrier basis. In December 1999, the
FCC issued its first Section 271 authorization, allowing Bell Atlantic to begin
originating interstate and international calls from New York. It is likely that
additional such approvals will be issued in the coming months. We cannot assure
you that we will be able to compete effectively with the regional Bell operating
companies once they are permitted to provide inter-LATA services.
Potential Liability of Internet Service Providers. Because we do not hold
ourselves out as editing or otherwise controlling the content of communications
that traverse our network, we are generally unaffected by government content
regulation. However, the law in the United States relating to the liability of
Internet service providers and providers of transmission capacity for
information carried on, disseminated through or hosted on their systems is
currently unsettled. Congress and several states have enacted or are considering
measures that would, under some circumstances, impose civil and criminal
liability upon Internet service providers, or providers of transmission capacity
to Internet service providers, for the transmission or dissemination of
information and materials. The imposition of this type of liability, if upheld
by the courts, may require us to implement measures to reduce our exposure to
this liability, which may require us to expend substantial resources and could
affect the demand for our services.
We filed federal trademark applications for the marks "Splitrock" and "A
Carrier of Wisdom" on September 18, 1997, and "splitrock.net" on March 6, 1998.
We also filed separate federal trademark applications for logos on the above
dates, for the 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. We have also filed trademark applications for the marks "Splitrock", "A
Carrier of Wisdom" and the Splitrock with triangle design in numerous foreign
countries. These applications are pending and we cannot assure you that they
will be granted. "Splitrock Services, Inc." is a trade name of our company.
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Insurance
We have insurance coverage that we believe to be adequate for the risks of our
business. Our primary insurance coverages include property, general liability
and directors and officers liability insurance. Our insurance coverage may not
be adequate or available to compensate us for all losses that may occur. The
occurrence of a significant loss not fully covered by insurance could have a
material adverse effect on our company.
Employees
As of December 31, 1999, we had 411 full-time employees and 25 independent
contract workers. None of our employees is represented by a union, and we have
experienced no strikes or work stoppages. Our management believes that we have
good relations with our employees.
Item 2. Properties
In August 1999, we began to occupy a new headquarters building located in The
Woodlands, Texas. This leased facility consists of approximately 69,000 square
feet and houses our principal executive and administrative headquarters. This
lease expires in 2009, unless we exercise the first of two 5-year renewal
options. We have an option to lease another building with approximately 69,000
square feet that would be constructed immediately adjacent to our new
headquarters building. Additionally, we have an option to purchase a minimum of
20 acres of land in The Woodlands, Texas, and the right to terminate our leased
facilities early in the event this option is exercised. Our option to purchase
this property at a fixed price expires on June 30, 2000; however, we have a
right of first refusal to purchase the land through December 31, 2001.
Our former headquarters, located within a half mile of our new headquarters,
is currently used as the network operations center and customer care center.
The lease on this 25,000 square foot facility expires in 2003.
We exercised an early termination option on our former Yorktown Heights, New
York network operations center. This facility, consisting of approximately
12,500 square feet, was subleased from Prodigy. The lease was terminated as of
December 31, 1999. In order to expand into web hosting, we entered into leases
totaling approximately 141,000 square feet for facilities in New York, Atlanta,
Houston and Los Angeles. Approximately 10,000 square feet in the New York
facility will be used, in part, as office space for employees relocated from
Yorktown Heights facility.
Local dial up access to our network is provided by approximately 340
strategically placed Points of Presence (POPs) across the country. A majority
of these POP facilities are shelters located on leased real estate. The average
term of these ground leases is five years with four renewal options for an
additional five years with each option period. The remaining POP facilities are
co-locations within other telecommunications carriers' facilities with terms
ranging from one to five years.
We believe that our current and planned facilities are adequate for the
foreseeable future and that suitable additional facilities will be available as
needed.
Item 3. Legal Proceedings
As previously disclosed in our annual report on Form 10-K for 1998, we entered
into an agreement with Ericsson, Inc. to construct 99 POP sites on a turnkey
basis. By November 1998, the contractor had failed to meet construction
milestones under our agreement. As a result, we had to hire other service
providers and suppliers in addition to supervisory field and office personnel to
complete the network on schedule. We also incurred additional expenses to
maintain POP sites on our legacy network. We have received invoices totaling
$9.1 million from the contractor and are disputing the amount due. The
contractor has indicated that it will seek to secure payment of these invoices.
We believe that the amounts the contractor has claimed are not owed because of
the contractor's failure to perform under the terms of our agreement and the
offsetting expenses we incurred to complete the work. We also believe that
resolution of this matter will not have a material adverse effect on our
business. On November 4, 1999, Ericsson filed a Demand for Arbitration on the
"contract dispute" pursuant to the Commercial Arbitration Rules with the
American Arbitration Association. We have filed a counterclaim and intend to
vigorously defend the dispute pursuant to state tort and contract causes of
action, including negligent misrepresentation, fraud in the inducement, breach
of contract, failure to timely perform, failure to perform in a good and
workmanlike manner, breach of the duty of good faith, failure of consideration
and failure of essential purpose. We are seeking damages by offset and credit.
Both parties are in the process of selecting arbitrators so that a preliminary
hearing can be scheduled.
Item 4. Submission of Matters to a Vote of Security Holders
None
16
<PAGE>
PART II
Item 5. Market For Registrant's Common Equity and Related Shareholder Matters
On July 12, 1999, we effected a .563-for-1 reverse stock split of our common
stock.
On August 3, 1999, our common stock began trading on the Nasdaq Stock Market
as a result of our initial public offering of common stock completed on August
6, 1999 pursuant to a registration statement on Form S-1 (file no. 333-79909)
filed with the Securities and Exchange Commission and declared effective on
August 3, 1999. All the securities registered were sold. The managing
underwriter was Bear, Stearns & Co., Inc. The Company sold 9,692,628 shares of
common stock at a price of $10.00 per share which resulted in gross proceeds of
$96.9 million, $6.5 million of which was applied to the underwriting discount
and $2.0 million of which was used for other fees and expenses. None of the net
proceeds of the offering was paid by us, directly or indirectly, to any
director, officer or general partner of ours or any of their associates, or to
any persons owning ten percent or more of any class of our equity securities, or
to any of our affiliates. The underwriters purchased 692,628 of the shares
pursuant to an over-allotment option. Additionally, 157,372 additional shares
were sold, under the same agreement, by certain existing shareholders. We did
not receive any of the proceeds from the sale of the 157,372 shares sold by the
selling stockholders.
Splitrock common stock is listed on The Nasdaq Stock Market and traded under
the symbol "SPLT." Splitrock common stock has been quoted continuously on The
Nasdaq Stock Market since the initial public offering of Splitrock common stock
on August 3, 1999. Before August 3, 1999, no established public trading market
for Splitrock common stock existed. The following table sets forth for the
periods indicated the high and low sales price per share of Splitrock common
stock as reported by The Nasdaq Stock Market.
High Low
-------- --------
1999
----
Third Quarter $17.13 $ 8.94
Fourth Quarter 25.00 14.50
As of March 6, 2000, there were 177 shareholders of record of our common
stock.
We have never paid any cash dividends on our common stock and do not
anticipate declaring or paying any cash dividends in the foreseeable future. We
currently intend to retain future earnings, if any, to fund the development and
growth of our business. Declaration or payment of future dividends, if any, will
be at the discretion of our board of directors after taking into account various
factors, including our financial condition, operating results and current and
anticipated cash needs and plans for expansion. In addition, our ability to pay
dividends on the common stock is restricted by certain covenants in the
indenture governing our outstanding 11 3/4% senior notes.
The net proceeds of our initial public offering of $88.4 million were
predominantly held in a money market account as of December 31, 1999. We intend
to use the net proceeds from the offering principally to fund capital
expenditures, operating losses and possible future acquisitions or strategic
investments, including:
. the acquisition of rights to use dark fiber;
. the enhancement of our network to provide additional value-added services;
and
. the improvement of our network management, billing and other back-office
services.
17
<PAGE>
Item 6. Selected Consolidated Financial Data
You should read the following discussion together with our consolidated
financial statements and the notes to those statements included elsewhere in
this document. The results shown in this document are not necessarily indicative
of the results we will achieve in any future periods. This discussion contains
forward-looking statements based upon our current expectations which involve
risks and uncertainties. Our actual results could differ materially from those
described in the forward-looking statements due to a number of factors,
including those set forth in the section entitled "Risk Factors" and elsewhere
in this document.
The following selected consolidated financial information set forth below with
respect to the Company's consolidated statements of operations for the period
from inception (March 5, 1997) to December 31, 1997 and the years ended December
31, 1998 and 1999, and the consolidated balance sheet data as of December 31,
1997, 1998, and 1999 are derived from the consolidated 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 consolidated 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 Year ended
December 31, 1997 December 31, 1998 December 31, 1999
---------------------- ------------------ ------------------
(Dollars in thousands, except share and
per share amounts)
Consolidated Statement of Operations Data:
<S> <C> <C> <C>
Revenue................................................ $ 22,708 $ 63,611 $ 89,556
Operating expenses:
Splitrock network costs.............................. 2,362 32,912 87,398
Legacy network costs................................. 25,804 58,292 31,904
Selling, general and administrative.................. 1,276 6,390 21,386
Depreciation and amortization........................ 3,500 13,850 27,322
----------- ----------- -----------
Total operating expenses..................... 32,942 111,444 168,010
----------- ----------- -----------
Loss from operations................................... (10,234) (47,833) (78,454)
Other income (expense):
Interest income...................................... 348 5,393 7,714
Interest expense..................................... (235) (15,390) (32,581)
----------- ----------- -----------
Loss before income taxes............................... (10,121) (57,830) (103,321)
Provision for income taxes............................. -- -- --
----------- ----------- -----------
Net loss............................................... $ (10,121) $ (57,830) $ (103,321)
=========== =========== ===========
Loss per share -- basic and diluted.................... $(0.42) $(1.30) $(2.03)
=========== =========== ===========
Weighted average shares -- basic and diluted........... 24,109,823 44,388,948 50,866,855
=========== =========== ===========
<CAPTION>
As of
December 31,
------------------------------
1997 1998 1999
------- --------- ---------
(Dollars in thousands)
Consolidated Balance Sheet Data:
<S> <C> <C> <C>
Cash and cash equivalents........................................................ $ 7,710 $ 28,330 $ 92,593
Unrestricted investments......................................................... -- 120,475 5,441
Restricted investments(1)........................................................ 3,472 58,477 33,786
Property and equipment, net...................................................... 38,504 73,899 120,863
Total assets..................................................................... 54,388 296,141 301,286
Long term debt and capital lease obligations (including current
portion)....................................................................... 25,120 275,581 298,410
Stockholders' equity (deficit)................................................... 20,407 (30,291) (45,184)
</TABLE>
__________
(1) As of December 31, 1997, restricted investments represented collateral to
support an outstanding letter of credit. Restricted investments as of
December 31, 1998, represented escrowed funds that, together with interest
received thereon, will be sufficient to pay, when due, the first four semi-
annual interest payments on the Senior Notes. As of December 31, 1999,
restricted investments included $3.5 million held as collateral to support
outstanding letters of credits with the remainder representing escrowed
funds that, together with interest received thereon, will be sufficient to
pay, when due in 2000, the next two semi-annual interest payments on the
Senior Notes.
18
<PAGE>
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Forward-looking Statements
All references to "we", "us", "Splitrock", or "our" refer to Splitrock
Services, Inc. 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. Investors
are cautioned that all forward-looking statements involve risks and uncertainty,
including, without limitation, our ability to continue building the Splitrock
network, our ability to diversify our 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 we expect or
anticipate 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 Splitrock'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 we believe 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 us or any other
person that our objectives and plans will be achieved.
Investors should also be aware that while we do, from time to time,
communicate with securities analysts, it is against our policy to disclose to
them any material non-public information or other confidential commercial
information. Accordingly, investors should not assume that we agree with any
statement or report issued by any analyst irrespective of the content of the
statement or report. Furthermore, we have a policy against issuing or
confirming financial forecasts or projections issued by others. Thus, to the
extent that reports issued by securities analysts contain any projections,
forecasts or opinions, we are not responsible for those reports.
Overview
We are a facilities-based provider of advanced data communications services.
We market our services to Internet service providers, telecommunications
carriers and other businesses throughout the United States. Our services
include an array of Internet access and data communications services delivered
over our high capacity, facilities-based network. The combination of our
existing broadband access network with our acquisition of significant fiber
optic facilities positions us to deliver a broad range of end-to-end data
communications services on our network, including:
. dial and dedicated Internet access
. Internet access for higher bandwidth services, such as digital subscriber
line and cable modem
. value-added services such as virtual Internet services, virtual private
networks and web hosting
. bandwidth leasing and colocation services.
We were founded in March 1997. In July 1997, we acquired the existing legacy
network infrastructure of Prodigy Communications Corporation, and agreed to
build and operate a nationwide communications network and to provide network
services for Prodigy's customers. We initially provided service to Prodigy's
subscribers using Prodigy's legacy network. For locations outside the coverage
area of the legacy network, we have used the AT&T Global Services network
(formerly IBM's Internet Global Services Network). Since September 1997, we
have deployed our broadband access network in metropolitan areas across the
country. Over time, as more coverage became available on our access network, we
decommissioned the Prodigy legacy network POPs and have substantially
discontinued the use of the AT&T network.
Our broadband access network, comprised of 339 installed POPs as of December
31, 1999, is managed and supported by its state-of-the-art network operations
center in Houston, Texas. We have deployed asynchronous transfer mode (ATM)
switches at every core, hub and remote POP of our network. This network
architecture, called "ATM-to-the-EdgeTM," enables us to serve as a broad-based
provider of data communications services through the creation of a platform that
efficiently delivers multiple services, such as Internet access, virtual private
networks and web hosting, across multiple protocols, including Internet
Protocol, frame relay and ATM. The flexibility inherent to our network design
allows us to expand our service offerings to provide fully integrated data,
video and voice services. This flexibility also allows us to incorporate future
technological innovations into our network architecture with a
19
<PAGE>
lower incremental investment than that required by other communications service
providers with legacy systems that have separate networks for voice and data.
Our network gives us a physical presence in all 50 states, and allows us to
target 90% of U.S. businesses and 87% of U.S. households with a local call. In
October 1999, we committed to purchase $64.1 million of dial access equipment to
support our future access demand pursuant to an agreement with Nortel. The
agreement also allows us to exchange our existing dial access modems with these
recently introduced dial access modems which offer greater capacity and improved
call reliability. We are currently in the process of switching out the old
modems with the new modems. We expect the conversion to be fully complete by
mid-year 2000.
As part of our ongoing efforts to further expand and enhance our network and
service offerings, we have agreed to acquire indefeasible rights to use four
dark fiber strands in a state-of-the-art fiber optic network currently under
construction by Level 3 Communications, LLC, with an option expiring April 26,
2000, to acquire indefeasible rights to use up to 12 additional fibers. This
nationwide fiber network will cover approximately 15,000 route miles and will be
delivered in segments that are expected to become available from the first
quarter of 2000 through the first quarter of 2001. Combining this fiber optic
backbone with our broadband access network positions us to:
. deliver, on our own facilities, a broad array of end-to-end data
communications services at the high level of quality and reliability
increasingly demanded by customers
. reduce significantly our network costs as a percentage of revenues as we
substitute the acquired bandwidth for existing leased circuit arrangements
with various telecommunications carriers
. expand our service offerings by providing bandwidth leasing services on a
stand alone basis or bundled with our other services
. increase the reliability and redundancy of our network
. increase the variety of service options and speeds available to customers
In connection with the fiber optic network deployment, in October 1999, we
committed to purchase a minimum of approximately $50 million of fiber optronics
equipment, associated network management systems, and installation services from
Nortel. The equipment and services are expected to be delivered through the
next five quarters as the dark fiber network is available.
In July 1998, we raised $261 million through the issuance of our 11 3/4%
senior notes and warrants to purchase common stock, principally to finance
capital expenditures related to the construction and installation of our
broadband access network. In August 1999, we completed our initial public
offering, which resulted in net proceeds of $88.4 million after deducting
commissions and other fees and expenses. We are using the proceeds from the
initial public offering to fund a portion of the fiber acquisition and to fund
operational losses, working capital needs and certain other capital
expenditures. In October 1999, a third party leasing company committed to
provide lease financing to fund up to $122 million to significantly increase the
capacity of our broadband access network and to purchase fiber optronics
equipment and associated network management systems from Nortel.
On February 11, 2000, we signed an amended and restated merger agreement with
McLeodUSA. If the merger is completed as proposed, our shareholders will receive
0.5347 shares of McLeodUSA Class A common stock for each share of Splitrock
common stock. Splitrock will become a wholly owned subsidiary of McLeodUSA if
the proposed transaction closes. The transaction is expected to be completed
at the end of the first quarter of 2000.
Revenues
Currently, Splitrock provides Internet dial access and related services to
Prodigy, which is the primary customer of Splitrock and one of the largest
Internet service providers in the United States. Splitrock is currently
Prodigy's primary provider of dial access services. Historically, Prodigy has
accounted for substantially all of our revenues since our inception. We
experienced a significant increase in Prodigy revenue as a result of Prodigy's
subscriber growth particularly in the third quarter of 1999. Even with
Prodigy's growth, we have reduced our concentration of Prodigy revenue by almost
27% through the expansion of our customer base. For the month ended December
31, 1999, Prodigy accounted for 73.2% of our revenue. For the years ended
December 31, 1999 and 1998, Prodigy accounted for 85.5% and 99% of our revenues,
respectively. While we expect revenues from Prodigy to decrease as a
20
<PAGE>
percentage of our total revenues in future periods, we believe that Prodigy will
continue to account for a significant portion of our revenues.
We provide network services, including Internet dial services and other
network connections, to Prodigy in exchange for a monthly service charge. Since
April 1998 through the year ended December 31, 1999, the service charge was
calculated based on the total number of subscribers. The minimum monthly
service charge is $4.0 million and will increase to $4.5 million on July 1,
2000. Effective January 1, 2000, the pricing formula for the services we provide
to Prodigy was converted from a subscriber based arrangement to a fixed hourly
fee for usage. The effect of this price change to our January revenue from
Prodigy was a 2.9% reduction in Prodigy revenue, compared to what we would have
received under the old formula,.
As part of this amendment, the term of the contract was extended to December
31, 2001. After the initial term, either party may terminate the agreement upon
12 months prior written notice. If no notice is received, the term of the
agreement is automatically extended for successive 12-month terms. Under the
agreement, we are required, among other things, to provide Prodigy with
financial and other information and to meet network performance standards. We
are required to provide credits to Prodigy if we fail to meet these standards.
Prodigy may terminate the agreement following a cure period if we fail to meet
specified service level objectives or otherwise fail to comply with our
agreement. Prodigy may also terminate the agreement during the initial term
without cause by providing 12 months' prior written notice and paying a
termination charge of $3.0 million.
In addition to providing Internet dial access and related services to Prodigy,
we provide Internet dial access, Internet dedicated services, virtual private
network services (VPN) and virtual Internet services (VIS) to other customers.
We launched our VIS to ISP customers in the third quarter of 1999. VIS is
marketed to ISPs which desire to outsource certain back office and support
functions, such as billing and customer service, in addition to Internet dial
access services. The Company began billing its first VIS customer in the third
quarter of 1999. We are currently building our first web hosting data center in
Houston, Texas to offer web hosting services, and we plan to build three more
over the next year. Revenues from these facilities are expected to commence in
the first half of the year 2000, but we can not assure you that we will generate
revenues from this new product line. We are focusing our current VPN efforts on
dial VPN services for corporations with remote offices or business travel users.
In future periods we expect to expand our VPN offerings to include dedicated
access services such as frame relay and ATM.
In January 2000, McLeodUSA contracted with us to purchase dial-up Internet
access service. The term of the master services agreement is two years and
provides for minimum revenue of $15.0 million over the two-year term.
As segments of our fiber backbone are constructed, we plan to use the
additional network capacity to offer bandwidth-leasing services. However,
overcapacity could result from the construction of competing networks,
technological advances, strategic alliances, or a decline in the growth rate of
demand for bandwidth capacity. If this occurs, we could encounter significant
pricing pressure, which could limit the amount we could competitively charge for
these services.
McLeodUSA also signed a letter of intent in January 2000, setting forth the
principle terms of a proposed $90.0 million bandwidth agreement. The principle
terms of this agreement will include:
. a specified number of DS-3 capacity miles on the nationwide multi-conduit
fiber optic communications system provided on a dark fiber basis to
Splitrock by Level 3 Communications, and as further converted to lit fiber
by Splitrock, for a specified amount per route mile;
. twenty-year term subject to renewal consistent with any renewal term
offered by Level 3 Communications to Splitrock on the dark fiber lease;
. access and rights to interconnect for McLeodUSA at the Splitrock facilities
and certain accommodations to additional access points;
. optronics maintenance by Splitrock at least equal to maintenance Splitrock
provides to itself and within industry standards;
. liquidated damages for certain delays.
21
<PAGE>
Splitrock Network Costs
Our Splitrock network costs include all expenses incurred in connection with
operating our network. These costs primarily include leased telecommunication
line charges for connecting our POPs to local central offices and for backbone
transmission, personnel expenses, and operating expenses related to network
operations, maintenance, field operations and facility management.
Increases in Splitrock network operating costs relate to the increase in our
network facilities and line charges incurred in connection with the growth in
total subscriber usage. As of December 31, 1999, we have substantially
completed our broadband access platform and have 339 installed POPs.
We are increasing our network operating expenditures to significantly expand
our broadband access network and backbone capacity in anticipation of expected
increases in dial access and other services. We may incur expenditures to
increase our capacity to serve customers in advance of entering into new
customer relationships.
During the year 2000 we will be acquiring fiber segments and installing
equipment to utilize a 15,000 route mile fiber optic network. In connection
with the installation of the fiber optic network, operating expenses related to
these new facilities such as maintenance and colocation costs will increase.
However, we expect our network operating costs to decrease as a percentage of
revenues as we substitute our acquired fiber optic backbone network for existing
leased circuit arrangements with various telecommunications carriers.
Legacy Network Costs
Legacy network costs include all expenses incurred in connection with
operating and decommissioning the Prodigy legacy network, including the AT&T
network, and legacy network costs of servicing the InfiNet legacy network until
we transition the InfiNet traffic to our network. These costs include facility
leases, line charges, occupancy costs, equipment maintenance costs, access fees,
as well as significant transition costs which will be incurred until the traffic
from these networks is migrated to our network.
Legacy network costs have declined throughout 1999. The largest component of
our legacy network costs were paid to AT&T for usage incurred on their network
(formerly IBM's Global Services Network). We have moved substantially all of
the traffic from the AT&T network to the Splitrock network. In the first
quarter of 2000, we plan to complete migrating all of the traffic from InfiNet's
legacy network to our network. We do not expect to incur any significant legacy
network costs in the future.
Selling, General and Administrative Expenses
Selling, general and administrative expenses consist of personnel and
operating costs relating to executive management, accounting and finance,
information systems, human resources, sales and marketing, customer support,
network planning, development, and administrative employees. We expect our
selling, general and administrative expenses to continue to increase in dollar
amount and as a percentage of revenue in 2000 and 2001 principally due to the
following factors:
. expansion of our sales and marketing force; and
. expansion of our back-office, customer care, billing, and administrative
functions.
We expect to make a substantial investment in our sales and marketing programs
to achieve and properly support the intended expansion in our customer base.
Through the combination of a direct sales force and alternative distribution
channels, we believe that we will be able to access markets and increase
revenue-producing traffic on our network.
In 1999, we began to implement our distribution strategy by developing an in-
house direct sales force. We intend to utilize our direct sales force to market
our services directly to Internet service providers, carriers, value added
service providers, and medium and large businesses. As of December 31, 1999 our
sales and marketing staff totaled 75 professionals, the majority of which
comprised the direct sales force. We are also utilizing alternate distribution
channels, such as agents, resellers and wholesalers, to market our services. We
cannot assure you that we will be successful in our marketing plan.
In addition to the expanded sales force, we continued back-office expansion,
including the continued implementation of a new customer care and billing system
in the fourth quarter of 1999. During the quarter ended September 30, 1999 we
completed the implementation of PeopleSoft's financial and human resource
management information system.
22
<PAGE>
We leased 69,000 square feet of additional office space for our headquarter
facility, which we began to occupy in August 1999. This office lease and
related occupancy costs increased selling, general and administrative costs
during 1999.
Depreciation and Amortization
Depreciation and amortization expense consists primarily of depreciation of
network equipment. We anticipate that our depreciation and amortization
expenses will increase significantly as we deploy our fiber optic network and
significantly expand the capacity of our broadband dial access network.
Interest Expense
Interest expense represents interest on our 113/4% Senior Notes and interest
at various rates on our capital leases. The lease arrangements we recently
entered into, for the purchase of fiber optronics equipment and associated
management systems, were recorded as capital leases and will result in a
significant increase in our interest expense beginning in January of 2000.
Net Losses
We have incurred net losses since our inception in March 1997. We anticipate
that we will continue to incur net losses while we complete the construction and
installation of our fiber optic network and expand our sales and marketing
force. The extent to which we continue to incur net losses is largely dependent
upon the timely deployment of the fiber optic network, the rate at which we can
expand our customer and revenue base and our ability to maximize use of our
nationwide network.
23
<PAGE>
Results of Consolidated Operations
The following table sets forth selected unaudited quarterly and audited
partial year from inception and audited annual consolidated statements of
operations data:
<TABLE>
<CAPTION>
Period from
Inception
(March 5, 1997)
Three Months Ended (unaudited) Through
---------------------------------------------------------------------------- Year Ended Year Ended
December 31, March 31, June 30, September 30, December 31, December 31, December 31, December 31,
1998 1999 1999 1999 1999 1997 1998 1999
--------- --------- --------- --------- --------- --------- --------- ---------
(Dollars in thousands, except share and per share amounts)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Consolidated
Statement of
Operations Data:
Revenue................ $ 16,019 $ 16,352 $ 17,889 $ 23,703 $ 31,612 $ 22,708 $ 63,611 $ 89,556
Operating expenses:
Splitrock network
costs............... 11,977 16,022 18,128 22,832 30,416 2,362 32,912 87,398
Legacy Network
costs............... 15,692 13,029 8,842 6,652 3,381 25,804 58,292 31,904
Selling, general
And administrative.. 2,221 2,570 3,768 6,070 8,978 1,276 6,390 21,386
Depreciation
And amortization.... 6,139 4,635 6,602 8,039 8,046 3,500 13,850 27,322
--------- --------- --------- --------- --------- --------- --------- ---------
Total
Operating
expenses........ 36,029 36,256 37,340 43,593 50,821 32,942 111,444 168,010
--------- --------- --------- --------- --------- --------- --------- ---------
Loss from
operations........... (20,010) (19,904) (19,451) (19,890) (19,209) (10,234) (47,833) (78,454)
Other income
(expense):
Interest
income.............. 2,546 2,604 1,731 2,001 1,378 348 5,393 7,714
Interest
expense............. (8,254) (8,191) (8,155) (8,125) (8,110) (235) (15,390) (32,581)
--------- --------- --------- --------- --------- --------- --------- ---------
Loss before
income tax............ (25,718) (25,491) (25,875) (26,014) (25,941) (10,121) (57,830) (103,321)
Provision for
income tax............ -- -- -- -- -- -- -- --
--------- --------- --------- --------- --------- --------- --------- ---------
Net loss............... $ (25,718) $ (25,491) $ (25,875) $ (26,014) $ (25,941) $ (10,121) $ (57,830) $(103,321)
========= ========= ========= ========= ========= ========= ========= =========
Other:
Unrealized net
gain (loss) on
securities.......... (298) (242) (140) (11) 213 -- 47 (180)
--------- --------- --------- --------- --------- --------- --------- ---------
Comprehensive
net loss............. $ (26,016) $ (25,733) $ (26,015) $ (26,025) $ (25,728) $ (10,121) $ (57,783) $ (103,501)
========= ========= ========= ========= ========= ========= ========= =========
Net loss per
share -- basic
and diluted.......... $(0.55) $(0.55) $(0.55) $(0.49) $(0.46) $(0.42) $(1.30) $(2.03)
========= ========= ========= ========= ========= ========= ========= =========
Weighted average
shares -- basic
and diluted........... 46,621,968 46,659,188 46,678,316 52,979,209 56,902,263 24,109,823 44,388,948 50,866,855
========== ========== ========== ========== ========== ========== ========== ==========
Other Data:
EBITDA(1).............. $ (13,871) $ (15,269) $ (12,849) $ (11,851) $ (11,163) $ (6,734) $ (33,983) $ (51,132)
========= ========= ========= ========= ========= ========= ========= =========
Cash provided by
(used in):
Operating
activities......... $ (2,918) $ (32,052) $ (15,671) $ (31,387) $ (9,148) $ (2,233) $ (735) $ (88,258)
Investing
activities......... (148,717) 29,765 3,299 27,902 18,422 (17,198) (169,512) 79,388
Financing
activities......... (2,357) (2,678) (2,666) 86,702 (8,225) 27,141 190,867 73,133
</TABLE>
_________
(1) EBITDA is defined as net loss plus net interest expense, provision for
income taxes, depreciation and amortization.
24
<PAGE>
We effected a 0.563-for-1 reverse stock split of our common stock on July 12,
1999. All share and per share amounts presented here and in the consolidated
financial statements have been retroactively adjusted to give effect to the
reverse stock split.
Year Ended December 31, 1999 Compared to Year Ended December 31, 1998
Revenues. Revenues for the year ended December 31, 1999 totaled $89.6
million, an increase of $26.0 million from revenues of $63.6 million for the
year ended December 31, 1998. This 40.8% increase was due to increased Prodigy
revenue as a result of their subscriber growth and an increase in revenue from
our expanding customer base.
Splitrock Network Costs. Splitrock network costs for the year ended December
31, 1999 were $87.4 million compared to $32.9 million for the year ended
December 31, 1998. This $54.5 million increase was due to the growth in the
size of our network from 89 operational POPs as of December 31, 1998 to 339 POPs
as of December 31, 1999 and an increase in minutes of traffic transported by our
network. As a percentage of revenues, Splitrock network costs increased to
97.6% of revenue for the year ended December 31, 1999 from 51.7% of revenues for
the year ended December 31, 1998.
Legacy Network Costs. Legacy network costs for the year ended December 31,
1999 were $31.9 million compared to $58.3 million for the year ended December
31, 1998. This $26.4 million or 45.3% decrease was primarily attributable to a
decrease in access charges incurred for use of the AT&T network, as a result of
the expanded coverage becoming available on the Splitrock network and the
migration of additional traffic from the legacy networks to the Splitrock
network. As a percentage of revenues, legacy network costs decreased to 35.6%
of revenue for the year ended December 31, 1999 from 91.6% of revenues for the
year ended December 31, 1998.
Selling, General and Administrative Expenses. Selling, general and
administrative expenses for the year ended December 31, 1999 were $21.4 million
compared to $6.4 million for the year ended December 31, 1998. The majority of
this increase was due to personnel costs incurred in building our direct sales
force beginning in the second quarter of 1999 and the increase in personnel to
support the growth in the size of our network. As a percentage of revenues,
selling, general and administrative expenses increased to 23.9% of revenue for
the year ended December 31, 1999 from 10.0% of revenues for the year ended
December 31, 1998.
Depreciation and Amortization. Depreciation and amortization was $27.3
million for the year ended December 31, 1999 compared to $13.9 million for the
year ended December 31, 1998. This increase was due to the increase in
equipment and facilities placed in service between the two periods.
Interest Expense. Interest expense was $32.6 million for the year ended
December 31, 1999, compared to $15.4 million for the year ended December 31,
1998. This increase is the result of our 113/4% Senior Notes issued at the end
of July 1998 which, by comparison were outstanding for the full year of 1999.
Interest Income. Interest income relates to the interest earned on
investments of cash on hand in investment grade commercial paper and money
market accounts. Interest income was $7.7 million for the year ended December
31, 1999, compared to $5.4 million for the year ended December 31, 1998. This
increase is due to the increase in the cash balances between the two periods.
In August 1999, we raised net proceeds of $88.4 million through our initial
public offering. The proceeds have been invested in short-term investments
which began earning interest upon our receipt of the funds in the third quarter
of 1999.
Income Taxes. No provision for income taxes has been recognized because we
had operating losses for both tax and financial reporting purposes in all
periods. On December 31, 1999, we had approximately $71.8 million of gross
deferred tax assets comprised primarily of net operating loss carryforwards.
Given our history of operating losses, it is uncertain that we would realize
these assets, and so we have provided a reserve to reduce the carrying value of
the assets to zero. We will continue to assess the ability to realize the
deferred tax assets based on actual and forecasted results.
Year Ended December 31, 1998 Compared to Period from Inception on March 5, 1997
through December 31, 1997
From inception (March 5, 1997) through June 30, 1997, we had not yet begun
deploying the Splitrock network nor had we consummated the Prodigy Agreement. As
a result, we 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.
25
<PAGE>
Since inception, we have focused on building our broadband access network
while maintaining and decommissioning, as appropriate, the Legacy Network.
Through December 31, 1998, we had not focused on increasing sales, as the
Splitrock network had not yet been completed. Prodigy represented our primary
source of revenue during both 1997 and 1998. In the second quarter of 1998, we
began efforts to raise capital to complete the build of the Splitrock broadband
access network. On July 24, 1998, we issued and sold $261.0 million in senior
notes and warrants to acquire 1,487,791 shares of common stock and began a
campaign to recruit and employ the personnel necessary to complete, operate and
maintain our network.
To support our network, we have been adding employees. At the end of 1997 and
1998, respectively, we had 67 and 188 full time employees and contractors.
Additionally, during 1998, we added a state of the art network operations center
in The Woodlands, Texas.
Liquidity and Capital Resources
Our operations have required funding of substantial operating losses and
capital investment for the purchase of communications equipment and the design
and development of our network.
Since our inception, we have satisfied our cash requirements primarily through
the issuance of equity or debt securities. As of December 31, 1999, we had
raised approximately $386.6 million, including:
. $34.9 million through private sales of our equity securities, including
$18.0 million invested by our senior management and directors and $15.6
million invested by another major stockholder;
. $263.3 million through the issuance of debt; and
. $88.4 million in net proceeds from the Company's initial public offering.
On August 6, 1999, we completed our initial public offering of 9,692,628
shares of our common stock at a price of $10.00 per share resulting in net
proceeds of approximately $88.4 million after deducting the underwriting
discount and other estimated fees and expenses payable by us. The underwriters
purchased 692,628 of the shares from us pursuant to an over-allotment option.
Additionally, 157,372 shares were sold by certain of our stockholders under the
same over-allotment option and we did not receive any proceeds from the sale of
those shares. We are using our net proceeds for capital expenditures, including:
. the acquisition of rights to use dark fiber;
. the enhancement of our network to provide additional value-added services;
and
. the improvement of our network management, billing and other back-office
services.
We are also using a portion of the net proceeds from the offering to fund
operating losses, working capital requirements and other general corporate
purposes.
In addition we have incurred $63.2 million in equipment financing, primarily
from equipment vendors and leasing companies. In October 1999, we entered into
lease financing arrangements with a third party leasing company to fund up to
$122.0 million of our purchase commitments with Nortel. These lease
arrangements are structured as a capital leases.
We expect our future liquidity and capital requirements to relate primarily
to:
. the acquisition of rights to use dark fiber;
. capital expenditures;
. operating losses;
. debt service payments; and
. working capital and other corporate purposes.
26
<PAGE>
Net cash used in operating activities was $88.3 million during the year ended
December 31, 1999. The net cash used in operating activities in this period was
primarily attributable to the Company's net losses. Net cash used in operating
activities was $0.7 million for the year ended December 31, 1998. During the
year-ended December 31, 1998, the cash flow effect of net losses were largely
offset by increases of $42.0 million in current liabilities due to the timing of
payments for purchases to equipment vendors and accrued interest to bond
holders.
Net cash provided by investing activities during the year ended December 31,
1999 was $79.4 million. This consisted primarily of net proceeds of $114.8
million from the liquidation of unrestricted investments, $28.2 million net
liquidation of restricted investments which were used to pay the interest on the
senior notes, offset by $39.5 million used for purchases of property and
equipment, the payment of a deposit of $11.2 million related to dark fiber
acquisition agreement and approximately $12.9 million primarily for costs
incurred in connection with the construction of our broadband access platform
and other intangible costs. Net cash used in investing activities for the year
ended December 31, 1998 was $169.5 million and consisted primarily of the
purchase of unrestricted investments of $119.5 million and $45.3 million in
equipment purchases.
Net cash provided by financing activities for the year ended December 31, 1999
was $73.1 million and consisted primarily of $88.4 million in net proceeds from
the Company's initial public offering offset primarily by principal payments on
capital leases, $2.1 million paid to the holders of the Senior Notes, and the
restriction of $3.5 million under credit agreements. This $2.1 million was paid
to the bond holders in consideration of their consents and waivers of covenant
provisions which allowed us to enter into the capital lease financing related to
the purchase commitment with Nortel. Net cash provided by financing activities
for the year ended December 31, 1998 was $190.9 million, which was derived
primarily from the issuance of our senior notes, net of issuance costs and
proceeds restricted to finance future interest payments.
As of December 31, 1999, we had aggregate operating and capital lease payments
of $29.2 million, $18.1 million, $17.3 million, $7.3 million and $5.8 million
due in each of the next five years. We expect lease payments to increase in the
year 2000 under the lease financing commitments obtained in October 1999 to
expand the capacity of our broadband access network and for the related
facilities and telecommunications equipment for our fiber optronic backbone.
The principal amount of our 113/4% Senior Notes ($261.0 million) is payable in
2008 subject to early redemption upon the occurrence of a change of control,
which would require the Company to tender an offer to repurchase all Senior
Notes at a price equal to 101% of the principle plus accrued interest. The fair
market value of these notes at December 31, 1999 was 92% of the principle
amount. The proposed merger with McLeod would constitute a change in control.
If the holders of our Senior Notes required us to redeem the notes, we would be
required to record an extraordinary loss of approximately $14.0 million.
Interest payments on the notes are due semi annually. Interest payments due on
January 15, 2000 and July 15, 2000 are funded by certain of the proceeds,
together with interest thereon, escrowed in connection with the issuance of the
113/4 Senior Notes to provide for the first four interest payments of the senior
notes. The remaining escrow amounts for the last two payments are recorded as
restricted investments at December 31, 1999. Beginning in year 2001, the
interest payments will be funded from our cash and unrestricted investments.
We have agreed to acquire indefeasible rights to use four dark fibers, with an
option to use up to 12 additional fibers, in the fiber optic network under
construction by Level 3. We are required to pay for the dark fiber in segments
as they become available, which is expected to occur through the first quarter
of 2001. If the option to purchase the additional 12 fibers is exercised in
April 2000, the Company will be required to pay approximately $36.5 million upon
exercise with the remaining amount to be paid as segments are accepted.
Capital expenditures including purchases under capital lease agreements were
$72.1 million and $50.1 million for the year ended December 31, 1999 and the
year ended December 31, 1998, respectively.
We estimate that our capital expenditures (including purchases anticipated to
be funded with capital leases) for 2000, 2001 and 2002 will be approximately
$252 million, $40 million and $93 million, respectively, including capital
expenditures for:
. the acquisition of rights to use four dark fiber strands and the related
electronics necessary to transmit data over a portion of the fiber;
. the enhancement of our network to provide additional value added services;
and
. the improvement of our network management, billing and other back office
systems.
27
<PAGE>
As of December 31, 1999, we had an accumulated deficit of $171.3 million,
cash and cash equivalents and unrestricted investments of $98.0 million, and
restricted investments of $33.8 million.
On January 6, 2000, independently of our definitive merger agreement with
McLeodUSA, we entered into a $115 million secured revolving credit agreement
with Citibank USA, Inc., the proceeds of which can be used for general working
capital, a $15 million master services agreement with McLeod for Internet dial-
access services and a $90 million letter of intent to sell bandwidth capacity to
McLeodUSA. These agreements cannot be terminated in the event that the merger
between us and McLeodUSA is not consummated unless Splitrock undergoes a change
in control as defined in the credit agreement.
The credit agreement will give us access to $115 million in staggered
tranches available through March 31, 2001, on which date all amounts become due
and payable. Citibank could declare the revolving loans immediately due and
payable upon a change of control as defined in the agreement. The principal
terms of the facility are described as follows:
Availability. The availability under the facility is up to:
. $20 million from March 1, 2000 to March 31, 2000
. $55 million from April 1, 2000 to April 30, 2000
. $85 million from May 1, 2000 to May 31, 2000
. $105 million from June 1, 2000 to June 30, 2000
. $115 million from July 1, 2000 to the maturity date of March 31, 2001
Rates and Fees. Loans under the facility bear interest at:
. prime plus 4% to July 6, 2000
. prime plus 4.5% from July 7, 2000 to October 6, 2000
. prime plus 5% from October 7, 2000
The commitment fee is 1.25% of undrawn amounts. Splitrock is required to pay
an arrangement fee of $100,000 and an administration fee of $10,000, in addition
to reimbursing Citicorp's out-of-pocket expenses.
Prepayment. Splitrock may at its option prepay any borrowings at par at any
time. Mandatory prepayments are required on a basis consistent with the terms of
the Indenture for the Splitrock 11 3/4% Senior Notes due 2008.
Security. Up to $75 million of the facility is secured by a guarantee by a
newly formed subsidiary of Splitrock, a pledge of the stock of this subsidiary
and a security agreement covering substantially all of the available assets of
Splitrock.
Covenants. The covenants in the credit agreement in large part mirror the
covenants contained in the Indenture for Splitrock's 11 3/4% Senior Notes due
2008.
Splitrock will provide wholesale Internet dial-access services to McLeod over
a 2-year term for a minimum of $15 million under the master services agreement.
Payments will not be due until borrowings under the credit agreement are fully
utilized, but no later than December 31, 2000.
Under the bandwidth capacity letter of intent, Splitrock and McLeod will
execute a definitive agreement to provide McLeod with capacity on Splitrock's
fiber network over a twenty year term for total consideration of $90 million.
The purchase price will not be payable until borrowings under the credit
agreement with Citibank and payments under the dial access services agreement
are fully utilized, but no later than March 31, 2001.
28
<PAGE>
We currently anticipate that our available cash resources should be sufficient
to meet our anticipated cash needs for the reasonable foreseeable future.
However, we cannot assure you that our financial resources will be adequate to
fund all of our anticipated or unanticipated losses, working capital
requirements and capital expenditures during this period. We intend to finance
additional cash requirements by raising additional funds through the issuance of
equity or debt securities, vendor financing, bank financing, strategic
relationships or some combination of the foregoing. The terms of our debt
securities restrict our ability to incur indebtedness, create liens, and make
dividend payments and investments, and may make it more difficult for us to
raise the capital we will need to fully implement our business plan.
We cannot assure you that the additional financing we will need, will be
available on terms acceptable to us, or at all. If we are unable to obtain the
funds necessary to finance our expected capital requirements, we may have to
revise our business plans and this may materially and adversely affect our
financial condition, results of operations and filing. Furthermore, any
additional equity financing may be dilutive to stockholders, and debt financing,
if available, may involve restrictive covenants and significant interest
expense.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
The following discusses our exposure to market risk related to changes in
interest rates, equity prices and foreign currency exchange rates. Market risk
generally represents the risk of loss that may result from the potential change
in the value of a financial instrument as a result of fluctuations in interest
rates and market prices. We have not traded or otherwise bought and sold
derivatives nor do we expect to in the future. We also do not invest in market
risk sensitive instruments for trading purposes.
This discussion contains forward-looking statements that are subject to risks
and uncertainties. Actual results could vary materially as a result of a number
of factors including those set forth under "Item 2. Management's Discussion and
Analysis of Financial Condition - Forward Looking Statements."
Interest Rate Risk
We may be exposed to market risk related to changes in interest rates. At
this time, we have not entered into any interest rate risk arrangements, and
while we may enter into interest rate risk hedging arrangements in the future,
we cannot assure you that we will be able to find commercially satisfactory
terms at that time. Our investment policy is to manage our investment portfolio
to preserve principal and liquidity while maximizing the return on the
investment portfolio through the full investment of available funds. We
diversify our marketable securities portfolio by investing in multiple types of
investment-grade securities. Our 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.
Our Short-Term Investments. As of December 31, 1999, we had unrestricted
short-term investments of $5.4 million and restricted short-term investments of
$33.6 million. These short-term investments are highly liquid investments with
original maturities at the date of purchase of between three and twelve months
and consist primarily of money market funds and high-grade securities such as
corporate notes, municipal securities and U.S. Treasury notes. We value these
investments at fair market value. These investments are subject to interest
rate risk and will fall in value if market interest rates increase. A
hypothetical increase in market interest rates by 10% from levels at December
31, 1999 would cause the fair value of these short-term investments to decline
by an immaterial amount. We have the ability to hold these investments until
maturity, and therefore would not expect the value of these investments to be
affected to any significant degree by the effect of a sudden change in market
interest rates. Declines in interest rates over time will, however, reduce our
interest income, especially from money market funds whose rates change on a
daily basis.
Our Long-Term Investments. As of December 31, 1999, we maintained restricted
long-term investments totaling $0.1 million in connection with our 113/4% Senior
Notes due 2008. These long-term investments consist of high-grade securities
such as corporate notes, municipal securities and U.S. Treasury notes, all of
which are considered liquid and available for sale. These securities will not
be held to maturity. A hypothetical increase in market interest rates by 10%
from levels at December 31, 1999 would cause the fair value of these securities
to decline by an immaterial amount.
Outstanding Debt. As of December 31, 1999, the carrying value of our
outstanding senior notes was approximately $258.4 million at a fixed interest
rate of 113/4%. In certain circumstances, we may redeem this long-term debt.
Because the interest rates on these instruments are fixed, a hypothetical 10%
decrease in interest rates would not have a material impact on our financial
condition,
29
<PAGE>
revenues or operations. Increases in interest rates could, however, increase the
interest expense associated with future borrowings, if any. We do not hedge
against interest rate increases.
Equity Price Risk
We do not own an equity stake or investment in another company or business
entity and therefore we do not believe that we have any direct equity price
risk. We do not hedge against equity price changes.
Foreign Currency Exchange Rate Risk
All of our revenues are realized in dollars and all of our revenues are from
customers in the United States. Therefore, we do not believe that we have any
significant direct foreign currency exchange rate risk. We do not hedge against
foreign currency exchange rate changes.
Item 8. Financial Statements and Supplementary Data
The consolidated 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.
30
<PAGE>
PART III
Item 10. Directors and Executive Officers
Our directors and executive officers are as follows:
<TABLE>
<CAPTION>
Name Age Principal Position With the Company
- ------------------------------ --- ---------------------------------------
<S> <C> <C>
Kwok Li....................... 42 Chairman of the Board of Directors and
Chief Technical Officer
William R. Wilson............. 52 President, Chief Executive Officer and
Director
J. Robert Fugate.............. 39 Executive Vice President and
Chief Financial Officer
David M. Boatner.............. 51 Executive Vice President and Chief
Marketing Officer
Jorge L. Rosado............... 48 Senior Vice President of Operations and
Development
Todd W. Wilkens............... 33 Senior Vice President of Engineering
Patrick J. McGettigan, Jr..... 47 Senior Vice President, Secretary and
General Counsel
Roy A. Wilkens................ 57 Director
Marshall C. Turner............ 58 Director
James M. Nakfoor.............. 36 Director
</TABLE>
Kwok Li has served as a Chairman of the Board since July 1997 and has served
as Chief Technical Officer of Splitrock since April 1998. Mr. Li is a co-founder
of Splitrock. 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 Systems, an ATM switch
manufacturer, 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 Splitrock since its inception and
as Chief Executive Officer since April 1998. Mr. Wilson is a co-founder of
Splitrock. Prior to assuming his position at Splitrock, 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, an
interexchange carrier. 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.
J. Robert Fugate joined Splitrock 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.
David M. Boatner joined Splitrock 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, a telecommunication provider, 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.
31
<PAGE>
Jorge L. Rosado joined Splitrock in October 1999 and assumed the position of
Senior Vice President of Operations and Development in December 1999. From 1995
to 1999, Mr. Rosado served as Vice President of Operations and Planning for
GridNet International, a start-up Internet services company (later purchased by
MCI Worldcom, a telecommunications provider), where he was one of the founding
officers. During this tenure Mr. Rosado was instrumental in the planning,
deployment and installation of the Gridnet network leveraging the WCOM
infrastructure. From 1987 to 1995, he held positions at Integrated Communication
Systems, a professional services company, where he served as General Manager of
Enhanced Network Services (ENS). In this role he was responsible for the
development, delivery and support of ENS under contract to BellSouth
Telecommunications and Vice President of Operations. Also in this capacity, Mr.
Rosado established an organization to manage and support outsourced engineering
and management of newly developed voice and data network services. Previously,
Mr. Rosado held numerous key management roles in operations and network planning
for Southern Bell Telephone. He received his B.S. in Electrical Engineering from
Florida Atlantic University.
Todd Wilkens has served as Vice President of Engineering of Splitrock since
July 1997 and as Senior Vice President since April 1999. From 1996 to 1997, Mr.
Wilkens was Vice President, Engineering and Operations, at GridNet
International, a start-up Internet services company (later purchased by MCI
Worldcom, a telecommunications provider), where he helped GridNet, a start-up
Internet services company, implement a nationwide frame relay/ATM network. From
1994 to 1996, Mr. Wilkens was Manager, Advanced Products Support, at MCI
WorldCom where he helped build the Internet Support Organization which
specialized in building and operating Internet service provider backbones. Prior
to that, Mr. Wilkens supported offshore communications in the Gulf of Mexico for
Conoco/Dupont. Mr. Wilkens holds a B.S.E.E. from Oklahoma State University. Mr.
Wilkens is the son of Roy A. Wilkens, a director of Splitrock.
Patrick J. McGettigan, Jr., has served as General Counsel of Splitrock since
September 1997, as Secretary since March 1998, and as Senior Vice President
since April 1998. Prior to joining Splitrock, 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 Splitrock 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.
Roy A. Wilkens has served as a director of Splitrock since April 1998. Mr.
Wilkens was President of The Williams Pipeline Company, an interstate national
gas 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
MCI WorldCom. Mr. Wilkens served as Vice Chairman of MCI 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.
Marshall C. Turner joined Splitrock's board of directors in April 1999. Mr.
Turner is an independent consultant and technology venture investor. From 1981
through 1998, Mr. Turner was General Partner of Taylor & Turner Associates,
Ltd., which itself was a general partner of several venture capital
partnerships. Mr. Turner has been a venture capital principal or operating
executive in technology industries for 25 years. He is a director of the
Alliance Technology Fund, Inc., DuPont Photomasks, Inc., and four privately-
held companies, including Linsang, one of our largest shareholders. In June
1999, Mr. Turner was appointed as interim Chief Executive Officer and Chairman
of the Board of DuPont Photomasks, Inc. Mr. Turner is also Vice Chairman of the
Smithsonian Museum of Natural History, a director of the PBS Enterprises, Inc.,
and director of the George Lucas Educational Foundation. Mr. Turner received
B.S. and M.S. degrees in Mechanical Engineering and Product Design from Stanford
University and an M.B.A. from Harvard University.
James M. Nakfoor joined Splitrock's board of directors in April 1999. Since
1991, Mr. Nakfoor has served as Vice President of Securities Trading for
Inversora Bursatil, S.A. de C.V., a wholly-owned subsidiary of Grupo Financiero
Inbursa, S.A. de C.V., which is engaged in the securities brokerage, investment
banking and money management business in Mexico. Grupo Financiero, which is
affiliated with Carso Global Telecom, is a Mexican financial group whose
businesses include banking, brokerage, insurance, leasing, factoring and other
financial services. Since September 1997, Mr. Nakfoor has been a member of the
Board of Directors of Prodigy Communication Corporation. Mr. Nakfoor holds a
B.A. degree in Economics and an M.B.A. degree from The University of Texas at
Austin.
32
<PAGE>
Board of Directors
Our board of directors is divided into three classes. Each class consists of
up to two directors elected for staggered, three-year terms.
<TABLE>
<CAPTION>
Directors whose Directors Directors whose
terms expire in 2000 whose terms expire in 2001 terms expire in 2002
- ----------------------------------------------------------------------------------------
<S> <C> <C>
Marshall C. Turner William R. Wilson Kwok Li
Roy A. Wilkens James M. Nakfoor
</TABLE>
Committees of the Board of Directors
Our board has standing audit and compensation committees. The compensation
committee currently consists of Kwok Li, William R. Wilson and Roy A. Wilkens,
although membership may be changed to consist solely of non-employee directors.
The audit committee members are Roy A. Wilkens, Marshall C. Turner and James M.
Nakfoor.
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 years ended December 31, 1998 and
1999.
33
<PAGE>
Summary Compensation Table
<TABLE>
<CAPTION>
Annual Compensation Long-Term
------------------------------------------------- Compensation
Awards
-----------
Other Securities
Annual Underlying
Name and Principal Position Year Salary($) Bonus ($) Compensation($) Options(#)
- ------------------------------------------- ---- ---------- ---------- ---------------- -----------
<S> <C> <C> <C> <C> <C>
Kwok Li, Chairman of the Board and
Chief Technical Officer.................. 1999 -- -- --
1998 -- -- -- --
1997 -- -- $10,600(1) --
William R. Wilson, President and Chief
Executive Officer........................ 1999 $198,691 $150,000 -- --
1998 151,440 -- --
1997 62,980 $16,400(1) --
J. Robert Fugate, Executive Vice
President and Chief Financial Officer.... 1999 $144,180 $129,375 -- 250,000
David M. Boatner, Executive Vice
President and Chief Marketing Officer.... 1999 $146,904 $147,917 -- 325,000
Todd W. Wilkens, Senior Vice President
of Engineering........................... 1999 $163,588 $100,000 -- 37,000
1998 $125,225 -- $10,000 --
1997 $ 84,330 -- $10,000 563,000
Patrick J. McGettigan, Jr., Senior Vice
President, Secretary and General
Counsel(2)............................... 1999 $178,500 $105,000 -- 109,250
1998 150,833 -- -- --
1997 46,933 $ 65,000 -- 140,750
</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 $18,000 from the Company.
Option Grants In Fiscal Year 1999
The following table shows information with respect to grants of stock options
to each of the named executive officers during the year ended December 31, 1999.
No stock appreciation rights were granted in the year ended December 31, 1999.
<TABLE>
<CAPTION>
Potential Realizable
Value at Assumed
Individual Grants Annual Rates of Stock Price
- -------------------------------------------------------------------------------------------------
Appreciation for Option Term
------------------------------
% Total Options
Number of Securities Granted to
Underlying Options Employees Exercise Price Expiration
Name Granted (# ) In Fiscal Year ($/sh) Date 5% 10%
- ------------------- -------------------- --------------- -------------- ----------------- ---------- ----------
<S> <C> <C> <C> <C> <C> <C>
Kwok Li -- -- -- -- -- --
William R. Wilson -- -- -- -- -- --
J. Robert Fugate 197,050 6.4% $ 9.77 March 21, 2009 $1,210,734 $1,360,064
52,950 1.7% $10.00 August 3, 2009 $ 333,000 $ 374,071
David M. Boatner 225,200 7.3% $ 9.77 February 28, 2009 $1,383,696 $1,554,358
99,800 3.2% $10.00 August 3, 2009 $ 627,637 $ 705,048
Todd W. Wilkens 37,000 1.2% $10.00 August 3, 2009 $ 232,691 $ 261,391
Patrick J. McGettigan, Jr. 109,250 3.5% $10.00 August 3, 2009 $ 687,067 $ 771,809
</TABLE>
34
<PAGE>
Aggregated Option Exercises and Fiscal Year-End Option Values
The following table sets forth information for each Named Executive Officer
concerning the exercise of options during fiscal year 1999, the number of
securities underlying unexercised options at the 1999 year-end and the year-end
value of all unexercised in-the-money options held by such individuals. There
were no stock appreciation rights outstanding in 1999.
<TABLE>
<CAPTION>
Number of Securities
Underlying Unexercised Value of Unexercised
Options Held at In-the-Money Options
December 31, 1999 at December 31, 1999(2)($)
Shares Acquired Value -------------------------- --------------------------
Or Exercised Realized(1)($) Exercisable Unexercisable Exercisable Unexercisable
--------------- -------------- ----------- ------------- ----------- -------------
<S> <C> <C> <C> <C> <C> <C>
Kwok Li -- -- -- -- -- --
William R. Wilson -- -- -- -- -- --
J. Robert Fugate -- -- -- 250,000 -- $2,514,072
David M. Boatner -- -- -- 325,000 -- $3,261,171
Todd W. Wilkens -- -- 340,150 259,850 $6,382,915 $4,547,155
Patrick J. McGettigan, Jr. 25,000 $222,250 67,895 157,105 $1,274,050 $2,445,968
</TABLE>
__________
(1) Represents the difference between the exercise price and the closing price
of our common stock on The Nasdaq Stock Market on the date of exercise.
(2) Represents the difference between the exercise price and the closing price
of our common stock on The Nasdaq Stock Market on December 31, 1999.
Employment Agreements
We have entered into employment agreements with Messrs. Wilson, Boatner and
Fugate.
Under Mr. Wilson's employment agreement, which terminates on March 15, 2002,he
is entitled to receive an annual base salary of $150,000, subject to adjustment
by the board of directors or the Compensation Committee. The board adjusted Mr.
Wilson's annual salary to $200,000 as of January 1, 1999. If Mr. Wilson's
employment is terminated upon his death or disability or by us without cause,
then he is entitled to continue to receive his base salary through the remaining
term of the agreement. The agreement further provides that Mr. Wilson may engage
in other business endeavors without violating any of provisions of the
agreement.
Under Mr. Boatner's employment agreement, which terminates on February 28,
2001, he is entitled to receive an annual base salary of $175,000. Mr. Boatner
also received a signing bonus of $75,000 and was granted options to acquire
225,200 shares of our common stock at an exercise price of $9.77 per share.
These options vest in four equal annual installments beginning on March 1, 2000.
If we terminate Mr. Boatner's employment without cause, then he is entitled to
continue to receive his base salary through the remaining term of his agreement.
Under Mr. Fugate's employment agreement, which terminates on March 21, 2001,
he is entitled to an annual base salary of $185,000. Mr. Fugate also received a
signing bonus of $50,000 and was granted options to purchase 197,050 shares of
our common stock at an exercise price of $9.77 per share. These options vest in
four equal annual installments beginning on March 21, 2000. If we terminate Mr.
Fugate's employment without cause, then he is entitled to continue to receive
his base salary for 12 months following termination, if his employment is
terminated before March 21, 2000, or for six months following termination, if
his employment is terminated after March 21, 2000.
Stock Incentive Plans
Our 1999 stock incentive plan became effective on July 1, 1999 and replaced
the 1997 incentive share plan discussed below. The purpose of both stock
incentive plans is to strengthen our company by providing an incentive to our
employees, officers, consultants,
35
<PAGE>
directors and advisors through the granting or awarding of incentive and
nonqualified stock options, stock appreciation and dividend equivalent rights,
restricted stock, performance units, performance shares, share awards and
phantom stock awards, thereby encouraging these individuals to devote their
abilities and energies to our success.
The 1999 stock incentive plan is administered by our board of directors and
could be administered by a committee of the board consisting of non-employee
directors or our President authorized by the board to grant options or awards to
eligible persons who are not executive officers. Under the 1999 stock incentive
plan, the board or the committee administering the plan has the authority to,
among other things:
. select the employees to whom stock options and other incentive awards will
be granted;
. determine the type, size and the terms and conditions of stock options and
other incentive awards; and
. establish the terms for treatment of stock options and other incentive
awards upon a termination of employment.
We have authorized shares of common stock for issuance under the 1999 stock
incentive plan for the grant of stock options and other incentive awards to
eligible individuals. The 1999 stock incentive plan will terminate on June 30,
2009. The board of directors will be able to at any time and from time to time
amend or terminate the 1999 stock incentive plan; provided, however, that, to
the extent necessary under applicable law, no such change will be effective
without the requisite approval of our stockholders. In addition, no such change
will alter or adversely impair any rights or obligations under any stock options
and other incentive awards previously granted, except with the written consent
of the grantee.
Options under the plans have a term of ten years and are generally granted
with an exercise price equivalent to fair market value at the date of grant.
Individual option grants vest over time, based upon a schedule approved by our
board of directors, which is generally four years. All of our common stock
options vest automatically upon a change in control, as defined in the plan
documents.
Our 1997 incentive share plan became effective on June 16, 1997. On April 1,
1998, our board of directors approved and adopted an amendment and restatement
of the plan which was subsequently approved and adopted by our stockholders on
April 27, 1998. While other types of awards were permitted under the plan, we
only granted non-qualified stock options under the 1997 plan. Options under the
1997 plan have a term of ten years and were generally granted with an exercise
price equivalent to fair market value at the date of grant. Individual option
grants vest over time, based upon a schedule approved by our board of directors,
which was generally four years. All of our common stock options vest
automatically upon a change in control, as defined in the 1997 plan. Our
compensation committee administered the 1997 plan. As of December 31, 1999,
options for 2,616,788 shares granted under the 1997 plan remained outstanding.
We do not expect to make any further grants or awards under the 1997 plan.
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, plus reimbursement for reasonable expenses incurred in conjunction
with attending meetings. The Company did not make any cash compensation payments
to the Directors in 1999, 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 45,040 shares of the Common Stock at $1.95 per share, with options to
purchase 11,260 of such shares vesting on each of the first four anniversaries
of the date of grant. On April 22, 1999, our board accelerated the vesting of
11,260 of Mr. Salameh's options otherwise due to vest on May 28, 1999 as a
result of his service on the board. On April 22, 1999, we granted each of our
new outside directors options to purchase 45,040 shares of common stock at $9.77
per share, with options to purchase 11,260 shares vesting on each of the first
four anniversaries of the date of grant.
Compensation Committee Interlocks and Insider Participation
In 1999, a compensation committee consisting of Kwok Li, William R. Wilson and
Roy Wilkens, determined the compensation of our executive officers consistent
with guidelines established by the board of directors. Mr. Li and Mr. Wilson are
executive officers of Splitrock.
36
<PAGE>
Samer Salameh, a member of our board of directors until April 1999, is
chairman of the board of directors of Prodigy, our principal customer, and James
M. Nakfoor, a current member of our board of directors, has been a member of
Prodigy's board of directors and its compensation committee since September
1997. We have entered into an agreement to provide network services to Prodigy
for its subscribers in exchange for a monthly service charge. During the fiscal
year ended December 31, 1999, we received approximately $76.6 million in
revenues from Prodigy.
Excise Tax Agreements Related to the Merger
In January, 2000, we entered into excise tax agreements with Mssrs. Fugate,
Boatner, McGettigan, Rosado and Todd Wilkens, each of whom may be subject to
excise tax under Section 280G of the Internal Revenue Code of 1986, as amended,
as a result of the merger. Under the excise tax agreements, if any amount
payable to any of these individuals is a "parachute payment" within the meaning
of the Code and is subject to the excise tax imposed on such parachute payments,
Splitrock will make an additional payment to the executive officer or director.
The additional payment will be equal to the amount of the excise tax payable by
the individual plus any income and excise taxes payable by the individual with
respect to this additional payment. We may also enter into excise tax
agreements with Mssrs. Wilson, Turner, Nakfoor, Roy Wilkens, and the other
employees of Splitrock who may be subject to the same excise tax.
37
<PAGE>
Item 12. Security Ownership of Certain Beneficial Owners and Management
The following beneficial ownership table sets forth information regarding
beneficial ownership of Splitrock common stock as of February 1, 2000 by:
. each person or entity who is known to Splitrock to own beneficially
more than 5% of the Splitrock common stock
. each director of Splitrock
. the chief executive officer and four other most highly compensated
officers of Splitrock
. all of the executive officers and directors of Splitrock as a group
Under the Exchange Act, a person is deemed to be a ``beneficial owner'' of a
security if he or she has or shares the power to vote or direct the voting of
the security or the power to dispose or direct the disposition of the security.
A person is also deemed to be a beneficial owner of any securities of which that
person has the right to acquire beneficial ownership within 60 days. More than
one person may be deemed to be a beneficial owner of the same securities. The
percentage ownership of each stockholder is calculated based on the total number
of outstanding shares of common stock as of the record date plus those shares of
common stock that the stockholder has the right to acquire within 60 days.
Consequently, the denominator for calculating the percentage ownership may be
different for each stockholder.
The table is based upon information supplied by the directors and executive
officers. Unless otherwise indicated in the footnotes to the table, each of the
stockholders listed has sole voting and dispositive power with respect to the
shares shown as beneficially owned. The number of shares includes shares of
common stock that the individuals named in the table have the right to acquire
within 60 days from the record date upon exercise of options and warrants.
<TABLE>
<CAPTION>
Beneficially Owned Securities
Number of Shares Beneficially
Owned Includes
Total Number _________________________ Percentage
of shares Securities Securities Of Shares
Beneficially Underlying Underlying Beneficially
Owned Warrants Options Owned
------------ -------------- ------------- -------------
<S> <C> <C> <C> <C>
Kwok Li........................................... 21,561,543 62,704 -- 37.8%
Linsang Partners, LLC............................. 15,425,848 62,704 -- 26.9%
8301 Professional Drive
Landover, MD 20785
William R. Wilson................................. 9,439,600 -- -- 16.6%
Roy A. Wilkens.................................... 309,650 -- 11,260 *
Marshall C. Turner................................ 28,150 -- -- *
Patrick J. McGettigan............................. 68,895 -- 67,895 *
James M. Nakfoor.................................. -- -- -- *
Todd W. Wilkens................................... 377,840 -- 375,340 *
David M. Boatner.................................. 56,300 -- 56,300 *
Jorge Rosado...................................... 1,000 -- -- *
J. Robert Fugate.................................. 50,263 -- 50,263 *
Carso Global Telecom S.A.de C.V. de C.V........... 14,075,000 -- -- 24.7%
Insurgentes Str #3500
Col. Pena Pobre
Mexico, D.F. 14060
Directors and executive officers as a
group (10 people)................................ 31,893,241 62,704 561,058 35.9%
</TABLE>
________________* Less than 1%.
The shares beneficially owned by Mr. Li include 144,700 shares owned by his
spouse, 30,402 shares owned by his minor children, and 15,425,848 shares owned
beneficially and of record by Linsang, a limited liability company controlled by
Mr. Li, and members of his family.
38
<PAGE>
The shares beneficially owned by Linsang include 62,704 shares issuable upon
exercise of warrants included as part of the units purchased by Linsang in the
senior notes offering.
The shares beneficially owned by Mr. Nakfoor exclude stock owned by Carso
Global Telecom, S.A. de C.V. Carso Global is an affiliate of Grupo Financiero
Inbursa, S.A. de C.V. and Mr. Nakfoor is a Vice President of Inbursa. Mr. Carlos
Slim Helu, a Mexican citizen, and 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
Global.
The shares beneficially owned by Mr. Wilkens are held by Mr. Wilkens and
Sandra L. Wilkens jointly. These shares exclude 377,840 shares attributable to
vested options beneficially owned by Mr. Wilkens' son and 152,010 shares owned
by other family members of Mr. Wilkens.
The shares beneficially owned by Mr. Turner do not include shares
beneficially owned by Linsang, of which Mr. Turner is a director.
Change in Control
Splitrock entered into an amended and restated agreement and plan of merger,
dated as of February 11, 2000, with McLeodUSA and its wholly-owned subsidiary,
Southside Acquisition Corporation. The merger agreement provides for two
distinct but related transactions:
. a holding company reorganization, in which Splitrock Merger Sub, Inc., a
wholly owned subsidiary of Splitrock Holdings, Inc., will merge with and
into Splitrock Services, Inc. and Splitrock Services will become a wholly
owned subsidiary of Splitrock Holdings, Inc.; and
. a merger in which Splitrock Holdings will become a wholly owned subsidiary
of McLeodUSA.
As a result of the reorganization and the merger, each share of Splitrock
common stock, including the warrant shares offered in this registration
statement, will be converted into the right to receive 0.5347 of a share of
McLeodUSA Class A Common Stock. The reorganization and the merger are intended
to be tax-free to the stockholders of Splitrock. Holders of Splitrock's common
stock will vote on a proposal to approve the merger agreement at a meeting to be
held on March 30, 2000. Stockholders of Splitrock holding approximately 52.3%
of the outstanding shares of Splitrock common stock have agreed to vote in favor
of the approval of the merger agreement.
Item 13. Certain Relationships and Related Transactions
In September 1997, Orient Star, a wholly owned subsidiary of Carso Global,
purchased 11.3 million shares of our common stock for $12.5 million. Orient Star
subsequently acquired, pursuant to an option, an additional 2.8 million shares
for $3.1 million and merged into Carso Global. Carso Global held approximately
24.7% of our outstanding common stock at December 31, 1999. Samer Salameh, the
Chairman of Prodigy, an affiliate of Carso Global, was a member of our board of
directors from April 1998 to April 1999, when he was succeeded on the board of
directors by James Nakfoor, another director of Prodigy. In July 1999, Samer
Salameh, exercised in full a stock option previously granted to him and
purchased 11,260 shares of our common stock for $.02 million. Mr. Nakfoor is
Vice President of another Carso Global affiliate, Inversora Bursatil, S.A. de
C.V., a wholly-owned subsidiary of Grupo Financiero Inbursa, S.A. de C.V. Carso
Global is a controlling stockholder of Prodigy and an affiliate of Telefonos de
Mexico. We are currently testing connectivity between our network and Telmex's
network in anticipation of possible future business relationships. As a result
of Mr. Nakfoor's relationships with Carso Global and Prodigy, conflicts of
interest may arise, including conflicts relating to potential corporate
opportunities. If any conflict arises, we anticipate that the non-interested
members of the board of directors will pass on the appropriateness of any
particular matter.
In August 1999, Clark McLeod, Chief Executive Officer of McLeodUSA, exercised
in full a stock option previously granted to him and purchased 11,260 shares of
our common stock for $.02 million. Mr. McLeod was a member of our board of
directors from May 1998 to May 1999. We have signed a merger agreement with
McLeodUSA.
On August 6, 1999, we completed our initial public offering of 9,692,628
shares of our common stock at a price of $10.00 per share resulting in net
proceeds of approximately $88.4 million after deducting the underwriting
discount and other estimated fees and expenses payable by us. The underwriters
purchased 692,628 of the shares from us pursuant to an over-allotment option.
39
<PAGE>
Additionally, 157,372 shares were sold by certain of our stockholders, including
William R. Wilson and Patrick J. McGettigan, under the same over-allotment
option and we did not receive any proceeds from the sale of those shares.
In January 2000, some of our executive officers, directors and principal
stockholders who collectively own approximately 52.3% of our outstanding common
stock, including Kwok Li and William R. Wilson and their affiliates, agreed to
vote the shares over which they have voting control in favor of approving the
merger agreement with McLeod USA. Several of these stockholders who collectively
own approximately 50.5% of our outstanding common stock have also entered into
stock option agreements with McLeodUSA granting McLeodUSA an option to purchase
their Splitrock shares. The option is exercisable in specified circumstances,
including where a party other than McLeodUSA acquires or seeks to acquire us.
If McLeodUSA exercises the option, it will exercise control over all matters
requiring approval by our stockholders.
McLeodUSA has announced that if the merger is consummated, one of our
directors, Mr. Roy Wilkens will become the President and Chief Executive Officer
of Data Services Operations of McLeodUSA, which will include Splitrock. Mr.
Wilkens did not participate in our board's consideration of the merger
agreement.
40
<PAGE>
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:
<TABLE>
<CAPTION>
Exhibit
Number Description
- ---------------------- -------------------------------------------------------------
<S> <C>
3.1 - Restated Certificate of Incorporation of the Company. (2)
3.2 - Restated By-laws of the Company. (2)
4.1 - Form of certificate of common stock. (2)
4.2 - Indenture dated as of July 24, 1998, between Bank of Montreal Trust
Company (as trustee) and the Company. (1)
4.3 - Specimen 11-3/4% Series B Senior Note due 2008. (1)
4.4 - Escrow and Disbursement Agreement dated as of July 24, 1998, among the Chase
Manhattan Bank (as escrow agent), the Bank of Montreal Trust Company, and the
Company.(1)
4.5 - Exchange and Registration Rights Agreement dated as of July 24, 1998 by and
between Chase Securities, Inc. and the Company. (1)
4.6 - Warrant Agreement dated as of July 29, 1998 by and between the Company and
Bank of Montreal Trust Company. (1)
4.7 - Form of Warrant. (1)
4.8 - First Supplemental Indenture by and between Splitrock Services, Inc., and
Harris Trust and Savings Bank as Trustee, dated as of November 24, 1999. (7)
4.9 - Second Supplemental Indenture by and among Splitrock Services, Inc.,
Splitrock Leasing, LLC and Harris Trust and Savings Bank as Trustee, dated as
of December 22, 1999. (7)
10.1 - Purchase Agreement dated as of July 21, 1998, by and between the Company and
Chase Securities, Inc. (1)
10.2 - Plan of Merger dated as of May 7, 1998, by and between Splitrock Services,
Inc. (a Texas Corporation) and Splitrock Services, Inc. (a Delaware
Corporation). (1)
10.3 - Splitrock Full Service Agreement dated as of June 24, 1997 by and between
the Company and Prodigy Services Corporation (certain portions omitted
based on a grant of confidential treatment filed separately with the
Commission). (1)
10.4 - Amendment to Full Service Agreement between the Company and Prodigy
Communications Corporation dated May 18, 1999. (2) (3)
10.5 - Definitive Agreement dated as of June 24, 1997, by and between Prodigy
Services Corporation and the Company. (1)
10.6 - Transition Services Agreement dated as of June 24, 1997, by and between
Prodigy Services Corporation and the Company. (1)
10.7 - Network Implementation Agreement effective as of April 23, 1998, by and
between the Company and Ericsson, Inc. (1)
10.8 - Purchase Agreement effective July 1, 1997, by and between the Company
and Yurie Systems, Inc. (1)
10.9 - Customer Service Agreement effective April 1, 1998, by and between the
Company and International Business Machines Corporation ("IBM"). (1)
10.10 - IBM Customer Agreement effective April 1, 1998 by and between the
Company and International Business Machines Corporation. (1)
10.11 - Product Support Services Agreement dated February 27, 1998,
together with Addendum effective March 1, 1998. (1)
10.12 - Splitrock Services, Inc. 1997 Incentive Share Plan. (1)
10.13 - Employment Agreement effective March 15, 1997, between William R.
Wilson and the Company. (1)
10.14 - Employment Agreement effective September 1, 1998 between Patrick J.
McGettigan, Jr. and the Company. (1)
10.15 - Employment Contract effective March 15, 1999, between the Company
and David M. Boatner. (2)
10.16 - Employment Contract, effective March 22, 1999, between the Company
and J. Robert Fugate. (2)
10.17 - Cost Sharing National IRU Agreement effective April 26, 1999, by and
between Level 3 Communications, LLC and the Company. (2) (3)
10.18 - First Amendment to Cost Sharing National IRU Agreement by and
between Level 3 Comminations, LLC and the Company. (2) (3)
10.19 - Splitrock Services, Inc. 1999 Stock Incentive Plan. (2)
10.20 - Letter Agreement by and between David Boatner and Splitrock Services, Inc.,
dated as of November 30, 1999.
12.1 - Computation of Earnings to Fixed Charges. (7)
23.1 - Consent of PricewaterhouseCoopers LLP.
27.1 - Financial Data Schedule.
</TABLE>
41
<PAGE>
__________
(1) Incorporated by reference from our Registration Statement on Form S-4, File
No. 333-61293.
(2) Incorporated by reference from our Registration Statement on Form S-1, File
No. 333-97707.
(3) Portions of this exhibit have been redacted and are subject to an order for
confidential treatment issued by the U.S. Securities and Exchange
Commission.
(4) Incorporated by reference from our Registration Statement on Form S-4, File
No. 333-61293.
(5) Incorporated by reference from our Registration Statement on Form S-1, File
No. 333-97707.
(6) Portions of this exhibit have been redacted and are subject to an order for
confidential treatment issued by the U.S. Securities and Exchange
Commission.
(7) Incorporated by reference from our Post-effective Amendment on Form S-3 to
our Registration Statement on Form S-1, File No. 333-63001.
(b) Financial Statement Schedule
(1) Consolidated Financial Statements are set forth on pages F-2 through F-15
hereto. The index to the Consolidated Financial Statements is found on
page F-1.
(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
Year ended December 31, 1999.................... $25,745 $39,310 $ -- $65,055
Allowance for Doubtful Accounts:
Period from inception (March 5, 1997)
to December 31, 1997......................... $ -- $ -- $ -- $ --
Year ended December 31, 1998.................... $ -- $ 537 $ -- $ 537
Year ended December 31, 1999.................... $ 537 $ 866 $ -- $ 1,403
</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:
(1) A current report on Form 8-K dated January 6, 2000 reported the
Company's execution of a definitive merger agreement with McLeodUSA, Inc.
(2) An amended current report on Form 8-K/A dated February 11, 2000
reported the amendment and restatement of the Company's definitive merger
agreement with McLeodUSA, Inc.
(3) A current report on Form 8-K dated February 16, 2000 reported the
Company's earnings for the quarter ended December 31, 1999.
42
<PAGE>
SPLITROCK SERVICES, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
Page
----
<S> <C>
Financial Statements:
Report of Independent Accountants........................................................................................ F-2
Consolidated Balance Sheets as of December 31, 1998 and 1999............................................................. F-3
Consolidated Statements of Operations and Comprehensive Loss for
the Period from Inception (March 5, 1997) Through December 31, 1997
and the years ended December 31, 1998 and 1999........................................................................ F-4
Consolidated Statements of Stockholders' Equity(Deficit) for the Period from
Inception (March 5, 1997) Through December 31, 1999................................................................... F-5
Consolidated Statements of Cash Flows for the Period from Inception (March 5, 1997)
Through December 31, 1997 and the years ended December 31, 1998 and 1999.............................................. F-6
Notes to Consolidated Financial Statements............................................................................... F-7
Financial Statement Schedule:
Schedule II -- Valuation and Qualifying Accounts.........................................................................
</TABLE>
F-1
<PAGE>
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders of
Splitrock Services, Inc.
In our opinion, the consolidated financial statements listed in the index
appearing on page F-1, present fairly, in all material respects, the financial
position of Splitrock Services, Inc. and its subsidiary at December 31, 1998 and
1999, and the results of their operations and their cash flows for the period
from inception (March 5, 1997) to December 31, 1997 and for each of the two
years in the period ended December 31, 1999, in conformity with accounting
principles generally accepted in the United States. 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 consolidated 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
auditing standards generally accepted in the United States, 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
February 15, 2000
F-2
<PAGE>
SPLITROCK SERVICES, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except share and per share amounts)
ASSETS
<TABLE>
<CAPTION>
December 31,
----------------------
1998 1999
---------- ----------
<S> <C> <C>
Current assets:
Cash and cash equivalents..................................................................... $ 28,330 $ 92,593
Unrestricted investments -- short term........................................................ 120,475 5,441
Restricted investments -- short term.......................................................... 39,476 33,646
Accounts receivable, net of $537 and $1,403 allowance in 1998 and 1999,
respectively............................................................................... 3,205 11,292
Prepaid expenses and other current assets..................................................... 480 2,975
-------- ---------
Total current assets.................................................................. 191,966 145,947
Restricted investments -- long term............................................................. 19,001 140
Deposits........................................................................................ 270 11,910
Property and equipment, net..................................................................... 73,899 120,863
Intangibles, net................................................................................ 11,005 22,426
-------- ---------
$296,141 $ 301,286
======== =========
LIABILITIES AND STOCKHOLDERS' DEFICIT
Current liabilities:
Current maturities of capital lease obligations............................................... $ 9,121 $ 21,089
Accounts payable.............................................................................. 21,582 2,906
Accrued interest payable...................................................................... 13,375 14,141
Accrued liabilities........................................................................... 15,894 31,013
-------- ---------
Total current liabilities............................................................. 59,972 69,149
Senior notes payable ($261,000 face value net of unamortized discount )......................... 258,217 258,387
Capital lease obligations....................................................................... 8,243 18,934
-------- ---------
Total liabilities..................................................................... 326,432 346,470
Commitments and contingencies
Stockholders' deficit:
Preferred stock, $.001 par value, 25,000,000 shares authorized, no
shares issued.............................................................................. -- --
Common stock, $.001 par value, 150,000,000 shares authorized,
46,624,845 and 57,030,590 shares issued and outstanding as of
December 31, 1998 and 1999, respectively................................................... 47 57
Common stock warrants......................................................................... 2,849 1,750
Additional paid-in capital.................................................................... 34,717 124,461
Accumulated other comprehensive income (loss)................................................. 47 (180)
Accumulated deficit........................................................................... (67,951) (171,272)
-------- ---------
Total stockholders' deficit........................................................... (30,291) (45,184)
-------- ---------
$296,141 $ 301,286
======== =========
</TABLE>
The accompanying notes are an integral part of these consolidated
financial statements.
F-3
<PAGE>
SPLITROCK SERVICES, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS
(in thousands, except share and per share amounts)
<TABLE>
<CAPTION>
Period from
Inception
(March 5, 1997) to Year Ended Year Ended
December 31, 1997 December 31, 1998 December 31, 1999
------------------- ------------------ ------------------
<S> <C> <C> <C>
Revenue............................................................. $ 22,708 $ 63,611 $ 89,556
Operating expenses:
Splitrock network costs........................................... 2,362 32,912 87,398
Legacy network costs.............................................. 25,804 58,292 31,904
Selling, general and administrative............................... 1,276 6,390 21,386
Depreciation and amortization..................................... 3,500 13,850 27,322
----------- ----------- -----------
32,942 111,444 168,010
----------- ----------- -----------
Loss from operations................................................ (10,234) (47,833) (78,454)
Other income (expense):
Interest income................................................... 348 5,393 7,714
Interest expense.................................................. (235) (15,390) (32,581)
----------- ----------- -----------
Loss before income taxes............................................ (10,121) (57,830) (103,321)
Provision for income taxes.......................................... -- -- --
----------- ----------- -----------
Net loss............................................................ (10,121) (57,830) (103,321)
Other comprehensive income (loss):
Unrealized gain (loss) on securities.............................. -- 47 (180)
----------- ----------- -----------
Comprehensive loss.................................................. $ (10,121) $ (57,783) $ (103,501)
=========== =========== ===========
Net loss per share -- basic and diluted............................. $(0.42) $(1.30) $(2.03)
=========== =========== ===========
Weighted average shares -- basic and diluted........................ 24,109,823 44,388,948 50,866,855
=========== =========== ===========
</TABLE>
The accompanying notes are an integral part of these consolidated
financial statements.
F-4
<PAGE>
SPLITROCK SERVICES, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
Period From Inception (March 5, 1997) Through December 31, 1999
(in thousands, except share and per share amounts)
<TABLE>
<CAPTION>
Accumulated
Common Stock Common Additional Other
-----------------
Par Stock Paid-in Comprehensive Accumulated
Shares Value Warrants Capital Income (Loss) Deficit Total
---------- ----- --------- ---------- -------------- ------------ ----------
<S> <C> <C> <C> <C> <C> <C> <C>
Initial capitalization................... 15,764,000 $16 -- $ 12 -- -- $ 28
Issuance of Common Stock for
cash of $1.11 per share and
warrant.............................. 18,466,400 18 -- 20,482 -- -- 20,500
Conversion of note payable to
Common Stock at $1.11 per
share................................ 9,008,000 9 -- 9,991 -- -- 10,000
Net loss............................... -- -- -- -- -- $ (10,121) (10,121)
---------- --- ------- -------- ----- --------- ---------
Balance at December 31, 1997............. 43,238,400 43 -- 30,485 -- (10,121) 20,407
Unrealized gain on
securities........................... -- -- -- -- $ 47 -- 47
Issuance of warrants to
purchase 1,487,791 shares of
Common Stock in connection
with Senior Notes (Note 5)........... -- -- $ 2,849 -- -- -- 2,849
Exercise of stock options and
Warrant.............................. 3,386,445 4 -- 4,232 -- -- 4,236
Net loss............................... -- -- -- -- -- (57,830) (57,830)
---------- --- ------- -------- ----- --------- ---------
Balance at December 31, 1998............. 46,624,845 47 2,849 34,717 47 (67,951) (30,291)
Unrealized loss on
securities........................... -- -- -- -- (227) -- (227)
Exercise of stock options and
warrants............................. 713,117 1 (1,099) 1,322 -- -- 224
Sale of Common Stock under
public offering, net of
expenses............................. 9,692,628 9 88,422 88,431
Net loss............................... -- -- -- -- -- (103,321) (103,321)
---------- --- ------- -------- ----- --------- ---------
Balance at December 31, 1999............. 57,030,590 $57 $ 1,750 $124,461 $(180) $(171,272) $ (45,184)
========== === ======= ======== ===== ========= =========
</TABLE>
The accompanying notes are an integral part of these consolidated
financial statements.
F-5
<PAGE>
SPLITROCK SERVICES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
<TABLE>
<CAPTION>
Period from
Inception (March
5, 1997) through ------------------ ------------------
December 31, 1997 Year Ended Year Ended
------------------ December 31, 1998 December 31, 1999
------------------ ------------------
Cash flows from operating activities:
<S> <C> <C> <C>
Net loss.............................................................. $(10,121) $ (57,830) $(103,321)
Adjustments to reconcile net loss to net cash used in operating
activities:
Depreciation and amortization....................................... 3,500 13,850 27,322
Amortization of debt discount and deferred financing costs.......... -- 467 1,114
Changes in assets and liabilities:
(Increase) decrease in accounts receivable.......................... (4,252) 1,047 (8,087)
Increase in prepaid and other current assets........................ (221) (259) (2,495)
Increase (decrease) in accounts payable and accrued liabilities..... 8,861 28,615 (3,557)
Increase in accrued interest payable................................ -- 13,375 766
-------- --------- ---------
Net cash used in operating activities............................ (2,233) (735) (88,258)
-------- --------- ---------
Cash flows from investing activities:
Purchase of equipment................................................. (16,969) (45,261) (39,464)
(Purchase) liquidation of unrestricted investments.................... -- (119,462) 114,807
Reinvestment of interest earned on unrestricted investments........... -- (966) --
Reinvestment of interest earned on restricted investments............. -- (1,725) 28,194
Increase in deposits.................................................. (229) (41) (11,640)
Increase in intangibles............................................... -- (2,057) (12,509)
-------- --------- ---------
Net cash provided by (used in)investing activities............. (17,198) (169,512) 79,388
-------- --------- ---------
Cash flows from financing activities:
Proceeds from initial public offering, net of offering costs.......... -- -- 88,422
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) (2,079)
Restriction of cash under senior note agreement....................... -- (56,752) --
Sale of common stock and exercise of stock options and warrants....... 20,528 4,236 224
Proceeds from sale-leaseback of equipment............................. 1,152 960 --
Principal payments on capital lease obligations....................... (2,067) (11,548) (9,931)
Restriction of cash under credit agreement............................ (3,472) 3,472 (3,503)
-------- --------- ---------
Net cash provided by financing activities...................... 27,141 190,867 73,133
-------- --------- ---------
Increase in cash and cash equivalents................................... 7,710 20,620 64,263
Cash and cash equivalents:
Beginning of period................................................... -- 7,710 28,330
-------- --------- ---------
End of period......................................................... $ 7,710 $ 28,330 $ 92,593
======== ========= =========
Supplemental cash flow information:
Cash paid for interest................................................ $ 235 $ 1,536 $ 30,679
======== ========= =========
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 $ 32,590
======== ========= =========
Conversion of note payable to stockholder into common stock........... $ 10,000 $ -- $ --
======== ========= =========
Approximately $18,400 of the increase in accounts payable and
accrued liabilities at December 31, 1998, were related to
equipment purchases.
</TABLE>
The accompanying notes are an integral part of these consolidated
financial statements.
F-6
<PAGE>
SPLITROCK SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(amounts in thousands, except share and per share amounts)
1. 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 May 8, 1998. The Company
provides high-quality, nationwide telecommunication services on a flexible
multi-service platform.
On October 29, 1999 the Company formed Splitrock Leasing, LLC, a wholly-owned
subsidiary. The accompanying consolidated financial statements include the
operations of Splitrock Leasing, LLC. Significant intercompany accounts and
transactions have been eliminated in the consolidated financial statements.
The Company effected a 0.563-for-1 reverse stock split of its common stock on
July 12, 1999. All share and per share amounts included in these consolidated
financial statements have been retroactively adjusted to give effect to the
reverse stock split.
The following is a summary of the Company's significant accounting policies:
Use of Estimates. The preparation of the Company's consolidated 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 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 of more than three months and
a remaining maturity of less than one year at the date of purchase. At December
31, 1998 and 1999, 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 and 1999:
<TABLE>
<CAPTION>
Gross Gross
Amortized Cost Unrealized Gains Unrealized Losses Fair Value
------------------ ---------------- ------------------- ------------------
1998 1999 1998 1999 1998 1999 1998 1999
-------- -------- ------- ------- --------- -------- -------- --------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Available for sale securities:
Money market funds.............................. $ 23,557 $ 3,944 $ -- $ -- $ -- $ -- $ 23,557 $ 3,944
Corporate notes................................. 108,496 5,414 3 -- (80) (3) 108,419 5,411
Municipal securities............................ 12,061 -- -- -- (6) -- 12,055 --
U.S. Treasury notes............................. 34,791 30,049 181 5 (51) (182) __34,921 29,872
-------- ------- ----- ----- ----- ----- -------
$178,905 $39,407 $ 184 $ 5 $(137) $(185) $178,952 $39,227
======== ======= ===== ===== ===== ===== ======== =======
</TABLE>
At December 31, 1997, restricted investments represented collateral to support
an outstanding letter of credit. Restricted investments as of December 31, 1998,
represented escrowed funds that, together with interest received thereon, will
be sufficient to pay, when due, the first four semi-annual interest payments on
the Senior Notes. As of December 31, 1999, restricted investments included
$3,500 held as collateral to support outstanding letters of credits with the
remainder were held that, together with interest received thereon, will be
sufficient to pay, when due, the next two semi-annual interest payments on the
Senior Notes.
Concentration of Credit Risk. Financial instruments which potentially subject
the Company to concentration of credit risk are primarily cash and cash
equivalents, investments and accounts receivable. The Company's cash investment
F-7
<PAGE>
policies limit investments to short-term, investment grade instruments with
quality financial institutions. The Company's revenues and its accounts
receivable balances for the periods ended December 31, 1998 and 1999, were
largely derived from services provided to Prodigy, the Company's major customer
during the periods. Prodigy was the Company's only customer from inception
through December 31, 1997 and during 1998 and 1999 represented 99% and 85.5%,
respectively, of the Company's revenue. Management believes that the risk of
incurring material losses related to credit risks is 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, 1999, approximates $241,000, based upon quoted market prices.
Property and Equipment. Property and equipment are stated at cost. Shelters
are depreciated using the straight-line method over the estimated useful life of
twenty years. Depreciation and amortization of all other property and
equipment, including assets under capital leases, is initiated as it is placed
into service using the straight-line method over the estimated useful lives of
three to ten years from the date of installation.
Computer Software. Effective January 1, 1999, the Company adopted the
American Institute of Certified Public Accountants ("AICPA") 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
Deposits and Intangibles. At December 31, 1999, deposits include $11,200 paid
in connection with the fiber acquisition agreement with Level 3. Intangibles
consist primarily of debt issuance costs incurred in connection with the
issuance of our 11 3/4% Senior Notes, and other intangible assets such as
capitalized circuit charges, leasehold improvements and lease acquisition costs.
Debt issuance costs are amortized using the effective interest rate method. All
other intangibles are amortized by use of the straight-line method over their
estimated lives, which are generally two to five years. At December 31, 1998
and 1999, debt issuance costs, net of accumulated amortization, were $9,027 and
$10,183, respectively.
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, 1999.
Income Taxes. Deferred tax assets and liabilities are determined based on the
temporary differences between the consolidated 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.
Legacy Network Costs. Legacy network costs contain all expenses incurred in
connection with operating and decommissioning legacy networks. This includes
facility fees, line charges for legacy network POPs, certain personnel costs,
occupancy costs, equipment maintenance costs and access fees.
Comprehensive Loss. Effective January 1, 1998, the Company adopted SFAS No.
130, Reporting Comprehensive Income, as displayed in its Consolidated Statements
of Operations and Comprehensive Loss for all periods presented. This SFAS
establishes standards for reporting and display of comprehensive income and its
components. The Company's comprehensive loss is comprised of net loss and
unrealized gains and losses on available for sale securities.
F-8
<PAGE>
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 (loss) per share, which is based on the
weighted average number of common shares outstanding, and diluted earnings
(loss) per share, which is based on the weighted average number of common shares
outstanding and all dilutive potential common shares outstanding. At December
31, 1998, options to acquire 1,801,882 shares of Common Stock at the weighted-
average exercise price of $2.31 and warrants to acquire 1,487,791 shares of
Common Stock at $0.02 and at December 31, 1999, options to acquire 4,286,855
shares of Common Stock at the weighted-average exercise price of $7.78 and
warrants to acquire 914,730 shares of Common Stock at an exercise price of $0.02
were not included in the computation of diluted earnings per share because their
effect is anti-dilutive.
Segment Reporting. The Company conducts its business within one segment. The
Company presents its consolidated 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 ("SFAS No. 133"), which is effective for
fiscal years beginning after June 15, 1999, and establishes accounting and
reporting standards for derivative instruments. In June 1999, the FASB issued
SFAS No. 137, which deferred the effective date of SFAS No. 133 to June 15,
2000. 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 December 1999, the Securities and Exchange Commission issued Staff
Accounting Bulletin No. 101 ("SAB 101"), Revenue Recognition in Financial
Statements. SAB 101 provides guidance on applying generally accepted accounting
principles to revenue recognition issues in financial statements. The Company
will adopt SAB 101 as required in the first quarter of 2000 and does not expect
the adoption of this standard to have a material effect on it's financial
position of results of operations.
2. Prodigy Agreement
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
charges under this contract have increased from $3,000 to $4,000 and will
increase to $4,500 on July 1, 2000. Monthly maximum service charges 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. The agreement also allows Prodigy
to terminate its arrangement with the Company at any time upon the payment of a
termination charge. In February 2000, the Company amended the pricing and
extended the terms under its Full Service Agreement with Prodigy (see Note 11).
3. Property and Equipment
Property and equipment consisted of the following:
<TABLE>
<CAPTION>
December 31,
---------------------
1998 1999
--------- ----------
<S> <C> <C>
Telecommunications network equipment and shelters..................................................... $ 43,275 $ 76,103
Software.............................................................................................. 2,186 4,352
Furniture, fixtures and office equipment.............................................................. 1,749 5,429
Telecommunications network equipment under construction............................................... 13,289 9,982
-------- --------
60,499 95,866
Less -- accumulated depreciation...................................................................... (10,392) (21,884)
-------- --------
Purchased property and equipment, net............................................................... 50,107 73,982
-------- --------
Leased telecommunications network equipment........................................................... 29,102 51,315
Leased Software....................................................................................... -- 4,410
Leased office equipment............................................................................... 1,496 1,492
-------- --------
30,598 57,217
Less -- accumulated amortization...................................................................... (6,806) (10,336)
-------- --------
Leased property and equipment, net.................................................................. 23,792 46,881
-------- --------
Property and equipment, net........................................................................... $ 73,899 $120,863
======== ========
</TABLE>
F-9
<PAGE>
4. Accrued Liabilities
Acrued liabilities consisted of the following:
<TABLE>
<CAPTION>
December 31,
------------------
1998 1999
-------- --------
<S> <C> <C>
Access and transmission telecommunications line costs (Note 7).................. $ 3,172 $16,490
Telecommunications network equipment and shelters............................... 9,900 8,608
Other........................................................................... 2,822 5,915
------- -------
Accrued liabilities................................................. $15,894 $31,013
======= =======
</TABLE>
5. Indebtedness
The components of indebtedness are summarized as follows:
<TABLE>
<CAPTION>
December 31,
--------------------
1998 1999
--------- ---------
<S> <C> <C>
Senior Notes, net of unamortized discount of $2,783 and $2,613 $258,217 $258,387
-------- --------
$258,217 $258,387
======== ========
</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 1,487,791 shares of common stock ("the Senior Notes Offering"). Upon
issuance, the Senior Notes were recorded in the Company's consolidated 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 using the effective interest method. This
amortization will result in an increase in the consolidated financial statement
balance of the Senior Notes to a $261,000 face value by 2008. In November 1998,
the Senior Notes were exchanged for substantially the same terms in an offering
registered under the Securities Act of 1933.
Upon the occurrence of a change of control (as defined in the Indenture for
the Senior Notes) the Company will be required to make an offer to repurchase
all Senior Notes properly tendered at a price equal to 101% of the principal
amount plus accrued and unpaid interest to the date of repurchase. On January 6,
2000, the Company signed a definitive merger agreement, if approved, that will
constitute a change in control (see Note 11). The indenture also provides for
redemption of the Senior Notes at any time, in whole or in part, on or after
July 15, 2003 at a premium through July 15, 2005. In addition, on or prior to
July 15, 2001, the Company may redeem up to 35% of the original aggregate
principal amount of the Senior Notes at a premium with the proceeds of one or
more equity offerings.
The Senior Note indenture also restricts the Company's ability to incur
additional indebtedness, to create liens or other encumbrances, to make certain
payments, investments, loans and guarantees and to sell or otherwise dispose of
a substantial portion of assets to, or merge or consolidate with, an
unaffiliated entity. In October 1999, the Company paid the holders of the
Senior Notes $2,100 in consideration for modified terms which allowed the
Company to enter into a commitment for approximately $122,000 of capital lease
financing.
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 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, 1998 and
1999 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-10
<PAGE>
Deferred tax assets and liabilities consist of the following:
<TABLE>
<CAPTION>
December 31,
---------------------------------
1998 1999
--------------- ----------------
<S> <C> <C>
Net operating loss carryforwards.................................................... $ 22,465 $ 65,758
Depreciation........................................................................ 3,325 4,965
Other............................................................................... 429 1,082
-------- --------
Deferred tax assets............................................................... 26,219 71,805
-------- --------
Leases.............................................................................. (474) (6,750)
-------- --------
Deferred tax liabilities.......................................................... (474) (6,750)
-------- --------
Net deferred tax assets............................................................. 25,745 65,055
Valuation allowance................................................................. (25,745) (65,055)
-------- --------
Net deferred tax assets............................................................. $ -- $ --
-------- --------
</TABLE>
The Company's net operating loss carryforward totals approximately $173,000 of
which approximately $9,500 expires in 2012, $55,100 expires in 2018 and the
remainder in 2019. 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 $663 in 1998 and $5,131
in 1999.
Future minimum payments by year and in the aggregate related to noncancelable
operating and capital leases at December 31, 1999 are:
<TABLE>
<CAPTION>
Capital Operating
Leases Leases Total
--------- --------- --------
<S> <C> <C> <C>
2000.................................................................................... $22,956 $ 6,207 $29,163
2001.................................................................................... 11,004 7,061 18,065
2002.................................................................................... 10,366 6,962 17,328
2003.................................................................................... 384 6,912 7,296
2004.................................................................................... -- 5,806 5,806
------- ------- -------
Total minimum lease payments.................................................. 44,710 $32,948 $77,658
------- ======= =======
Less amount representing interest............................................. (4,687)
-------
Present value of minimum capital lease payments......................................... $40,023
=======
</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
consolidated 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. Line costs included in the Splitrock Network operating
costs were $22,617 and $67,131 during the year ended December 31, 1998 and 1999,
respectively. Line costs incurred during both years comprise a substantial
portion of the Network operating costs.
In October 1999, the Company entered into lease financing arrangements with a
third party leasing company to fund up to $122,000 of purchase commitments for
equipment, including optronics equipment. These lease arrangements were
originally structured as an operating lease, but were converted to a capital
lease after the Company obtained the necessary consents from the holders of the
Senior Notes. The consents were received on November 24, 1999. Capital leases
require payments on a monthly basis over periods ranging from 30 to 48 months,
with implicit interest rates of 9% to 12%.
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, 1999, the Company has incurred approximately $1,000 of such amount in
connection with this agreement.
In April 1999, the Company entered into a cost sharing agreement with a
national telecommunications provider (the Provider). The agreement grants the
Company an exclusive 20 year indefeasible right to use (IRU) in four dark fibers
in the nationwide fiber optic communication system currently under construction
by the Provider with an option to acquire the indefeasible rights to use up to
12 additional dark fibers, which expires April 26, 2000. The Company made an
initial payment of $11,200 to the Provider and is
F-11
<PAGE>
required to make additional payments as dark fiber segments are accepted, which
is expected to occur from the first quarter of 2000 through the first quarter of
2001. The Company's remaining obligation to retain its IRU in the original four
dark fibers approximates $81,600. In addition the Company is obligated to pay
its pro-rata portion of the maintenance costs incurred by the Provider for these
fiber strands for the term of the IRU.
In connection with the fiber optic network deployment, in October 1999, we
committed to purchase a minimum of approximately $50,000 of fiber optronics
equipment, associated network management systems, and installation services from
Nortel. The equipment and services are expected to be delivered through the
next five quarters as the dark fiber network is available.
On November 4, 1999, Ericsson, Inc. filed a Demand for Arbitration on a
"contract dispute" pursuant to the Commercial Arbitration Rules with the
American Arbitration Association concerning the Network Implementation
Agreement, between the parties. The Company has filed a counterclaim and
intends to vigorously defend the dispute pursuant to state tort and contract
causes of action, including negligent misrepresentation, fraud in the
inducement, breach of contract, failure to timely perform, failure to perform in
a good and workmanlike manner, breach of the duty of good faith, failure of
consideration and failure of essential purpose. The Company is seeking damages
by offset and credit. Both parties are in the process of selecting arbitrators
so that a preliminary hearing can be scheduled.
8. Equity Transactions
The Company effected a 1-for-100 stock exchange on June 3, 1997, a 1-for-10
stock exchange on August 8, 1997 and a 0.563-for-1 reverse stock split effected
July 12, 1999. All share amounts included in these consolidated financial
statements have been adjusted to reflect the effect of the stock exchanges and
reverse stock split.
Warrants issued in connection with the Company's Senior Note Offering are
exercisable at $.02 per share at any time on or after July 26, 1999 through July
15, 2008 for 1,487,791 shares of common stock. At December 31, 1999, warrants
for 914,730 shares of common stock remain unexercised.
On August 6, 1999, the Company completed its initial public offering of its
common stock pursuant to a Registration Statement filed with the Securities and
Exchange Commission. The Company sold 9,692,628 shares of common stock at a
price of $10.00 per share, which resulted in net proceeds of approximately
$88,400 after deducting the underwriting discount and other fees and expenses.
The underwriters purchased 692,628 of these shares pursuant to an over-allotment
option. In addition 157,372 additional shares were sold, under the same
agreement, by certain existing shareholders. The Company did not receive any of
the proceeds from the sale of the 157,372 shares.
9. Stock Options
The Company's 1997 and 1999 Incentive Share Plans provide for options to
purchase up to 11,260,000 shares of common stock to be granted to certain
directors, employees or consultants of the Company. Options under the Plans
have terms of ten years and are 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 (see Note 11).
The following summarizes the activity for the Plans:
<TABLE>
<CAPTION>
1997 1998 1999
------------------- ------------------- -------------------
Weighted Weighted Weighted
Average Average Average
Exercise Exercise Exercise
Shares Price Shares Price Shares Price
--------- -------- --------- -------- --------- --------
<S> <C> <C> <C> <C> <C> <C>
Options outstanding at beginning of fiscal
year............................................................ -- -- 1,058,440 $1.11 1,801,882 $ 2.31
Granted......................................................... 1,058,440 $1.11 1,443,251 $2.97 3,094,798 $10.77
Exercised....................................................... -- -- 571,445 $1.94 140,056 $ 1.41
Canceled........................................................ -- -- 128,364 $1.49 469,769 $ 8.34
--------- --------- ---------
Options outstanding at end of year................................ 1,058,440 $1.11 1,801,882 $2.31 4,286,855 $ 7.78
</TABLE>
F-12
<PAGE>
The following table summarizes information about the Company's stock options
outstanding at December 31, 1999:
<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 1999 Life (Years) Price 1999 Price
- ---------------------------------------------- ------------ ------------ -------- ------------ --------
<S> <C> <C> <C> <C> <C>
$1.11 - $1.95................................. 1,186,739 7.74 $ 1.18 696,018 $1.14
$5.95 - $11.25................................ 2,604,771 9.33 $ 9.10 97,581 $5.95
$13.88 - $24.19............................... 495,345 9.84 $16.70 -- $ --
--------- ---- ------ ------- --------
$1.11 - $24.19................................ 4,286,855 8.95 $ 7.78 793,598 $1.73
</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 and 1999, the Company recognized
compensation expense of $46 and $0 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 Pro forma
through Year ended Year ended
December 31, December 31, December 31,
1997 1998 1999
------------- ------------- -------------
<S> <C> <C> <C>
Net loss.................................................................... $(10,141) $(58,254) $(105,322)
Net loss per share -- basic and diluted..................................... (0.42) (1.31) (2.07)
</TABLE>
Options granted in 1997, 1998 and 1999 had weighted-average fair values of
$0.077, $1.00, and $6.42, 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%, 4.39% and 5.36%, assumed no volatility, 70.5% and 75% volatility, and
assumed expected life of the options of five, four and four years in 1997, 1998
and 1999, 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
$427 in equipment through December 31, 1998 and $17,600 in products and services
during the year ended December 31, 1999.
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 former director of the Company exercised a option to purchase 563,000 shares
of the Company Common Stock for $1,100 in June 1998 and 11,260 shares of the
Company common stock for $22 in August 1999.
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
11,260,000 shares of the Company for $1.11 per share and paid $0.10, for a
warrant to purchase an additional 2,815,000 shares of the Company through
September 18, 1998 for $1.11 per share. The warrants were exercised in September
1998.
F-13
<PAGE>
11. Subsequent Events
On February 11, 2000 the Company signed an amended and restated merger
agreement with McLeodUSA Incorporated ("McLeod"). Splitrock's shareholders will
receive 0.5347 shares of McLeod Class A common stock for each share of Splitrock
common stock. Splitrock will become a wholly owned subsidiary of McLeod if the
proposed transaction closes. The transaction is expected to close at the end of
the first quarter of 2000. This merger will constitute a change in control as
discussed in Note 5. Should the Senior Notes be redeemed at the request of the
holders, an extraordinary loss of approximately $14,000 would be recognized.
Also on January 6, 2000, Splitrock entered into a secured Revolving Credit
Agreement with Citibank USA, Inc. (the "Credit Agreement"), a Master Services
Agreement with McLeod for Internet dial-access services (the "Master Services
Agreement") and a Letter of Intent to sell bandwidth capacity (the "Bandwidth
Capacity Letter") to McLeod.
The Credit Agreement, the proceeds of which can be used for capital
expenditures and general working capital, will give Splitrock access to $115,000
in staggered tranches available through March 31, 2001 on which date all amounts
become due and payable. Citibank could declare the revolving loans immediately
due and payable upon a change of control as defined in the agreement. The
lenders shall make the following amounts, in U.S. dollars, available to
Splitrock from March 1, 2000 through March 31, 2000; from April 1, 2000 through
April 30, 2000; from May 1, 2000 through May 31, 2000; from June 1, 2000 through
June 30, 2000; and from July 1, 2000 through March 31, 2001, respectively:
$20,000; $55,000; $85,000; $105,000; and $115,000. Interest will be charged at
Citibank, N.A.'s Alternative Base Rate (the "CABR") plus 4.00% until July 6,
2000; at CABR plus 4.50% from July 7, 2000 through October 6, 2000 and at CABR
plus 5.00% thereafter.
Splitrock will provide wholesale Internet dial-access services to McLeod over
a 2-year term for a minimum of $15,000 under the Master Services Agreement.
Payments under this agreement will not be due until borrowings under the credit
agreement are fully utilized, but no later than December 31, 2000.
Under the Bandwidth Capacity Letter, Splitrock and McLeod will execute a
definitive agreement to provide McLeod with DS-3 miles of capacity on
Splitrock's fiber network over a twenty year term for total consideration of
$90,000. McLeod may terminate the agreement if a change of control occurs at
Splitrock. The purchase price will not be payable until borrowings under the
Credit Agreement and payments under the Master Services Agreement are fully
utilized, but no later than March 31, 2001.
In February 2000, the Company revised its agreement with Prodigy to convert
the pricing formula from a subscriber based arrangement to a fixed hourly fee
for usage effective January 1, 2000. As part of this amendment, the term of the
contract was extended to December 31, 2001. In January, the impact of this
change in price resulted in a decline of revenues from Prodigy by 2.9%.
F-14
<PAGE>
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 17 day of March, 2000.
SPLITROCK SERVICES, INC.
By: /s/ William R. Wilson
--------------------------
William R. Wilson
President and Chief Executive Officer
The undersigned directors and officers of Splitrock Services, Inc. hereby
constitute and appoint William R. Wilson and Patrick J. McGettigan, Jr. and each
of them with full power to act without the other and with full power of
substitution and resubstitution, our true and lawful attorneys-in-fact with full
power to execute in our name and behalf in the capacities indicated below this
Report on Form 10-K and any and all amendments thereto, and to file the same,
with all exhibits thereto and other documents in connection therewith, with the
Securities and Exchange Commission and hereby ratify and confirm that all such
attorneys-in-fact, or any of them, or their substitutes shall lawfully do or
cause to be done by virtue hereof. 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
- ----------------------------- ----------------------------------- --------------
<S> <C> <C>
/s/ William R. Wilson
- ---------------------------- President, Chief Executive March 17, 2000
William R. Wilson Officer and Director
(Principal Executive
Officer)
/s/ Kwok Li
- ---------------------------- Chairman of the Board of Directors, March 17, 2000
Kwok Li and Chief Technical Officer
/s/ James Nakfoor
- ---------------------------- Director March 17, 2000
James Nakfoor
/s/ Marshall Turner
- ---------------------------- Director March 17, 2000
Marshall Turner
/s/ Roy A. Wilkens
- ---------------------------- Director March 17, 2000
Roy A. Wilkens
/s/ J. Robert Fugate
- ---------------------------- Executive Vice President March 17, 2000
J. Robert Fugate and Chief Financial Officer
</TABLE>
<PAGE>
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
<PAGE>
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:
<TABLE>
<CAPTION>
Exhibit
Number Description
- ---------------------- -------------------------------------------------------------
<S> <C>
3.1 - Restated Certificate of Incorporation of the Company. (2)
3.2 - Restated By-laws of the Company. (2)
4.1 - Form of certificate of common stock. (2)
4.2 - Indenture dated as of July 24, 1998, between Bank of Montreal Trust
Company (as trustee) and the Company. (1)
4.3 - Specimen 11-3/4% Series B Senior Note due 2008. (1)
4.4 - Escrow and Disbursement Agreement dated as of July 24, 1998, among the Chase
Manhattan Bank (as escrow agent), the Bank of Montreal Trust Company, and the
Company.(1)
4.5 - Exchange and Registration Rights Agreement dated as of July 24, 1998 by and
between Chase Securities, Inc. and the Company. (1)
4.6 - Warrant Agreement dated as of July 29, 1998 by and between the Company and
Bank of Montreal Trust Company. (1)
4.7 - Form of Warrant. (1)
4.8 - First Supplemental Indenture by and between Splitrock Services, Inc., and
Harris Trust and Savings Bank as Trustee, dated as of November 24, 1999. (7)
4.9 - Second Supplemental Indenture by and among Splitrock Services, Inc.,
Splitrock Leasing, LLC and Harris Trust and Savings Bank as Trustee, dated as
of December 22, 1999. (7)
10.1 - Purchase Agreement dated as of July 21, 1998, by and between the Company and
Chase Securities, Inc. (1)
10.2 - Plan of Merger dated as of May 7, 1998, by and between Splitrock Services,
Inc. (a Texas Corporation) and Splitrock Services, Inc. (a Delaware
Corporation). (1)
10.3 - Splitrock Full Service Agreement dated as of June 24, 1997 by and between
the Company and Prodigy Services Corporation (certain portions omitted
based on a grant of confidential treatment filed separately with the
Commission). (1)
10.4 - Amendment to Full Service Agreement between the Company and Prodigy
Communications Corporation dated May 18, 1999. (2) (3)
10.5 - Definitive Agreement dated as of June 24, 1997, by and between Prodigy
Services Corporation and the Company. (1)
10.6 - Transition Services Agreement dated as of June 24, 1997, by and between
Prodigy Services Corporation and the Company. (1)
10.7 - Network Implementation Agreement effective as of April 23, 1998, by and
between the Company and Ericsson, Inc. (1)
10.8 - Purchase Agreement effective July 1, 1997, by and between the Company
and Yurie Systems, Inc. (1)
10.9 - Customer Service Agreement effective April 1, 1998, by and between the
Company and International Business Machines Corporation ("IBM"). (1)
10.10 - IBM Customer Agreement effective April 1, 1998 by and between the
Company and International Business Machines Corporation. (1)
10.11 - Product Support Services Agreement dated February 27, 1998,
together with Addendum effective March 1, 1998. (1)
10.12 - Splitrock Services, Inc. 1997 Incentive Share Plan. (1)
10.13 - Employment Agreement effective March 15, 1997, between William R.
Wilson and the Company. (1)
10.14 - Employment Agreement effective September 1, 1998 between Patrick J.
McGettigan, Jr. and the Company. (1)
10.15 - Employment Contract effective March 15, 1999, between the Company
and David M. Boatner. (2)
10.16 - Employment Contract, effective March 22, 1999, between the Company
and J. Robert Fugate. (2)
10.17 - Cost Sharing National IRU Agreement effective April 26, 1999, by and
between Level 3 Communications, LLC and the Company. (2) (3)
10.18 - First Amendment to Cost Sharing National IRU Agreement by and
between Level 3 Comminations, LLC and the Company. (2) (3)
10.19 - Splitrock Services, Inc. 1999 Stock Incentive Plan. (2)
10.20 - Letter Agreement by and between David Boatner and Splitrock Services, Inc.,
dated as of November 30, 1999.
12.1 - Computation of Earnings to Fixed Charges. (7)
23.1 - Consent of PricewaterhouseCoopers LLP.
27.1 - Financial Data Schedule.
</TABLE>
__________
(1) Incorporated by reference from our Registration Statement on Form S-4, File
No. 333-61293.
(2) Incorporated by reference from our Registration Statement on Form S-1, File
No. 333-97707.
(3) Portions of this exhibit have been redacted and are subject to an order for
confidential treatment issued by the U.S. Securities and Exchange
Commission.
(4) Incorporated by reference from our Registration Statement on Form S-4, File
No. 333-61293.
(5) Incorporated by reference from our Registration Statement on Form S-1, File
No. 333-97707.
(6) Portions of this exhibit have been redacted and are subject to an order for
confidential treatment issued by the U.S. Securities and Exchange
Commission.
(7) Incorporated by reference from our Post-effective Amendment on Form S-3 to
our Registration Statement on Form S-1, File No. 333-63001.
<PAGE>
EXHIBIT 10.20
November 22, 1999
David M. Boatner
7 Watermark Way
The Woodlands, Texas 77381
Re: Potential Acceleration of Option Vesting Schedule
-------------------------------------------------
Dear David:
This letter will confirm that the Board of Directors has agreed to
accelerate the vesting of your unvested stock options on the terms set forth
below.
You were previously granted options to purchase 325,000 shares of our
common stock as follows:
. 225,200 shares at an exercise price of $9.77 per share, vesting in
four equal annual installments of 56,300 shares beginning March 1, 2000; and
. 99,800 shares at an exercise price of $10.00 per share, vesting in
four equal annual installments of 24,950 shares beginning on August 3, 2000.
If you continue to be employed as our Chief Marketing Officer through at
least August 4, 2000 and you provide us with ninety (90) days' written notice of
any termination by you of your employment, then upon termination of your
employment:
. all stock options which would otherwise have vested within the one
year period following the date of termination, shall automatically become fully
vested.
. the accelerated options shall be exercisable in four equal
installments during each of the four full calendar quarters immediately after
the date of termination; and
. each quarterly installment will expire if it is not exercised during
the relevant quarter.
<PAGE>
Options that have vested prior to termination of your employment will be
exercisable for a period of ninety [90] days thereafter, in accordance with the
terms of our option plans, and will thereafter expire if not exercised.
For example, if you were to deliver written notice to Splitrock on June 30,
2000 of your intention to terminate your employment on October 1, 2000, then (i)
the options to purchase 81,250 shares that vested prior to the date of
termination of your employment (i.e. 56,300 on March 1, 2000, and 24,950 shares
on August 3, 2000) would continue to be exercisable for a 90-day period (i.e.,
until December 29, 2000), and (ii) options to purchase 81,250 shares that would
otherwise not have vested until March 1, 2001 and August 3, 2001 would be
accelerated and vest on October 1, 2000. These accelerated options would be
exercisable as follows:
. options to purchase 20,312.5 shares could be exercised during the
quarter ending March 31, 2001 (and such options would expire if not exercised by
the end of that quarter);
. options to purchase 20,312.5 shares could be exercised during the
quarter ending June 30, 2001 (and such options would expire if not exercised by
the end of that quarter);
. options to purchase 20,312.5 shares could be exercised during the
quarter ending September 30, 2001 (and such options would expire if not
exercised by the end of that quarter); and
. options to purchase 20,312.5 shares could be exercised during the
quarter ending December 31, 2001 (and such options would expire if not exercised
by the end of the quarter).
This letter shall serve as an amendment to the formal stock option
agreements previously executed.
Sincerely,
William R. Wilson
President and CEO
<PAGE>
Exhibit 23.1
CONSENT OF INDEPENDENT ACCOUNTANTS
We hereby consent to the incorporation by reference in the Post-Effective
Amendment No. 1 to Form S-1 on Form S-3 (No. 333-63001) of our report dated
February 15, 2000 relating to the financial statements and financial statement
schedule, which appears in this Form 10-K.
PricewaterhouseCoopers LLP
Houston, Texas
March 16, 2000
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
This schedule contains summary financial information extracted from (a) the
Company audited consolidated financial statements for the year ended December
31, 1999 and is qualified in its entirety by reference to such (b) financial
statements included in the Company's Form 10K for the year ended December 31,
1999.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> DEC-31-1999
<PERIOD-START> JAN-01-1999
<PERIOD-END> DEC-31-1999
<CASH> 92,593
<SECURITIES> 5,441
<RECEIVABLES> 12,695
<ALLOWANCES> (1,403)
<INVENTORY> 0
<CURRENT-ASSETS> 145,947
<PP&E> 153,083
<DEPRECIATION> (32,220)
<TOTAL-ASSETS> 301,286
<CURRENT-LIABILITIES> 69,149
<BONDS> 258,387
0
0
<COMMON> 57
<OTHER-SE> (45,241)
<TOTAL-LIABILITY-AND-EQUITY> 301,286
<SALES> 89,556
<TOTAL-REVENUES> 89,556
<CGS> 87,398
<TOTAL-COSTS> 168,010
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 32,581
<INCOME-PRETAX> (103,321)
<INCOME-TAX> 0
<INCOME-CONTINUING> (103,321)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (103,321)
<EPS-BASIC> (2.03)<F1>
<EPS-DILUTED> (2.03)
<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>
