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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ___________ to ___________
Commission file number 333-64717
US XCHANGE, L.L.C.
(Exact name of registrant as specified in its charter)
MICHIGAN 38-33505418
(State or Other Jurisdiction of (I.R.S. Employer Identification No.)
Incorporation or Organization)
20 MONROE AVENUE NW, SUITE 450, GRAND RAPIDS, MICHIGAN 49503
(Address of Principal Executive Offices) (Zip Code)
Registrant's telephone number, including area code: (616) 493-7000
Securities registered pursuant to Section 12(b) of the Act:
NONE
Securities registered pursuant to Section 12(g) of the Act:
NONE
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes |X| No |_|
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. |X|
At March 25, 1999, all of the membership interests of the registrant were
held by two affiliates of the registrant.
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PART I
ITEM 1. BUSINESS.
EXCEPT FOR HISTORICAL INFORMATION, THE FOLLOWING DESCRIPTION OF US
XCHANGE'S BUSINESS CONTAINS FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS AND
UNCERTAINTIES. OUR ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THOSE SET FORTH
IN THESE FORWARD-LOOKING STATEMENTS AS A RESULT OF A NUMBER OF FACTORS,
INCLUDING, BUT NOT LIMITED TO, THOSE SET FORTH UNDER THE CAPTION "RISK FACTORS"
IN EXHIBIT 99.1 TO THIS ANNUAL REPORT ON FORM 10-K.
WHO WE ARE
US Xchange, L.L.C. is a full service, facilities-based competitive
telephone company. We provide bundled local and long distance telephone, data
and internet communications services over our own high speed digital networks
and switching systems. We offer our telecommunications services primarily in
Tier III Markets in the midwestern United States. We consider "Tier III Markets"
as metropolitan areas in the United States with populations ranging from 100,000
to 750,000. Our target customers include small and medium-sized businesses,
internet service providers and government and other institutional end users, as
well as residential end users. Our objective is to become the leading competitor
to the incumbent local telephone company, either Ameritech Corp. or GTE
Corporation, in each of our current markets, by offering complete,
cost-effective telecommunications solutions.
We commenced commercial operations in July 1997. Ronald H. VanderPol and
Richard Postma, our co-founders and Co-Chairmen, are experienced operators of
competitive telecommunications companies, including:
- City Signal, Inc., one of the country's first competitive local
telephone companies, which sold its Michigan operations to Brooks
Fiber Properties, Inc. in 1996 and sold certain other fiber properties
to Teleport Communications Group Inc. and a predecessor of Nextlink
Communications Inc.;
- Teledial America, Inc., a switch-based long distance reseller that was
sold to LCI International, Inc. in 1996; and
- Digital Signal, Inc., a carrier's carrier that was sold to a
predecessor of Qwest Communications International Inc. in 1990.
Mr. VanderPol has invested $60 million in equity of the Company. Our senior
management team includes individuals with over 100 years of collective
experience in the telecommunications industry, including key executives with
significant experience in telecommunications marketing, network design,
deployment and operation, operations support and other back office systems,
finance and regulatory affairs.
We are a Michigan limited liability company, and our principal executive
offices are located at 20 Monroe Avenue NW, Suite 450, Grand Rapids, Michigan
49503. Our telephone number is (616) 493-7000.
WHERE WE PROVIDE TELECOMMUNICATIONS SERVICES
We provide telecommunications services in eight commercial regions in
Wisconsin, Indiana, Illinois and Michigan. Upon entering a market, we initially
resell the services of the incumbent local telephone company. As each of our
local networks and switching systems becomes commercially operational in that
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market, we transition our resale customers to our own facilities-based services.
As of December 31, 1998, we had switches and local fiber optic networks that
were commercially operational in Appleton, Green Bay, Milwaukee, Madison and
Oshkosh, Wisconsin, and in South Bend, Indiana. During the first calendar
quarter of 1999, our switches and networks in Bloomington, Ft. Wayne, Elkhart
and Evansville, Indiana and Rockford, Illinois became operational. We own all of
these switches and local fiber networks, except for part of the network in
Milwaukee, where we lease transmission capacity and related electronic equipment
connected to our own host switch. We are currently deploying switches
and local networks in each of our other markets in Wisconsin, Indiana
and Michigan. See "-Markets" below.
HOW OUR NETWORKS WORK
We interconnect our networks with all or substantially all of the central
offices of the incumbent local telephone company and the "points of presence,"
or "POPs," of the principal long distance providers in each of our markets. A
central office is a switching center, or central switching facility, of the
incumbent local telephone company. Incumbent telephone companies often collect
calls from multiple central offices at an "access tandem," which is an
interconnection point on their local networks where they then transmit calls to
other central offices or to a long distance carrier's POP. A POP is a location
where a long distance telephone company has installed transmission equipment
that serves as, or relays calls to, a network switching center of the long
distance company.
We also obtain "last mile" connections to our customers primarily through
unbundled network elements that we lease from the incumbent local telephone
company. Unbundled network elements are any of a number of facilities and
equipment that an incumbent local telephone company may lease to another
telecommunications provider, which then may offer its own telecommunications
services. Unbundled network elements include features, functions and
capabilities such as subscriber numbers, databases, signaling systems and
information sufficient for billing and collection or necessary to transmit or
route traffic or otherwise provide telecommunications services. In specific
cases, if customer demand justifies the cost, we can directly connect our
networks to our customers. We can also obtain access to our customers through
the use of wireless transmission capacity that we can lease from other
providers.
Our network design enables us to cost effectively access the entire
targeted customer base in a broad geographic area and avoid underutilized or
stranded investments in connections to customer premises. We believe these
design features substantially reduce our investment in facilities and our
ongoing operational expenses and provide us with a cost advantage over the
incumbent local telephone companies.
KEY OPERATING STATISTICS
As of December 31, 1998, US Xchange had:
- approximately $100.3 million in net networks and equipment;
- approximately 700 route miles of local and long haul optical fiber
deployed;
- approximately 23,000 access lines in service (of which approximately
12% were served by our own facilities);
- 13 local sales offices; and
- 615 full-time employees, including approximately 220 employees engaged
full time in our sales and marketing efforts.
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We have entered into interconnection agreements with Ameritech in Wisconsin,
Illinois, Indiana and Michigan and with GTE in Wisconsin, Illinois and Indiana.
We are certified as a competitive local telephone company in each of our
markets.
OUR BUSINESS STRATEGY
The principal elements of our business strategy include:
(1) focusing primarily on Tier III Markets in the Midwest;
(2) achieving early-to-market competitive and marketing advantages in
each of our markets;
(3) deploying networks and switching facilities that can serve customers
in an entire commercial region;
(4) fully integrating our networks throughout all of our commercial
regions;
(5) emphasizing our local presence to gain market share;
(6) installing high quality, flexible networks at a low cost; and
(7) implementing innovative, integrated and scaleable operations support,
customer care and billing systems.
OUR TELECOMMUNICATIONS SERVICES
We began providing services in July 1997. Upon entering a market, we
provide switched local, long distance and centrex services on a resale basis. As
each of our local networks and switching systems becomes commercially
operational, we are able to offer customers in that market a broader array of
integrated telecommunications products and services utilizing our own
facilities.
We currently offer the following facilities-based switched services:
TYPE OF SERVICE WHAT WE PROVIDE
--------------- ---------------
LOCAL SWITCHED We offer a full complement of local
SERVICES switched services, including local dial
tone, 911, directory assistance and
operator-assisted calling. We also offer
expanded local area calling plans that
are generally unavailable from the
incumbent local telephone company.
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TYPE OF SERVICE WHAT WE PROVIDE
--------------- ---------------
ADVANCED LOCAL The advanced software and equipment on
FEATURES our networks also allow us to offer
advanced local features to supplement
our local switched services, including:
- conference calling;
- speed dialing;
- call waiting;
- voice mail;
- call forwarding;
- caller ID;
- last number redial; and
- return calling.
We also offer a full range of advanced
intelligent network services, such as
end-user time-of-day routing and local
number portability, which we believe are
attractive features for many customers.
CENTREX Our switches are equipped with the
software and equipment needed to provide
centrex services to business customers
seeking a less costly alternative to
their own on-site private branch
exchange equipment to direct their
telecommunications traffic. Centrex
services include features such as direct
dialing within a given phone system,
direct dialing of incoming calls, voice
mail and other value-added services.
ADVANCED DATA We offer high speed, digital packet-
SERVICES switched data transmission services,
such as Integrated Services Digital
Network, or "ISDN," and have recently
begun offering frame relay services.
ISDN is a complex networking concept
designed to support more sophisticated
telecommunications services. These
services include high-speed data file
transfer, desktop videoconferencing,
telecommuting, data network linking and
other enhanced services that use a
variety of voice, data and digital
interface standards. Frame relay is a
high-speed switching service used to
transport "packets" of data between
computers, particularly in local area
networks.
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TYPE OF SERVICE WHAT WE PROVIDE
--------------- ---------------
LONG DISTANCE We provide a full range of domestic,
SERVICES international and toll-free 800/888 long
distance telephone services. We purchase
some of these services wholesale from
long distance carriers for resale to our
customers. We also provide our own
facilities-based long distance services
over leased and owned long haul fiber
that interconnects our local networks
and switches and through leased feature
group access to the access tandems of
the incumbent local telephone companies
in regions that are contiguous to our
owned facilities, as well as certain
other regions when cost and demand
justify.
DEDICATED ACCESS We offer private line, dedicated access
services to customers who desire high
capacity transmission connections to
long distance carrier points of presence
and to interconnect their own internal
networks. These customers are typically
larger businesses and governmental and
other institutional end users.
INTERNET We offer a variety of internet services
for both retail customers and internet
service providers. We offer dedicated
and dial-up high speed internet access
services via conventional modem
connections, ISDN and frame relay. We
market our retail internet services
under the US Xchange brand name. We
incorporate Netscape Communications
Corporation's high-end commercial
internet software products into our
internet services and receive technical
support for such products from Netscape.
We also offer individualized,
comprehensive turn-key internet services
to our business customers, including web
page hosting and design. We recently
began offering a full range of local and
internet access services on a wholesale
basis to internet service providers,
including local telephone numbers and
switched and dedicated access to the
internet.
PAGING, CELLULAR, PCS We currently offer paging services and
SERVICES intend to offer cellular/PCS services on
a resale basis by bundling such services
with our other service offerings.
OUR NETWORK DESIGN AND ARCHITECTURE
Recent developments in switching technologies have allowed us to
cost-effectively bundle our own switched local and long distance services with
services of other providers within the same switching platform. We deploy Class
5 switching systems and advanced transmission equipment throughout our networks.
All systems are equipped with advanced software and are designed to offer a full
complement of features and have the flexibility to add new services, including
broadband and wireless communications, without significant incremental cost.
We install Lucent Series 5ESS(TM)-2000 host switches and transmission
equipment in each of our commercial regions. Markets within certain of our
commercial regions are served only by a host switch,
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while others are served by a Lucent Series 5ESS(TM)-2000 EXM remote switch or
Lucent FAST(TM)-equipment. A remote switch is linked to a host switch through
high capacity fiber optic transmission lines for administrative functions. We
believe this remote switching equipment can provide substantially all of the
same telecommunications services as a host switch, even if the link connecting
them is temporarily interrupted, for approximately 33% to 50% of the
installation and operational costs of a host switch. We use FAST(TM) equipment
in markets with only one incumbent carrier central office to carry traffic from
such central office location to our host switch. By accommodating up to 3,500
access lines, FAST(TM) equipment serves as a cost-effective alternative to
standard subscriber loop carrier transmission equipment, which can only
accommodate up to 672 access lines. We believe our network architecture allows
us to cost-effectively provide our services in smaller markets and over a
broader geographic area.
Our owned networks consist of digital fiber optic cable backbones that
typically contain 72 fiber strands. These network backbones have the high
bandwidth transmission capacity needed to accommodate the rapidly increasing
demand for data communications services. We construct our local networks in a
ring design that allows for the routing of traffic simultaneously in both
directions around the ring. This provides an alternative transmission path in
the event of a fiber cut in the network. We also install back-up electronics
that become operational in the event of the failure of the primary network
components. We believe this built-in redundancy, by increasing the reliability
of our networks and systems, is important to customers with critical
communications requirements.
In Milwaukee, we operate our own host switch but lease local network
transmission capacity and related electronic equipment from another
telecommunications carrier pursuant to service agreements that expire in
December 2000 and April 2001. We pay this carrier aggregate monthly fees of
approximately $50,000 for these leased facilities. The leasing carrier may
terminate these agreements in the event of a material breach that we do not
correct within 30 days of our receipt of notice of the breach. We expect to
replace this leased capacity in the future with our own fiber if and when we
experience sufficient traffic volume growth to warrant this investment.
We connect our networks throughout our commercial regions in the Midwest
by constructing, leasing or acquiring long haul fiber transmission capacity. We
also lease feature group access to the access tandems of the incumbent local
exchange carrier to originate and terminate calls in regions bordering our owned
facilities, as well as certain other regions where cost and demand justify. We
believe that this allows us to reduce our use of the facilities of other
providers and transmit long distance calls for our customers at an attractive
cost.
We have acquired and plan to acquire long haul fiber linking certain of
our networks through swap and joint build arrangements with other providers.
Swap arrangements involve exchanges of indefeasible rights to use dark fiber.
Joint build arrangements involve cost-sharing construction of owned fiber. We
believe these arrangements provide a cost-effective means of acquiring the long
haul transmission capacity we need to interconnect our networks.
We monitor our fiber optic networks and switching and transmission
equipment seven days per week, 24 hours per day, using our network operations
control center in Grand Rapids, Michigan.
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OUR MARKETS
We evaluate each of our potential markets on the basis of the following:
- our "bottom up" analyses of the potential demand for our
telecommunications services, which includes analyses of certain
publicly available economic and demographic data and our
experience in similar markets;
- the level of actual and potential competition from other competitive
local telephone companies; and
- the disparity between the incumbent local telephone company's local
service pricing and our anticipated cost of providing comparable
service.
We believe that we can most effectively penetrate our markets by installing
networks and switching facilities that can address customers in an entire
commercial region. We believe that this regional focus enables us to
- take advantage of economies of scale in network marketing, management
and operation;
- cost-effectively address the available customer base in each of our
markets; and
- leverage the US Xchange brand name across the markets within a
commercial region.
The following table presents information concerning our current markets:
<TABLE>
<CAPTION>
OTHER LOCATIONS SWITCH AND
COMMERCIAL SUPPORTED BY RESALE NETWORK ROUTE ADDRESSABLE APPROXIMATE
REGION(1) HOST SWITCH(1) COMMENCEMENT(2) OPERATIONAL(2) MILES(3) COLLOCATIONS ACCESS LINES POPULATION(4)
- ---------------- ---------------- --------------- -------------- -------- ------------ ------------ -------------
<S> <C> <C> <C> <C> <C> <C> <C>
GREEN BAY/
APPLETON, WI 3Q/97 1Q/98 1 2 97,660 433,000
Oshkosh, WI 3Q/97 2Q/98 4 1 42,711 --
Green Bay, WI 3Q/97 2Q/98 23 4 114,196 337,000
MILWAUKEE, WI 3Q/97 3Q/98 70 7 260,876 1,799,000
Kenosha, WI 3Q/97 2Q/99 6 2 50,065 --
Racine, WI 3Q/97 2Q/99 4 2 61,085 --
MADISON, WI 3Q/97 3Q/98 28 5 156,984 649,000
Beloit, WI 3Q/97 2Q/99 12 1 25,031 --
Janesville, WI 3Q/97 2Q/99 1 1 41,808 234,000
SOUTH BEND, IN 1Q/98 4Q/98 20 4 137,580 349,000
Elkhart, IN 2Q/98 1Q/99 25 3 74,888 252,000
BLOOMINGTON, IN 2Q/98 1Q/99 15 2 75,193 235,000
FT. WAYNE, IN 2Q/98 1Q/99 50 8 183,900 680,000
EVANSVILLE, IN 3Q/98 1Q/99 30 3 74,888 518,000
ROCKFORD, IL 4Q/98 1Q/99 22 3 126,878 439,000
KALAMAZOO, MI 4Q/98 2Q/99 30 2 84,213 377,000
Battle Creek, MI 4Q/98 2Q/99 20 2 58,111 233,000
Grand Rapids, MI 1Q/99 2Q/99 25 5 234,386 1,009,000
</TABLE>
- ----------
(1) Host switch locations are indicated in bold type; remote switch locations
are indicated in standard type; and locations with other transmission
equipment are italicized.
(2) Quarter during which we began offering services on a resale basis or the
network or switch became or is planned to become commercially operational,
as the case may be.
(3) Does not include long haul fiber that interconnects networks. As of
December 31, 1998, we had deployed approximately 300 route miles of local
fiber and approximately 400 route miles of long haul fiber and we plan to
deploy approximately 1,000 additional route miles of local and long haul
fiber by the end of 1999.
(4) Cities whose populations are not included in this table are included with
other cities in the same commercial region. Populations are based on 1996
figures contained in the 1998 Rand McNally Commercial Atlas and Marketing
Guide.
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OUR SALES AND MARKETING EFFORTS
Our customer base includes both business and residential end users. We also
offer certain of our services on a wholesale basis to internet service
providers, utilities and other telecommunications providers.
We believe that rapidly establishing a broad, local market presence and
brand name recognition across both business and residential customer bases is
important for our success in our markets. To gain early entry into our markets,
we establish a local sales force in each market which offers switched local,
long distance and centrex services on a resale basis until we complete
construction of our networks and switch our customers to our own facilities. By
initially reselling other carriers' services, we build brand name recognition in
each of our markets and a customer base that we transition to our own networks
as they become operational. Typically, we have required approximately six to
nine months from the beginning of network construction in a market to the
provision of our own facilities-based switched services. To accelerate the
deployment of our networks, we have outsourced the installation and initial
service turn-up of our network systems to Lucent Technologies, Inc.
In each of our markets, we engage in market-wide US Xchange brand name
advertising campaigns, including print, television and radio advertisements,
that support both our business and residential marketing efforts. We also
utilize both inbound and outbound telemarketing programs and participate in
affinity group programs and marketing partnerships with local and regional
businesses, including utilities. These programs have a local market emphasis
tailored to each particular market. We believe that our locally oriented,
personalized sales and marketing organization and programs provides us
competitive advantages over less focused incumbent local telephone companies in
terms of image, service and customer loyalty.
We focus on providing responsive, personalized service to our customers on
a local market and regional basis. We establish sales offices serving, and
recruit our local managers from, each of our local markets. We also have inside
sales staff located in Green Bay, Wisconsin and at our headquarters in Grand
Rapids, Michigan. As of March 25, 1999, we had approximately 220 employees
engaged full time in our sales and marketing efforts, including approximately
200 persons staffing local sales offices in Wisconsin, Indiana, Illinois and
Michigan. Approximately 150 of these employees were quota-bearing sales
executives marketing our facilities based services. We also have agency programs
to supplement our internal marketing efforts.
In addition to their direct sales activities, our sales personnel provide
customer care services to our customers on both a local and regional basis. Our
support staffs in Green Bay and Grand Rapids provide customer care, seven days
per week, 24 hours per day, to customers who require support or service during
non-business hours.
OUR BUSINESS CUSTOMER STRATEGY
Our local sales forces primarily target small to medium-sized businesses in
their respective markets. We believe that a significant portion of these
customers prefer a single-source provider that can deliver a full range of
sophisticated and cost-effective solutions to their voice and data
telecommunications needs with excellent, personalized customer service. We also
believe that the incumbent local telephone companies typically do not have
effective "face-to-face" marketing and customer service programs that
specifically address the needs of these customers. We employ strategies designed
specifically to address these small and medium-sized businesses, including:
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- hiring and training specialized account executives dedicated to
developing this customer segment;
- increasing marketing efforts to shared tenant office buildings;
- developing special services and service packages that are attractive
to this market segment; and
- buliding US Xchange brand name recognition.
We also target larger businesses and governmental and other institutional
end users. These customers require maximum reliability, high quality solutions
and timely introduction of new and innovative services. We address the
requirements of these customers by providing:
- a specialized sales and service approach employing engineering and
sales professionals who design and implement cost-effective
telecommunications solutions;
- a strong, regional presence;
- ongoing development and integration of new telecommunications
services; and
- reliable, sophisticated networks and systems.
OUR RESIDENTIAL CUSTOMER STRATEGY
We also believe that there are attractive opportunities in our markets
for us to provide bundled telecommunications services to residential customers.
Our automated systems and procedures and the collocation of our networks in all
or substantially all of the incumbent carrier central offices enable us to
economically pursue sales to residential end users throughout our commercial
regions. We specifically target creditworthy residential customers who we
believe are likely to have needs for multiple services with various affinity
group and other cost-effective marketing programs and service packages designed
to appeal to such customers. We have developed affinity group programs with
certain utilities in our markets, including programs in which the utility
includes our marketing materials with its bills to its own customers, and with a
variety of local entities, such as minor league baseball teams and church
groups. We implement these programs in tandem with our other marketing programs
primarily directed towards business customers, including by marketing our
residential services to employees of our business customers.
OUR WHOLESALE STRATEGY
To further leverage our fixed costs, we have identified selective
channels for the sale of our services on a wholesale basis. For example, we have
begun offering our local and internet access services on a wholesale basis to
internet service providers in certain of our markets and have concluded an
exclusive arrangement with an interconnect company with over 200,000 access
lines in Indiana for the marketing of our services. We intend to establish other
strategic alliances with, and supply wholesale services to, electric utility
companies and other selected telecommunications providers for resale to their
own customers.
OUR INFORMATION AND PROCESSING SYSTEMS
To effectively serve our customers and manage our business, we rely
significantly on our automated operations support, customer care and billing
systems. We have either acquired these systems from, or
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developed them with, third party vendors with proven software and extensive
knowledge of these systems. We have recently completed the integration of our
provisioning, order entry and billing systems. This has allowed us to add more
efficiently to our customer base by processing new service orders and
provisioning new customers more quickly.
In addition to cost advantages, our automated information systems and
procedures for operations support and customer care provide us with a marketing
advantage by allowing us more quickly and efficiently to activate and change
services for our customers and provide more responsive customer support and
service. Unlike the legacy systems currently used by certain of the incumbent
local telephone companies, our systems are:
- scaleable;
- may be employed either centrally or in more than one location; and
- automate many of the functions that previously required multiple
manual entries of customer information to accomplish order management,
provisioning, switch administration and billing.
The incumbent carriers' legacy systems are not only labor-intensive but also
create numerous opportunities for errors in provisioning services and billing,
delays in installation, service interruptions, poor customer service, increased
customer churn and significant added expenses due to duplicated efforts and the
need to correct service and billing problems.
Our automated systems enter, schedule, provision and track a customer's
order from the point of sale to the installation and testing of service and
include automated interfaces with trouble management, inventory, billing,
collection and customer service systems. This permits more rapid service
activation, changes and repairs with fewer errors.
To initiate service for a customer either on a resale basis or using
unbundled network elements, we must interface with the systems of the incumbent
local telephone companies and wholesale long distance providers. We have
established arrangements for "electronic bonding" with approximately 95% of the
central offices of the incumbent telephone companies and certain of the long
distance carrier points of presence in our markets. Electronic bonding permits
us to provision customer service electronically on an "assume as is" or "assume
as specified" basis. We currently provision the remaining central offices and
points of presence in our markets via fax or e-mail order entry. We plan to work
actively to establish electronic bonding between our automated operations
support and customer care systems and the remaining central offices and points
of presence to the fullest extent possible.
We have developed a convergent billing system that interfaces with our
operations support systems and enables issuance of a single billing statement
for all of our local, long distance and internet services, as well as for any
third-party paging, cellular and other services we offer for resale. Among other
benefits, this system generates a single billing statement that is "user
friendly". It provides our customers with more enhanced billing detail and is
easier to read and understand. Our billing system has the ability to provide
multiple summary methodologies, handle multiple hierarchies for commercial
accounts and accommodate a variety of output media, including paper, electronic
datafile, web site access and diskette.
We believe that our automated, integrated information and processing
systems allow us to provide faster customer service initiation and changes,
greater billing accuracy and customization, and a superior level of customer
service.
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OUR COMPETITION
The telecommunications industry is highly competitive, and one of the
primary purposes of the U. S. Telecommunications Act of 1996 is to foster
additional competition. We believe that the principal competitive factors
affecting our business operations are competitive pricing, quality of services
and products, and innovative service and product offerings. We expect to
experience declining prices and increasing price competition. Our ability to
compete effectively will depend upon our ability to provide high quality,
market-driven products and services with excellent personalized customer service
at prices generally below those of our competitors.
We believe that our investment in high speed fiber optic ring networks,
advanced switching, transmission and related electronic equipment, and automated
operations support, customer care and billing systems, coupled with our emphasis
on personalized sales and customer care, provide us certain competitive
advantages. We believe this allows us to
- cost-effectively tailor our service offerings to meet the diverse
voice and data transmission needs of our customers, and
- provide our customers with the convenience of "one-stop shopping" for
bundled offerings of telecommunications services.
In each of our markets, we compete principally with the incumbent local
telephone company serving such market, either Ameritech or GTE. We expect to
face significant competitive product and pricing pressure from these companies
because the incumbent generally has
- long-standing relationships with its customers,
- financial, technical, marketing, personnel and other resources,
including brand name recognition, substantially greater than ours,
- the potential to fund competitive services with cash flows from a
variety of businesses, and
- a nearly monopolistic market share.
Increasing competition has led to consolidations among the
regional Bell operating companies, including the pending agreement of
SBC Communications, Inc. to acquire Ameritech. Following this combination, SBC
would be a coast-to-coast local telephone company with an estimated 30% of all
United States local access lines. SBC has also announced plans to enter an
additional 30 markets outside the territories of the combined entity. In
addition, Bell Atlantic Corporation has reached an agreement for the acquisition
of GTE. We expect that, as telecommunications providers continue to consolidate
and form additional strategic alliances, we will face significant new
competitors, including regional Bell operating companies who seek to operate
outside their current local service areas.
In each of our commercial regions, we also face significant competition
from other facilities-based competitive local telephone companies and long
distance carriers, which further increases the pricing pressures on our
business. After the investment and expense of establishing a network and support
services in a given market, the marginal cost of carrying an additional call is
negligible. We believe that Tier III markets will support only a limited number
of competitors and that operations in Tier III markets with multiple competitive
providers are likely to be unprofitable for one or more of the competitive
providers.
The following table sets forth the competitive local telephone companies
that currently provide local services or have started or announced plans for
either construction or sales activities in our current markets.
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<TABLE>
<CAPTION>
MARKET COMPETITIVE LOCAL TELEPHONE COMPANY
------ -----------------------------------
<S> <C>
Green Bay/Appleton, Wisconsin TDS Telecom, Inc.
McLeod USA Incorporated
Milwaukee, Wisconsin AT&T Local Services
Time Warner Telecom
MCI WorldCom, Inc.
McLeod USA Incorporated
Madison, Wisconsin KMC Telecom Holdings, Inc.
TDS Telecom, Inc.
McLeod USA Incorporated
Ft. Wayne, Indiana KMC Telecom Holdings, Inc.
Evansville, Indiana SIGECO Advanced Communications Inc.
Rockford, Illinois McLeod USA Incorporated
Kalamazoo, Michigan Climax Telephone Company
Grand Rapids, Michigan MCI WorldCom Inc.
</TABLE>
There may also be additional competitors with plans to enter our markets. We are
currently not aware of any competitive local telephone companies that provide or
have announced plans to provide local services in South Bend, Elkhart or
Bloomington, Indiana.
Prices in both the long distance business and the data transmission
business have declined significantly in recent years and we expect them to
continue to decline. We face competition from large long distance carriers such
as AT&T Corp., MCI WorldCom, Inc. and Sprint Corporation, as well as smaller
carriers, who have begun to offer integrated local, long distance and data
telecommunications services. AT&T recently acquired Teleport Communications
Group, Inc., a major competitive local exchange carrier, and
Tele-Communications, Inc., a major cable television company, and MCI WorldCom
has recently acquired local networks in approximately 100 cities. These
combinations have enhanced the ability of these carriers to offer bundled local
and long distance telecommunications services. Regional Bell operating companies
are also making concerted efforts to gain regulatory permission to offer their
own bundled local and long distance telecommunications services.
As telecommunications technologies continue to change rapidly, we expect
increasing competition in our markets from other potential competitors who may
be considered less traditional providers of telecommunications services,
including:
- cable television companies;
- microwave, satellite and other wireless telecommunications providers;
- providers of internet telephony services;
- electric utilities; and
- resellers.
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In particular, companies offering or preparing to offer internet-protocol-based
voice and data transmission services, such as Qwest Communications
International, Inc., Level 3 Communications, Inc., and Williams Communications
Group, are building nationwide networks that can access each of our markets.
Electric utilities and cable companies are also likely competitors given their
existing rights of way. Electric utilities using digital line power technologies
can transmit internet and data services over their power lines at speeds faster
than those achievable by telephone companies on their digital subscriber or
integrated services digital network lines. Other new technologies such as
internet telephony, cable modem service and wireless networks utilizing local
multi-point distribution services and satellite transmission, which can be used
to provide high capacity wireless local loop, local area network, internet
access and interactive services, have also created significant new competitors
that may have a lower cost basis than ours. We believe that there may also be an
increasing level of agent and distributor resale initiatives in our markets,
which may add further to competitive pricing pressures.
The World Trade Organization agreement on basic telecommunications could
further increase the level of competition we face. Under this agreement, the
United States and 68 other World Trade Organization members committed themselves
to opening their respective telecommunications markets to foreign ownership
and/or to adopting regulatory measures to protect foreign competitors against
anticompetitive behavior by dominant telecommunications companies. We expect
that this initiative will encourage foreign companies to expand their operations
into the United States. An example of this is the recently announced agreement
of Global Crossing, Ltd. to acquire Frontier Corp. for $11.2 billion.
REGULATION
Our services are subject to varying degrees of federal, state and local
regulation. The Federal Communications Commission exercises jurisdiction over
all facilities of, and services offered by, telecommunications common carriers
to the extent those facilities are used to provide, originate or terminate
interstate or international communications. The state regulatory commissions
retain jurisdiction over the same facilities and services to the extent they are
used to originate or terminate intrastate communications. Local governments also
sometimes impose franchise or licensing requirements on competitive local
telephone companies.
FEDERAL REGULATION
The Telecommunications Act of 1996 provides for comprehensive reform of
the nation's telecommunications laws and is designed to enhance competition in
the telecommunications industry and to prevent anti-competitive practices. The
1996 Act seeks to accomplish these goals by:
- removing state and local entry barriers,
- requiring incumbent local telephone companies to provide
interconnection to their facilities,
- facilitating end users' choices to switch service providers
from incumbent local telephone companies to competitive
providers such as US Xchange,
- requiring that services be accessible to and usable by persons
with disabilities, and
- requiring access to rights-of-way.
Under the 1996 Act, regional Bell operating companies have the
opportunity to provide in-region long distance services if they meet certain
conditions, and they are no longer prohibited from providing certain cable TV
services. In addition, the 1996 Act eliminates certain restrictions on utility
holding companies, thus clearing the way for them to diversify into
telecommunications services.
The 1996 Act specifically requires all telecommunications carriers
(including incumbent local telephone companies and competitive local telephone
companies such as US Xchange):
- not to prohibit or unduly restrict resale of their services;
- to provide dialing parity and nondiscriminatory access to
telephone numbers, operator services, directory assistance and
directory listings;
- to afford access to poles, ducts, conduits and rights-of-way; and
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<PAGE> 15
- to establish reciprocal compensation arrangements for the transport
and termination of telecommunications.
The 1996 Act also requires incumbent local telephone companies to
provide interconnection for the transmission and routing of local exchange
services (a) at any technically feasible point within the incumbent local
telephone company's network, (b) that is at least equal in quality to that
provided by the incumbent local telephone company to itself, its affiliates or
any other party to which the incumbent provides interconnection and (c) at rates
and on terms and conditions that are just, reasonable and nondiscriminatory.
Incumbent local telephone companies also are required under the 1996 Act
to provide nondiscriminatory access to network elements on an unbundled basis at
any technically feasible point, to offer for resale at wholesale rates their
telecommunications services offered at retail to subscribers who are not
telecommunications carriers and to facilitate the collocation of equipment
necessary for competitors to interconnect with or access the unbundled network
elements. The term "network element" means a facility or equipment used in the
provision of telecommunications services and includes features, functions and
capabilities that are provided by means of such facility or equipment (including
subscriber numbers, databases, signaling systems, and information sufficient for
billing and collection or used in the transmission, routing or other provision
of telecommunications services). The 1996 Act delegated authority to the FCC to
determine which network elements should be made available to competitive
providers on an unbundled basis, taking into consideration, at a minimum,
whether competitive access to proprietary elements is necessary and whether the
failure to provide such access would impair the ability of the competitive
provider to provide the services it seeks to offer. However, certain aspects of
the FCC regulations designed to implement these provisions are subject to
litigation as discussed below.
The 1996 Act also removed on a prospective basis most restrictions on
the regional Bell operating companies resulting from the consent decree which
provided for divestiture of the regional Bell operating companies from AT&T in
1984. The 1996 Act establishes procedures under which a regional Bell operating
company can enter the market for inter-LATA (i.e., long distance) services
within the area where it provides local exchange service (the 1996 Act
permitted the regional Bell operating companies to enter the out-of region long
distance market immediately upon enactment). Before the regional Bell operating
company can provide in-region long distance services, it must obtain FCC
approval upon a showing that facilities-based competition is present in its
local market, that the regional Bell operating company has entered into
interconnection agreements with competitors in the states where it seeks
authority, that the interconnection agreements satisfy a 14-point "checklist"
of competitive requirements and that such entry is in the public interest. To
date, such authority has not been granted to any regional Bell operating
company, but requests by regional Bell operating companies are the subject of
various pending petitions and appeals. The provision of in-region long distance
services by regional Bell operating companies in our markets would permit them
to offer bundled local and long distance services, thereby eliminating one of
our current marketing advantages.
FCC Rules Implementing the Local Competition Provisions of the
Telecommunications Act of 1996. On August 8, 1996, the FCC issued an order which
established a framework of minimum, national rules enabling state public utility
commissions and the FCC to begin implementing many of the local competition
provisions of the 1996 Act. The order promulgated rules to implement Congress'
statutory directive concerning the interconnection obligations of the incumbent
local telephone companies. The FCC prescribed certain minimum points of
interconnection necessary to permit competing carriers to choose the most
efficient points at which to interconnect with the incumbent local telephone
companies' networks. The FCC adopted a minimum list of unbundled network
elements that incumbent local telephone companies must make available to
competitors upon request and a methodology for states to use in establishing
rates for interconnection and the purchase of unbundled network elements. The
FCC also adopted a methodology
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<PAGE> 16
for states to use when applying the 1996 Act's "avoided cost standard" for
setting wholesale prices with respect to retail services. On July 18, 1997, the
U.S. Court of Appeals for the Eighth Circuit vacated certain portions of the
FCC's rules.
On January 25, 1999, the U.S. Supreme Court overturned the Eighth
Circuit's decision and reinstated the FCC's rules. The Supreme Court upheld (1)
the FCC's "all elements" rule (i.e., the rule that a competitive local
telephone company can elect to provide service completely through access to the
incumbent local telephone company's unbundled elements), (2) the FCC's pricing
rules and (3) the FCC's "pick and choose" rule, which allows competitive
providers to select portions of previously approved interconnection agreements
for their own use. The Supreme Court also upheld the FCC's expansive definition
of network elements which are defined to include operator and directory
assistance services, OSS systems and vertical switching features such as caller
ID, call forwarding and call waiting.
However, the Supreme Court held that the FCC, when it gave competitive
local telephone companies blanket access to all network elements did not
adequately address the statutory provisions of the 1996 Act which require it to
consider (1) whether access to an incumbent local telephone company's
proprietary elements is "necessary" and (2) whether the failure to provide a
competitive local telephone company with access to particular elements would
"impair" the ability of that competitive carrier to provide the services it
seeks to offer. Accordingly, the FCC will be required on remand to supply some
access limiting standard rationally related to the goals of the 1996 Act. This
creates some regulatory uncertainty as to which elements will be required to be
made available and could provide a basis for incumbent local telephone companies
to challenge their obligations under existing agreements.
The Supreme Court remanded the cases to the Eighth Circuit for
proceedings consistent with its opinion. On February 18, 1999, various incumbent
local telephone companies requested that the Eighth Circuit, among other
actions, delay executing the Supreme Court's judgment with respect to the core
pricing and other matters on which they lost jurisdictional arguments in the
Supreme Court, pending resolution of the issues before the Eighth Circuit on
remand. The FCC and various intervening competitive providers have opposed this
request. At this time, we cannot predict the outcome of this proceeding and its
impact on our business.
Advanced Data Services. On August 7, 1998, the FCC issued an opinion
which stated that advanced data services, such as high-speed internet access and
video telephony, offered by incumbent local telephone companies are subject to
the provisions of the 1996 Act regarding terms of and procedures for
interconnection with local telephone companies, and that the facilities and
equipment used to provide such advanced services are network elements that must
be provided to new entrants on an unbundled basis. The FCC also held that
incumbent local telephone companies must offer for resale, at wholesale rates,
any advanced services that they offer to subscribers that are not
telecommunications carriers. SBC Communications has petitioned the Eighth
Circuit to review the FCC's opinion in an effort to obtain permission to offer
advanced services free of the unbundling and resale requirements.
The FCC also proposed, in a notice of proposed rulemaking, to permit
incumbent local telephone companies to form separate affiliates that could offer
advanced services without giving competitors access to network elements at
discounted prices. Thus, the separate affiliates could install new data
equipment to upgrade incumbent local telephone company networks to digital
subscriber line standards without having to share the new networks with
competitors. To the extent that the affiliates provided interstate exchange
access service, they would be presumed to be nondominant and therefore not
subject to price cap or rate of return regulation for advanced services, and
would not be required to file tariffs for such services. The incumbent local
telephone companies, however, would be required to give their competitors and
the new
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<PAGE> 17
affiliates access on an equitable basis to the incumbent local telephone
companies' central offices to install data equipment, and would also have to
provide access on an equitable basis to their local loops conditioned for data
use.
The FCC's proposal would not change the existing prohibition on the
provision of services by incumbent local telephone companies across local access
and transport area, or "LATA," boundaries, although the FCC stated that it would
take comments on easing these restrictions in special cases. It is unclear at
this time whether the FCC's proposal will ultimately be adopted in its present
form or what effect such adoption may have, and the impact on our business is
therefore uncertain.
On March 18, 1999, the FCC issued an order requiring incumbent telephone
companies to make new collocation arrangements, including cageless and shared
collocation of equipment, available to competing carriers such as US Xchange.
The FCC also established spectrum compatibility rules in order to promote the
timely deployment of advanced services. The FCC also tentatively concluded that
it is technically feasible for two different carriers to share a single line to
provide traditional voice and advanced services.
Other Regulations. The FCC has established different levels of regulation
for dominant carriers and nondominant carriers. For domestic common carrier
telecommunications regulation, large incumbent local telephone companies such as
Ameritech and GTE, are currently considered dominant carriers, while competitive
local telephone companies such as US Xchange are considered nondominant
carriers. As a nondominant carrier, we are subject to relatively minimal FCC
regulation.
- Tariffs. As a nondominant carrier, we may install and operate
facilities for the transmission of domestic interstate communications
without prior FCC authorization. Services of nondominant carriers have
been subject to relatively limited regulation by the FCC, primarily
consisting of the filing of tariffs and periodic reports concerning the
carrier's interstate circuits and deployment of network facilities.
However, we are required to offer interstate services on a
nondiscriminatory basis, at just and reasonable rates, and we are subject
to FCC complaint procedures.
In October 1996, the FCC adopted a detariffing order which eliminated
the requirement that nondominant interstate carriers maintain tariffs on
file with the FCC for domestic interstate services, and which provided
that, after a nine-month transition period, relationships between
interstate carriers and their customers would be set by contract. Several
parties requested reconsideration and/or filed appeals of the FCC's
detariffing order, and the FCC issued a reconsideration order on August
20, 1997, which reversed certain aspects of the FCC's previous
regulations. The reconsideration order would still significantly limit
the ability of carriers to tariff long distance services. If US Xchange
is not permitted to tariff our long distance services, we would be
required to provide such services on contractual terms and forgo reliance
on filed rates.
- Local Number Portability. In the 1996 Act, Congress sought to remove
a perceived barrier to local telecommunications competition by requiring
local telephone companies to enable customers to keep their telephone
numbers when switching local carriers. Local telephone companies have
implemented such number portability in the 100 largest Metropolitan
Statistical Areas. Local telephone companies are also required to
implement number portability in other areas within six months of
receiving a request from a telecommunications carrier. In order to
facilitate long-term number portability, the FCC adopted requirements on
May 12, 1998 that the costs associated with number portability (such as
those associated with building and operating regional number portability
databases) will generally be allocated to all common carriers based on
the carriers' intrastate, interstate and international end-user
telecommunications revenues for each region. Incumbent local
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<PAGE> 18
telephone companies will be permitted to recover costs directly related
to providing local number portability through a monthly end-user charge
that would be subject to FCC review. Carriers other than incumbent local
carriers, including wireless carriers and competitive local telephone
companies such as US Xchange, may recover such costs in any lawful
manner. While it therefore appears that the FCC's policies regarding
local number portability will not have a negative impact on our financial
condition, those policies could change in the future.
Access Charges. The FCC has granted the incumbent local telephone
companies significant flexibility in pricing their interstate special and
switched access services on a specific central office by central office basis.
Under this pricing scheme, incumbent local telephone companies may establish
pricing zones based on access traffic density and charge different prices for
each zone. We anticipate that the FCC will grant incumbent local telephone
companies increasing pricing flexibility as the number of interconnections and
competitors increases. In two orders released on December 24, 1996 and May 16,
1997, the FCC took action to reform the current interstate access charge system.
In the December 24th order, the FCC removed restrictions on incumbent local
telephone companies' ability to lower access prices and relaxed the regulation
of new switched access services in those markets where there are other providers
of access services. The May 16th order substantially increased the costs that
incumbent local telephone companies subject to the FCC's price cap rules may
recover through monthly, non-traffic-sensitive access charges and substantially
decreased the costs that incumbent carriers may recover through
traffic-sensitive access charges based on minutes of use. In the May 16th order,
the FCC also announced its plan to bring interstate access rate levels more in
line with costs. The plan will include rules that are expected to be established
sometime in 1999 that may grant incumbent local telephone companies increased
pricing flexibility upon demonstration of increased competition (or potential
competition) in relevant markets.
The manner in which the FCC implements this approach to lowering access
charge levels could have a material effect on our ability to compete in
providing interstate access services. These changes will reduce access charges
and will shift charges currently based on minutes of use to flat-rate, monthly
per line charges. As a result, the aggregate amount of access charges paid by
long distance carriers to access providers in the United States may decrease.
The FCC also announced that it intends in the future to issue detailed rules
for implementing a market-based approach to further access charge reform. That
process will give incumbent local telephone companies progressively greater
flexibility in setting rates as competition develops, gradually replacing
regulation with competition as the primary means of setting prices. The FCC
also adopted a "prescriptive safeguard" to bring access rates to competitive
levels in the absence of competition. On June 18, 1997, the FCC denied
petitions filed by several incumbent local telephone companies asking the FCC
to stay the effectiveness of its access charge reform decision. However,
the FCC subsequently granted petitions for reconsideration by Sprint and
various other parties and made relatively minor changes to, among other things,
its requirements regarding the information that incumbent local telephone
companies must provide to long distance carriers on the presubscribed long
distance carrier charges that the incumbent local telephone companies levy on
their presubscribed customers. The FCC's access charge order was appealed to
the Eighth Circuit. On August 19, 1998, the Eighth Circuit unanimously upheld
the FCC's access charge order. On October 6, 1998, the FCC released a public
notice asking parties to refresh the record on access charge reform. It
specifically requested comment on pricing flexibility proposals submitted by
two regional Bell operating companies and on charging the 6.5% X-factor
adjustment, which is applied annually to reduce incumbent local telephone
company price cap indices.
Incumbent local telephone companies around the country have been
contesting whether the obligation to pay reciprocal compensation to competitive
local telephone companies should apply to local telephone calls from the
incumbent carriers' customers to internet service providers served by the
competitive
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carriers. The incumbent local telephone companies claim that this traffic is
interstate in nature and therefore should be exempt from compensation
arrangements applicable to local, intrastate calls. Competitive local telephone
companies have contended that the interconnection agreements provide no
exception for local calls to internet service providers and reciprocal
compensation is therefore applicable. In response to carriers' requests for
clarification, on February 25, 1999 the FCC declared that, while internet
traffic is jurisdictionally mixed, it is largely interstate in nature. However,
the FCC's decision preserved the rule that exempts the internet and other
information services from interstate access charges. The FCC's jurisdictional
decision did not, however, determine whether calls to internet service providers
are subject to reciprocal compensation in any particular instance. In this
regard, the FCC concluded that carriers are bound by their existing
interconnection agreements, as interpreted by state commissions, and thus are
subject to reciprocal compensation obligations to the extent provided in their
interconnection agreements or as determined by state commissions. The FCC also
issued proposed rules to address inter-carrier compensation in the future.
Currently, 29 state commissions (including Wisconsin, Illinois and
Michigan), three federal courts and one state court have ruled that reciprocal
compensation arrangements do apply to calls between end users and internet
service providers within the same local calling area. Certain of these rulings
are subject to appeal. Additional disputes over the appropriate treatment of
internet service provider traffic are pending in other states. Despite the clear
intent of the FCC and unanimous state authority on the issue, Ameritech
announced on February 25, 1999 that, because the FCC has concluded that calls to
internet service providers are interstate, Ameritech believes that it is not and
never was required to pay reciprocal compensation on such calls and that
Ameritech intends to seek to overturn the prior inconsistent orders. Industry
experts expect other incumbent local telephone companies also to use the FCC
ruling to support their argument that states should overturn their decisions on
reciprocal compensation for dial-up calls to internet service providers. In an
effort to preclude this, on March 11, 1999, MCI WorldCom, Inc. asked the U. S.
Court of Appeals for the District of Columbia to review and vacate the FCC's
ruling on the grounds that it is arbitrary, capricious and otherwise contrary to
law. We provide local services to various internet service providers, and our
interconnection agreements with Ameritech and GTE require them to pay us
reciprocal compensation on calls from their customers to our internet service
provider customers. If these agreements are not enforced, it could have an
adverse effect on US Xchange.
Universal Service Reform. On May 8, 1997, the FCC issued an order
establishing a significantly expanded federal universal service subsidy regime
to implement the provisions of the 1996 Act relating to the preservation and
advancement of universal telephone service. The universal service order affirmed
Congress' policy principles for universal telephone service, including quality
of service, affordable rates, access in rural and high-cost areas, equitable and
nondiscriminatory contributions, specific and predictable support mechanisms and
access to advanced telecommunications services for schools, health care
providers and libraries. For example, the FCC established new subsidies of up to
$2.7 billion for telecommunications and information services provided to
qualifying schools and libraries and for services provided to rural healthcare
providers. Several parties have appealed the May 8th order. The appeals have
been consolidated in the United States Court of Appeals for the Fifth Circuit
where they are currently pending. In addition, on July 3, 1997, a number of
incumbent local telephone companies filed a petition for stay of the May 8th
order with the FCC. That petition is pending, as well as several petitions for
administrative reconsideration of the order.
All telecommunications carriers providing interstate telecommunications
services, including US Xchange, and certain other entities, must contribute to
the universal service support fund. Such contributions are assessed based on
intrastate, interstate and international end user
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telecommunications revenues. Contribution factors vary quarterly and carriers
are billed monthly. Currently, the FCC is assessing such payments on the basis
of a provider's revenue for the previous year. Based on the amount of our
revenues in 1997 and 1998, we have not been required to make subsidy payments in
any material amount during 1998 or 1999. However, we are currently unable to
quantify the amount of subsidy payments that we will have to make in subsequent
years and the effect that these required payments will have on our financial
condition and results of operation.
STATE REGULATION
Through our subsidiaries, we have obtained intrastate authority for the
provision of a full range of switched services in Wisconsin, Illinois, Indiana
and Michigan. We have also filed state tariffs setting forth the terms,
conditions and prices for services that are classified as intrastate. We have
entered into state-approved interconnection agreements with Ameritech in
Wisconsin, Illinois, Indiana and Michigan and with GET in Wisconsin, Illinois
and Indiana. We may be required to negotiate new or renegotiate existing
interconnection agreements as we expand operations in current and additional
markets in the future.
Our interconnection agreements with Ameritech do not provide for
termination except upon expiration of the term of the particular agreement. Our
interconnection agreements with GTE provide for termination only upon default,
which generally means a party's refusal or failure in any material respect to
perform its obligations under the agreement, the violation of any material terms
or conditions of the agreement and certain events of insolvency or bankruptcy.
The defaulting party has 60 days from the receipt of any notice of default to
cure the default before the other party may terminate the agreement.
In addition to certification and tariff filing requirements, some states
impose reporting, customer service and quality requirements, as well as
unbundling and universal service requirements. In addition, we are subject to
the outcome of generic proceedings held by state public service commissions to
determine state regulatory policies with respect to incumbent local telephone
company and competitive local telephone company competition, geographic
build-out, mandatory detariffing, etc. Certain states, including Wisconsin,
Illinois, Indiana and Michigan, have adopted or have pending proceedings to
adopt specific universal service funding obligations.
We believe that, as the degree of intrastate competition increases, the
states will offer the incumbent local telephone companies increasing pricing
flexibility. This flexibility may present the incumbent local telephone
companies with an opportunity to subsidize services that compete with our
services with revenues generated from non-competitive services, thereby allowing
incumbent local telephone companies to offer competitive services at lower
prices. We cannot predict the extent to which this may occur, but it could have
a material adverse effect on our business.
Certain states also require carriers to obtain prior approval for, or
notify the state commission of, certain events such as transfers of control,
sales of assets, corporate reorganizations, issuances of stock or debt
instruments and related transactions.
LOCAL AUTHORIZATIONS
When constructing a network, we generally must obtain municipal
franchises and other permits. These rights are typically the subject of
non-exclusive agreements of finite duration and provide for the payment of fees
or the provision of services to the municipality with no or minimal
compensation. In addition, we must secure rights-of-way, pole attachments and
other access rights, which are typically provided under non-exclusive multi-year
agreements that generally contain renewal options. Our network buildout is also
subject to various locally-imposed building codes and licensing regulations. In
some of our markets, we are required to pay license or franchise fees based on a
percentage of gross revenues or on a per linear foot basis, as well as to post
construction performance bonds or letters of credit.
We install our fiber optic cable over both aerial and underground
rights-of-way, which we obtain from electric and other utilities, state highway
departments and other governmental authorities, railroads and other providers.
The 1996 Act requires most utilities, including electric companies and most
incumbent
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local telephone companies, to provide access to rights-of-way to competitive
local telephone companies on non-discriminatory terms and conditions and at
reasonable rates. However, we can provide no assurance that delays and disputes
will not occur in connection with our existing or planned rights-of-way.
EMPLOYEES
As of March 25, 1999, US Xchange had approximately 700 full-time employees,
including approximately 220 employees engaged in our sales and marketing
efforts. None of our employees is represented by a labor union or subject to a
collective bargaining agreement. We have not experienced any work stoppages due
to labor disputes and we believe that our relations with our employees are good.
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ITEM 2. PROPERTIES.
US Xchange is headquartered in Grand Rapids, Michigan and leases offices
and space in a number of locations, primarily for regional management and local
sales offices and network equipment installations. The table below lists our
current facilities, all of which we lease directly or through our subsidiaries:
<TABLE>
<CAPTION>
APPROXIMATE
LOCATION LEASE EXPIRATION(1) SQUARE FOOTAGE
- ------------------------------------------------- ----------------------- --------------
<S> <C> <C>
Grand Rapids, Michigan December 2001(2) 7,800
August 2002(5) 44,000
March 2009(3) 10,500
Green Bay, Wisconsin July 2001(3) 6,600
February 2003(3) 6,600
January 2003(5) 1,200
Appleton, Wisconsin April 2003(3) 4,800
September 2002(5) 4,500
Oshkosh, Wisconsin September 2002(5) 1,100
Milwaukee, Wisconsin May 2008(5) 4,900
February 2003(3) 3,500
October 2008(4) 1,000
Madison, Wisconsin March 2003(5) 6,200
November 2003(3) 3,900
South Bend, Indiana May 2003(4) 5,500
May 2003(3) 3,500
Bloomington, Indiana June 2003(4) 8,100
April 2003(3) 3,200
Ft. Wayne, Indiana May 2003(4) 12,800
June 2003(3) 3,800
Elkhart, Indiana June 2008(4) 5,200
Evansville, Indiana August 2008(4) 7,500
July 2003(3) 3,300
Lafayette, Indiana August 2003(3) 3,000
June 2008(4) 7,000
Rockford, Illinois June 2003(4) 6,500
July 2003(3) 3,100
Kalamazoo, Michigan March 2004(3) 3,000
October 2008(4) 10,500
February 2009(4) 3,800
</TABLE>
- --------------------
(1) Dates indicate expiration of original term of leases, certain of which
also include automatic or optional renewal terms of one or more years.
(2) Sublease of our principal executive offices under a lease in which an
affiliated company is the lessee. See "Certain Relationships and Related
Transactions."
(3) Lease of office space only.
(4) Lease of network equipment facilities only.
(5) Lease of both office space and network equipment facilities.
We believe that our leased facilities are adequate to meet our current
needs in the markets in which we have deployed our networks and that additional
facilities are available to meet our development and expansion needs for the
foreseeable future.
We have made arrangements for the development of a new 65,000 square foot
addition to our existing 44,000 square foot headquarters facility in Grand
Rapids, Michigan that will accommodate our need for additional headquarters
office space. We expect to enter into a long-term lease and occupy the new
facility during the third quarter of 1999. The new facility is being developed
as a partnership between RVP
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Development Corporation (see Item 13 - "Certain Relationships and Related
Transactions") and a third party that owns the property.
ITEM 3. LEGAL PROCEEDINGS
On September 30, 1997, the U.S. Patent and Trademark Office refused to
grant an application for a registered service mark for the "US Xchange" name on
the grounds that it is merely geographically descriptive of telephone
communication services that are rendered in the United States. The decision of
the U.S. Patent and Trademark Office has been appealed. If we are unable to
obtain a reversal of the U.S. Patent and Trademark Office's decision, the "US
Xchange" name will not be accorded the legal protection that a registered
service mark would have provided.
We are not a party to any material litigation or any other legal
proceeding.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
There were no matters submitted to a vote of security holders during the
quarter ended December 31, 1998.
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PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
Not applicable.
ITEM 6. SELECTED FINANCIAL DATA.
The selected consolidated financial data set forth below for the years
ended December 31, 1998 and 1997 and for the period from August 5, 1996 (date of
inception) to December 31, 1996 were derived from the audited consolidated
financial statements of US Xchange, L.L.C. contained elsewhere in this Report,
which have been audited by BDO Seidman, LLP, independent certified public
accountants. All of the selected consolidated financial data should be read in
conjunction with "Management's Discussion and Analysis of Financial Condition
and Results of Operations" and our consolidated financial statements and notes
thereto included elsewhere in this Report.
<TABLE>
<CAPTION>
PERIOD FROM
YEAR ENDED DECEMBER 31, AUGUST 5, 1996(1)
1998 1997 TO DECEMBER 31, 1996
-------------- ------------- --------------------
<S> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Revenues............................................. $ 7,015,310 $ 206,682 $ --
Cost and expenses:
Cost of communication services..................... 16,338,583 749,662 --
Selling, general and administrative................ 28,679,670 5,065,589 137,810
Depreciation and amortization...................... 3,609,055 189,347 --
Total costs and expenses........................ 48,627,308 6,004,598 137,810
Loss from operations................................. (41,611,998) (5,797,916) (137,810)
Interest expense, net(2)............................. (13,486,96) (30,452) --
Interest income...................................... 4,476,061 -- --
Net loss............................................. $ (50,622,933) $ (5,828,368) $ (137,810)
============== ============= ==============
</TABLE>
<TABLE>
<CAPTION>
AS OF DECEMBER 31,
----------------------------------
1998 1997
-------------- --------------
<S> <C> <C>
BALANCE SHEET DATA:
Cash and cash equivalents............................ $ 40,018,552 $ 100,590
Restricted investments(3)............................ 84,731,847 --
Networks and equipment, net.......................... 100,344,506 27,967,741
Total assets......................................... 234,715,917 28,385,270
Advances from affiliate.............................. -- 21,038,789
Long-term debt, less current maturities.............. 202,533,333 2,189,000
Capital contributions................................ 60,000,000 5,000,000
Members' capital (deficit)........................... 3,410,889 (966,178)
</TABLE>
<TABLE>
<CAPTION>
PERIOD FROM
AUGUST 5, 1996(1)
YEAR ENDED DECEMBER 31, TO DECEMBER 31,
1998 1997 1996
----------- ---------------- ------------------
<S> <C> <C> <C>
OTHER DATA:
Capital expenditures................................... $75,619,611 $ 28,157,088 $ --
EBITDA(4).............................................. (38,002,943) (5,608,569) (137,810)
Cash flows from operating activities................... (29,087,976) (395,530) (163,485)
Cash flows from investing activities................... (158,465,165) (28,168,184) --
Cash flows from financing activities................... 227,471,103 28,664,304 163,485
Ratio of earnings to fixed charges(5).................. -- -- --
Deficiency of earnings to cover fixed charges(5)....... 52,918,654 5,830,471 137,810
</TABLE>
- -----------------
(1) US Xchange was organized on August 5, 1996.
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<PAGE> 25
(2) Excludes capitalized interest of $ 2.3 million for 1998 and $2,103 for
1997. During the construction of our networks, interest expense related to
construction expenditures is capitalized.
(3) Represents pledged securities which we purchased to secure the first six
scheduled interest payments on our 15% Senior Notes due 2008.
(4) EBITDA consists of earnings (loss) before net interest, income taxes,
depreciation and amortization. EBITDA is provided because we believe it is
a measure commonly used in the telecommunications industry. It is
presented to enhance an understanding of our operating results and is not
intended to represent cash flow or results of operations in accordance
with generally accepted accounting principles, or "GAAP". The indenture
governing our 15% Senior Notes contains (and we expect that agreements
governing any additional future indebtedness may contain) covenants based
on EBITDA that, among other things, may limit our ability to incur
additional indebtedness. EBITDA is not a measure of financial performance
under GAAP and should not be considered an alternative to earnings (loss)
from operations and net income (loss) as a measure of performance or to
cash flow as a measure of liquidity. EBITDA is not necessarily comparable
to similarly titled measures of other companies. Our consolidated
statements of cash flows used in and provided by operating, investing and
financing activities, as calculated under GAAP, are included with our
consolidated financial statements contained elsewhere in this Report.
(5) For purposes of calculating the ratio of earnings to fixed charges,
earnings are defined as net loss plus fixed charges. Fixed charges consist
of interest expense and amortization of debt issuance costs, whether
expensed or capitalized, and that portion of rental expense (one-third)
estimated to represent interest expense. After giving pro forma effect to
the increase in interest expense resulting from the issuance of our 15%
Senior Notes due 2008 on June 25, 1998, as of the beginning of each such
period, net interest expense would have been $23.8 million, $25.9 million
and $10.6 million, and earnings would have been insufficient to cover
fixed charges by approximately $64.0 million, $32.4 million and $11.0
million for the years ended December 31, 1998 and 1997 and for the period
from inception (August 5, 1996) through December 31, 1996, respectively.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
EXCEPT FOR HISTORICAL INFORMATION, THE DISCUSSION IN THIS ITEM 7 CONTAINS
FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS AND UNCERTAINTIES. OUR ACTUAL
RESULTS COULD DIFFER MATERIALLY FROM THOSE SET FORTH IN THESE FORWARD-LOOKING
STATEMENTS AS A RESULT OF A NUMBER OF FACTORS. THESE FACTORS INCLUDE, BUT ARE
NOT LIMITED TO, THE RISKS WE DISCUSS BELOW AND UNDER THE CAPTION "RISK FACTORS"
IN EXHIBIT 99.1 TO THIS ANNUAL REPORT ON FORM 10-K.
OVERVIEW
From our inception on August 5, 1996 through June 30, 1997, we were in
the development stage of operations. During that time, our principal activities
included developing our business plan, hiring management and other key
personnel, designing the architecture for our network systems and negotiating an
interconnection agreement with an incumbent local telephone company.
Our operations have resulted in significant losses, negative cash flows
from operating and investing activities and negative EBITDA to date. We expect
that planned capital expenditures, together with the associated operating
expenses in each of our markets, will result in operating losses, negative cash
flows from operating and investing activities and negative EBITDA for
approximately 24 to 36 months after we commence facilities-based switched
operations in each market. Accordingly, we expect to experience increasing
consolidated losses as we expand our operations, deploy our network and
switching facilities and develop our customer base.
25
<PAGE> 26
FACTORS AFFECTING RESULTS OF OPERATIONS
REVENUES
We direct our sales and marketing efforts primarily towards small to
medium-sized business customers, internet service providers and governmental and
other institutional end users in selected underserved markets. In each of our
markets, we initially resell incumbent carrier services to establish a market
presence and enhance our market penetration efforts. After our network switching
system becomes commercially operational in a market, we transition our resale
customers to our own switch-based network. We believe that this strategy results
in faster penetration of the available customer base. We compete primarily on
the basis of competitive pricing, superior service and products and innovative
service and product offerings. By using our own switched-based facilities, we
believe we will be able to achieve higher gross margins on our own
facilities-based services than we can achieve through reselling others'
services.
We also generate revenues from the sale of our services to residential
customers. We believe that our bundled service offerings, high degree of front
office and back office automation and automated customer care, billing and
credit-checking systems and procedures enhance our ability to offer services to
residential customers in our markets. In addition, we believe we have
significant operating leverage and a relatively low marginal cost of providing
service to residential customers. We target creditworthy residential customers
who we believe are likely to have needs for multiple services. We market our
residential services through various affinity group and other cost-effective
marketing programs and service packages specifically designed to appeal to these
customers.
To further leverage our fixed costs, we have identified selective
channels for the sale of our services on a wholesale basis. For example, we have
begun offering our local and internet access services on a wholesale basis to
internet service providers in certain of our markets and have concluded an
exclusive distribution arrangement with an interconnect company. We intend to
establish strategic alliances with and supply wholesale services to electric
utilities and other selected telecommunications providers for resale to their
own customers.
OPERATING EXPENSES
Our primary operating expenses consist of the cost of communication
services, selling, general and administrative expenses and depreciation and
amortization charges.
Cost of Communication Services. Cost of communication services consists
of the fixed costs of leased facilities, minutes-of-use charges for origination
and termination services and access line charges for local and long distance
services, including the costs to use incumbent local telephone company unbundled
network elements, costs for installation and initial service turn-up and support
services outsourced to Lucent, and costs of network personnel. We also incur
rights-of-way costs and, in certain markets, franchise fees and taxes paid to
local governments based on revenue. After we install our network infrastructure
and activate our switching systems, we can add customers and associated revenues
with lower incremental cost of communication services, so that such customers
provide greater contributions to our operating cash flows and EBITDA. While we
primarily target businesses, internet service providers, and governmental and
other institutional customers, we believe that, once a network is operational,
the marginal cost of providing our services to residential customers is low
enough to allow us to economically address these customers because they
generally require less complex services than our other customers. Cost of
communication services does not include depreciation and amortization.
26
<PAGE> 27
Selling, General and Administrative. Our selling, general and
administrative expenses include sales and marketing costs, customer service and
technical support, billing and collection, and general management and overhead
expenses. These costs grow significantly as we expand our operations, and
administrative overhead is a large portion of these expenses during the
deployment of our networks. However, as we expand our customer base, these
expenses represent a smaller percentage of our revenues.
Depreciation and Amortization. We depreciate and amortize our property
and equipment using the straight-line method over the estimated useful life of
the assets, ranging from five to eight years for equipment, 20 years for fiber,
three to five years for third-party software costs and the lesser of 10 years or
the lease term for leasehold improvements.
INTEREST EXPENSE
Prior to our issuance of the 15% Senior Notes in June 1998, we did not
incur material interest expense. Since then, however, we have incurred and
expect to continue to incur substantial interest expense.
RESULTS OF OPERATIONS
1998 Compared to 1997
Revenues for 1998 totaled $7.0 million, of which $559,000 was derived
from our facilities-based switched operations and the balance was derived from
resale services. The increase in our revenues from $207,000 in 1997 was
substantially due to our expansion into seven new markets during 1998: South
Bend, Elkhart, Bloomington, Fort Wayne and Evansville, Indiana; Rockford,
Illinois and Kalamazoo, Michigan. For those markets that we entered during 1997,
we also saw continued increases in the total number of, and usage by, our
customers during 1998. All revenues during 1997 were derived from resold
services. During 1998, we installed approximately 21,000 total access lines,
compared to 2,000 during 1997. At December 31, 1998, facilities-based lines
represented 12% of our total of approximately 23,000 installed access lines in
service.
Cost of communication services was $16.3 million for 1998, an increase of
$15.6 million from $750,000 in 1997. Approximately 63%, or $9.8 million, of the
increase is attributable to the growth in our customer base and the related
costs of leased telecommunications facilities and services from the incumbent
local telephone companies in connection with our resale services. Our
facilities-based network operating costs, including personnel-related costs,
have increased approximately $4.4 million, reflecting the networks which became
commercially operational during 1998.
Selling, general and administrative expenses increased to $28.7 million
for 1998 compared to $5.1 million for 1997. Of the $23.6 million increase,
approximately 67%, or $15.9 million, was due to hiring additional personnel to
support our continued growth. Our advertising and marketing costs increased
approximately $2.6 million in connection with our increased marketing efforts.
Depreciation and amortization expenses for 1998 increased to $3.6 million
from $189,000 in 1997. The increase reflected the six switches and networks that
became commercially operational during 1998 and the overall growth in capital
assets through December 31, 1998. Depreciation and amortization will continue to
increase as a result of continuing capital expenditures related to our network
expansion.
Interest expense was $13.5 million for 1998 and $30,500 for 1997. A
significant portion, approximately $13.2 million, relates to the accrual of
interest on our 15% Senior Notes, with the remainder associated with the
borrowings under our $4.0 million bank credit facility, which we describe in
detail
27
<PAGE> 28
below. Interest costs of $2.3 million and $2,103 were capitalized during 1998
and 1997, respectively, related to network construction projects.
Interest income of $4.5 million for 1998 resulted primarily from interest
earnings on the short-term investment of the cash proceeds of the issuance of
our 15% Senior Notes.
For the reasons stated above our net loss increased to $50.6 million in
1998, compared with $5.8 million in 1997.
1997 Compared to 1996
Following the completion of our development stage activities, we began
our sales efforts in July 1997 and generated resale revenues of approximately
$207,000 for 1997, of which approximately $178,000 was generated in the fourth
quarter of 1997.
Total operating expenses for 1997 approximated $6.0 million, including
approximately $750,000 related to cost of communication services, approximately
$5.1 million of selling, general and administrative expenses, which primarily
consisted of payroll and legal and professional costs related to the
commencement of our operations, and depreciation and amortization on office
equipment and leaseholds of approximately $189,000. During the period from
inception through December 31, 1996, we incurred general and administrative
expenses of approximately $138,000, primarily due to payroll and professional
costs related to the commencement of our operations. Interest expense for 1997
of approximately $30,000 was due to the borrowings under our bank credit
facility.
LIQUIDITY AND CAPITAL RESOURCES
We experienced a deficiency in net cash from operations of $29.1 million
and $396,000 for 1998 and 1997, respectively. Because we are in the early stages
of our development, significant cash outlays are necessary to develop and
operate our networks and back office systems infrastructure prior to the
generation of customer revenues. The increase in the deficiency for 1998
compared to 1997 is primarily the result of increased operating losses in
connection with our continued expansion into additional markets during 1998,
partially offset by a $22.4 million increase in payables and accrued
liabilities. We expect to experience continuing negative operating cash flows as
we expand our operations and transition our customers from resale services to
our facilities-based services.
Our net cash used in investing activities increased to $158.5 million for
1998 from $28.2 million for 1997. During 1998 we continued to make significant
capital expenditures to acquire network-related equipment, information systems
software and office furniture to support the growth of our business. Our capital
expenditures totaled $75.6 million and $28.2 million for 1998 and 1997,
respectively. In addition, during the second quarter of 1998, we set aside $82.5
million of the proceeds from the sale of our 15% Senior Notes to purchase U.S.
government securities and accrued interest thereon to secure and fund payment of
the first six interest payments on such Notes.
For 1998 we had net cash provided by financing activities totaling $227.5
million compared to $28.7 million for 1997. A significant portion of the
increase, approximately $193.0 million received during the second quarter of
1998, came from the proceeds of the sale of our 15% Senior Notes. Also, member
capital contributions and advances from RVP Development Corporation, a holding
company wholly-owned by Ronald VanderPol, our Co-Chairman and majority member,
of $34 million and $26 million were received in 1998 and 1997, respectively.
During the first quarter of 1998 and the fourth quarter of 1997,
28
<PAGE> 29
we also received $1.2 million and $2.8 million, respectively, of proceeds from
our bank credit facility referred to below.
In August 1997, we entered into a $4.0 million bank credit facility,
which was fully utilized as of March 31, 1998. We have used the proceeds of this
facility to acquire office furniture, equipment and computer software and for
construction costs related to leasehold improvements of office and switch site
locations. At December 31, 1998, we had $3.3 million of outstanding indebtedness
under this bank credit facility. The borrowings bear interest at an annual rate
equal to (1) 1/2% under the bank's prime lending rate or (2) 2% over the bank's
costs of funds, at our option. The effective annual interest rate of the bank
credit facility was 7.1% and 8.0% at December 31, 1998 and 1997, respectively.
The borrowings are repayable in monthly installments of $66,667 through March
31, 2003 and are secured by specific assets of the Company and one of our
wholly-owned subsidiaries and by the guarantees of the same subsidiary and of
RVP Development Corporation.
Our bank credit facility contains certain affirmative and restrictive
covenants, including, but not limited to, limitations on our ability to
- enter into any merger or consolidation or sell, lease, transfer or
dispose of all, substantially all or any material part of our assets,
except in the ordinary course of business,
- guarantee, endorse or otherwise become secondarily liable for or upon
the obligations of others, except by endorsement for deposit in the
ordinary course of business or
- create, incur, assume or suffer to exist any mortgage, pledge,
encumbrance, security interest, lien or charge of any kind upon any of
our assets.
All financial covenants under the bank credit facility apply to RVP Development
Corporation and not to US Xchange. At December 31, 1998, RVP Development
Corporation was in compliance with all of its covenant requirements under the
bank credit facility.
On June 25, 1998, we issued and sold $200 million aggregate principal
amount of our 15% Senior Notes due July 1, 2008. Of the $193.0 million of net
proceeds that we received for such Notes, we used approximately $82.5 million to
purchase U.S. government securities, including accrued interest, to secure and
fund our first six scheduled semi-annual payments of interest on such Notes.
Through December 31, 1998, we have spent approximately $70.5 million of the
remaining net proceeds to fund the installation and deployment of our networks
and their associated operating losses.
The indenture governing our 15% Senior Notes imposes certain financial
and operating restrictions on us and our restricted subsidiaries. These
restrictions limit, among other things, our ability to:
- incur additional indebtedness;
- create liens;
- engage in sale-leaseback transactions;
- sell assets;
- effect consolidations or mergers;
- make investments or certain other restricted payments;
- pay dividends or make distributions in respect of membership
interests;
- redeem membership interests;
- issue or sell membership interests of our restricted subsidiaries; and
29
<PAGE> 30
- enter into transactions with any of our members or affiliates.
While these limitations are subject to a number of important qualifications and
exceptions, if we were to fail to comply with these restrictions and, in some
cases, were to fail to cure our noncompliance, we would be in default under the
indenture.
Our operations have required a substantial capital investment for the
purchase of telecommunications equipment and the construction and development of
our networks. Since the beginning of fiscal 1997 and through December 31, 1998,
we have spent approximately $103.8 million on capital expenditures. We have
funded these expenditures through our existing equity capital, the proceeds from
the sale of our 15% Senior Notes and our bank credit facility.
On March 19, 1999, we arranged for a binding commitment, which is subject
to execution and delivery of definitive loan documentation, from a commercial
financing institution for a $50 million eight-year senior secured credit
facility for a wholly-owned financing subsidiary of US Xchange. All outstanding
amounts borrowed will bear interest at a floating rate equal to either a defined
base rate plus 3.0% or at LIBOR plus 4.0%, at our option. Interest will be
payable at least on a quarterly basis. Unused portions of this facility will be
subject to a commitment fee ranging between .75% and 1.25% of the unused amount.
Repayments of the aggregate outstanding principal will begin three years
following the closing date based upon the following annual debt reduction
formula: 10%, 15%, 20%, 25% and 30%. Borrowings will be secured by all present
and future real and personal property, assets and revenues of our wholly-owned
financing subsidiary and its subsidiaries. US Xchange and the subsidiaries of
the borrower will guarantee all indebtedness under this facility. In addition,
this facility will include, among other things, certain financial and other
covenants and limitations, including limitations on our ability to incur
additional indebtedness, create liens, make investments and pay dividends, among
others. We expect to close this facility by April 30, 1999.
The costs associated with the initial installation and expansion of each
of our networks, including development, installation, certain organizational
costs and early operating expenses, and the construction of our planned long
haul routes interconnecting our commercial regions are significant. We expect to
experience negative cash flow for each market until we establish an adequate
customer base and revenue stream. We estimate that, as of December 31, 1998, our
future capital requirements (including requirements for capital expenditures,
working capital, debt service and operating losses) to fund the installation,
deployment and operating losses of the networks in our current development plans
will total approximately $85 million. We expect that the remaining net proceeds
from the issuance of our 15% Senior Notes, approximately $40 million as of
December 31, 1998, and the proceeds of our pending $50 million senior secured
credit facility, together with cash expected to be generated from future
revenues, will be sufficient to fully fund the planned development of our
current markets, including estimated operating losses.
However, the actual amount and timing of our capital requirements may
vary significantly from our estimates based upon a number of factors, including,
among other things:
- the timing and success of our current development plans;
- shortfalls in our revenue and cost projections;
- demand for our services;
- regulatory, technological and competitive developments;
- any decision to expand our operations into additional commercial
regions or markets; and
30
<PAGE> 31
- any acquisitions or joint ventures that we decide to undertake.
Actual revenues and costs may vary materially from expected amounts, and such
variations will likely affect our future cash flow requirements. Accordingly, we
cannot assure you that our actual capital requirements will not exceed our
current estimates.
YEAR 2000 COMPLIANCE
The year 2000 issue is a matter of particular worldwide concern for
telecommunications carriers because it affects many aspects of
telecommunications technology, including the computer systems and software
applications that are essential for network administration and operations. A
significant portion of telecommunications voice and data networking and network
management devices have date-sensitive processing in them which affect network
administration and operations functions such as service activation, service
assurance and billing processes. However, because we have recently commenced
operations and acquired our key processing systems, our costs relating to year
2000 issues historically have not been material. Lucent and the other system
vendors have represented to us that their systems are year 2000 compliant
without any required modification. We will require confirmation of year 2000
compliance in our future requests for proposals from Lucent and our other
equipment and software vendors. Pursuant to our strategic year 2000 compliance
plan, we have modified and tested all of our mission-critical systems and
believe they are now fully year 2000 compliant. However, until the year 2000, we
cannot assure you that our computer systems and software applications will
accommodate the year 2000.
The failure of our computer systems and software applications to
accommodate the year 2000 could have a material adverse effect on our business
and financial condition. Further, if the networks and systems of the incumbent
local telephone companies, long distance carriers and others on whose services
we depend and with whom our networks and systems must interface are not year
2000 functional, it could have a material adverse effect on the operation of our
networks and, as a result, on our business and customers. The Telco Year 2000
Forum, a group representing the nation's largest local telephone companies, has
announced, based upon six months of interoperability testing, that such
companies remain confident that the public will be able to place telephone calls
at the start of 2000. However, other domestic and international carriers may not
be year 2000 functional. We have not yet established a contingency plan that
addresses our response to any potential failure of our systems, or those of
other entities on whose services we depend or with whom our networks and systems
must interface, to accommodate year 2000 issues. However, we have been
participating in industry interoperability testing processes and plan to
implement the contingency plans being put in place by industry organizations. We
intend to continue to monitor the performance of our accounting, information and
processing systems and software applications and those of our third-party
constituents to identify and resolve any year 2000 issues.
To the extent necessary, we may need to replace, upgrade or reprogram
certain existing systems and software applications to ensure that all of our
computer systems and software applications and all of our interoperability
applications are year 2000 functional. However, based on current information, we
do not believe that we will incur costs for any replacement, upgrade or
reprogramming of our computer systems and software applications to resolve any
year 2000 issues that will be material to our business, financial condition or
results of operations.
NEW ACCOUNTING STANDARDS
In June 1998, the Financial Accounting Standards Board issued SFAS No.
133, "Accounting for Derivative Instruments and Hedging Activities." Among other
provisions, this standard requires that
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<PAGE> 32
entities recognize all derivatives as either assets or liabilities in the
balance sheet and measure those instruments at fair value. Gains and losses
resulting from changes in the fair values of those derivatives would be
accounted for depending on the use of the derivative and whether it qualifies
for hedge accounting. This standard is effective for fiscal years beginning
after June 15, 1999, though earlier adoption is encouraged and retroactive
application is prohibited. Historically, we have not entered into, and we
currently have no plans to enter into, any derivative instruments. Accordingly,
we believe that this standard will not have a material impact on our
consolidated financial position, results of operations or cash flows.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Not applicable.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
PAGE
<S> <C>
CONSOLIDATED AUDITED FINANCIAL STATEMENTS:
Report of Independent Certified Public Accountants.............................. 33
Consolidated Balance Sheets, December 31, 1998 and 1997......................... 34
Consolidated Statements of Operations, Years Ended December 31, 1998 and 1997 and
Period from August 5, 1996 (date of inception) to December 31, 1996........... 35
Consolidated Statements of Members' Capital (Deficit), Years Ended December 31,
1998 and 1997 and Period from August 5, 1996 (date of inception) to December
31, 1996...................................................................... 36
Consolidated Statements of Cash Flows, Years Ended December
31, 1998 and 1997 and Period from August 5, 1996 (date of
inception) to December 31, 1996............................................... 37
Notes to Consolidated Financial Statements...................................... 38-42
</TABLE>
32
<PAGE> 33
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
US Xchange, LLC
Grand Rapids, Michigan
We have audited the accompanying consolidated balance sheets of US Xchange, LLC
and subsidiaries as of December 31, 1998 and 1997, and the related consolidated
statements of operations, members' capital (deficit) and cash flows for each of
the years in the two-year period ended December 31, 1998 and the period from
August 5, 1996 (date of inception) to December 31, 1996. These consolidated
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the consolidated financial statements are
free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the consolidated financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
consolidated financial statement presentation. We believe that our audits
provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of US Xchange, LLC and
subsidiaries at December 31, 1998 and 1997, and the results of their operations
and their cash flows for each of the years in the two-year period ended December
31, 1998 and the period from August 5, 1996 (date of inception) to December 31,
1996, in conformity with generally accepted accounting principles.
/s/ BDO SEIDMAN, LLP
Grand Rapids, Michigan
February 25, 1999, except
for Note 7, which is as
of March 19, 1999
33
<PAGE> 34
US XCHANGE, L.L.C.
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
DECEMBER 31,
-------------------------------
1998 1997
------------- --------------
<S> <C> <C>
ASSETS
CURRENT ASSETS
Cash and equivalents ............................. $ 40,018,552 $ 100,590
Restricted investments ........................... 28,525,109 --
Accounts receivable, less allowance for doubtful
accounts of $174,000 and $2,000 ................. 1,865,503 145,235
Other ............................................ 700,411 160,608
------------- -------------
TOTAL CURRENT ASSETS .......................... 71,109,575 406,433
------------- -------------
NETWORKS AND EQUIPMENT
Networks and networks in process (cost to complete
of $19,113,000) ................................. 85,821,872 24,825,481
Furniture and equipment .......................... 14,017,604 2,843,204
Leasehold improvements ........................... 3,937,223 488,403
------------- -------------
103,776,699 28,157,088
Less accumulated depreciation and amortization
3,432,193 189,347
------------- -------------
NET NETWORKS AND EQUIPMENT ......................... 100,344,506 27,967,741
------------- -------------
OTHER ASSETS
Restricted investments ........................... 56,206,738 --
Debt issuance costs, net ......................... 6,682,719 --
Miscellaneous .................................... 372,379 11,096
------------- -------------
TOTAL OTHER ASSETS ............................. 63,261,836 11,096
------------- -------------
TOTAL ASSETS ................................. $ 234,715,917 $ 28,385,270
============= =============
LIABILITIES AND MEMBERS' CAPITAL (DEFICIT)
CURRENT LIABILITIES
Accounts payable ................................. $ 11,264,241 $ 5,318,493
Accrued interest ................................. 15,521,634 --
Accrued other liabilities ........................ 1,185,820 205,166
Current maturities of long-term debt ............. 800,000 600,000
------------- -------------
TOTAL CURRENT LIABILITIES ..................... 28,771,695 6,123,659
ADVANCES FROM AFFILIATED COMPANY ................... -- 21,038,789
LONG-TERM DEBT, less current maturities:
15% Senior Notes ................................. 200,000,000 --
Notes payable .................................... 2,533,333 2,189,000
------------- -------------
TOTAL LIABILITIES ............................. 231,305,028 29,351,448
------------- -------------
MEMBERS' CAPITAL (DEFICIT)
Capital contributions ............................ 60,000,000 5,000,000
Accumulated deficit .............................. (56,589,111) (5,966,178)
------------- -------------
TOTAL MEMBERS' CAPITAL (DEFICIT) .............. 3,410,889 (966,178)
------------- -------------
$ 234,715,917 $ 28,385,270
============= =============
</TABLE>
See accompanying notes to consolidated financial statements.
34
<PAGE> 35
US XCHANGE, L.L.C.
CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
PERIOD FROM
AUGUST 5, 1996
YEAR ENDED YEAR ENDED (DATE OF INCEPTION)
DECEMBER 31, DECEMBER 31, TO DECEMBER 31,
1998 1997 1996
-------------- ------------- ---------------------
<S> <C> <C> <C>
REVENUES.............................................. $ 7,015,310 $ 206,682 $ --
COSTS AND EXPENSES
Cost of communication services (excluding
depreciation and amortization, shown separately below) 16,338,583 749,662 --
Selling, general and administrative................. 28,679,670 5,065,589 137,810
Depreciation and amortization....................... 3,609,055 189,347 --
------------- ------------ -----------------
TOTAL COSTS AND EXPENSES......................... 48,627,308 6,004,598 137,810
------------- ------------ -----------------
Loss from operations................................ (41,611,998) (5,797,916) (137,810)
------------ -----------------
INTEREST EXPENSE...................................... (13,486,996) (30,452) --
------------ -----------------
INTEREST INCOME....................................... 4,476,061 -- --
------------ -----------------
NET LOSS.......................................... $ (50,622,933) $ (5,828,368) $ (137,810)
============= ============ =================
</TABLE>
See accompanying notes to consolidated financial statements.
35
<PAGE> 36
US XCHANGE, L.L.C.
CONSOLIDATED STATEMENTS OF MEMBERS' CAPITAL (DEFICIT)
<TABLE>
<CAPTION>
CAPITAL ACCUMULATED
CONTRIBUTIONS DEFICIT TOTAL
------------- ------------- ------------
<S> <C> <C> <C>
Balance, August 5, 1996 (date of inception) $ -- $ -- $ --
Net loss for the period -- (137,810) (137,810)
------------ ------------ ------------
Balance, December 31, 1996 -- (137,810) (137,810)
Members' capital contributions 5,000,000 -- 5,000,000
Net loss for the year -- (5,828,368) (5,828,368)
------------ ------------ ------------
Balance, December 31, 1997 $ 5,000,000 $ (5,966,178) $ (966,178)
Members' capital contributions 55,000,000 -- 55,000,000
Net loss for the year -- (50,622,933) (50,622,933)
------------ ------------ ------------
Balance, December 31, 1998 $ 60,000,000 $(56,589,111) $ 3,410,889
============ ============ ============
</TABLE>
See accompanying notes to consolidated financial statements.
36
<PAGE> 37
US XCHANGE, L.L.C.
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
PERIOD FROM
AUGUST 5, 1996
YEAR ENDED YEAR ENDED (DATE OF INCEPTION)
DECEMBER 31, DECEMBER 31, TO DECEMBER 31,
1998 1997 1996
------------- ------------ -------------------
<S> <C> <C> <C>
OPERATING ACTIVITIES
Net loss .............................................. $ (50,622,933) $ (5,828,368) $ (137,810)
Adjustments to reconcile net loss to net cash used in
operating activities
Depreciation and amortization ....................... 3,609,055 189,347 --
Interest earned on restricted investments ........... (2,262,063) -- --
Changes in assets and liabilities:
Accounts receivable .............................. (1,720,268) (147,235) --
Other current assets ............................. (539,803) (134,933) (25,675)
Accounts payable ................................. 5,945,748 5,318,493 --
Accrued liabilities .............................. 16,502,288 205,166 --
------------- ------------ -------------------
NET CASH USED IN OPERATING ACTIVITIES ............ (29,087,976) (395,530) (163,485)
------------- ------------ -------------------
INVESTING ACTIVITIES
Purchase of restricted investments .................... (82,469,784) -- --
Purchase of networks and equipment .................... (75,619,611) (28,157,088) --
Increase in other assets .............................. (375,770) (11,096) --
------------- ------------ -------------------
NET CASH USED IN INVESTING ACTIVITIES ............ (158,465,165) (28,168,184) --
------------- ------------ -------------------
FINANCING ACTIVITIES
Proceeds from long-term debt, net of issuance costs ... 194,176,559 2,789,000 --
Repayment of long-term debt ........................... (666,667) -- --
Advances from affiliated company ...................... 61,211 20,875,304 163,485
Members' capital contributions ........................ 33,900,000 5,000,000 --
------------- ------------- -------------------
NET CASH PROVIDED BY FINANCING ACTIVITIES ........ 227,471,103 28,664,304 163,485
------------- ------------- -------------------
NET INCREASE IN CASH AND EQUIVALENTS ............. 39,917,962 100,590 --
CASH AND EQUIVALENTS, beginning of period ............. 100,590 -- --
CASH AND EQUIVALENTS, end of period ................... $ 40,018,552 $ 100,590 $ --
============= ============= ===================
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Interest paid (net of amounts capitalized) .......... $ 279,209 $ 12,334 $ --
============= ============= ===================
SUPPLEMENTAL DISCLOSURE OF NONCASH FINANCING ACTIVITIES
Conversion of advances to members' capital ............ $ 21,100,000 $ -- $ --
============= ============= ===================
</TABLE>
See accompanying notes to consolidated financial statements.
37
<PAGE> 38
US XCHANGE, L.L.C.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BUSINESS
US Xchange, L.L.C. and its wholly-owned subsidiaries (the "Company")
provide facilities-based competitive local telecommunications services in
selected cities of the north central area of the United States. The Company
operates in a single segment. The Company competes with incumbent local exchange
carriers ("ILECs") by offering business and residential customers innovative and
customized products, superior customer service and lower costs through the use
of an advanced telecommunications systems network.
From its inception in August 1996 until June 30, 1997, the Company was in
the development stage. During that time, the Company's principal activities
included developing its business plan, hiring management and other key
personnel, designing the architecture for its network systems and negotiating an
interconnection agreement with an ILEC. The Company's majority member and an
affiliated company of the majority member provided funding to the Company of 60
million.
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of US Xchange,
L.L.C. and its wholly-owned subsidiaries. All significant intercompany
transactions and balances have been eliminated in consolidation.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The carrying amounts for cash, accounts receivable, accounts payable and
accrued liabilities approximate their fair value. The carrying amount of
long-term debt also approximates its fair value. Fair value is determined based
on quoted market rates for similar financial instruments.
CASH AND EQUIVALENTS
The Company considers all highly liquid investments with a maturity of
three months or less when purchased to be cash equivalents.
CONCENTRATION OF CREDIT RISK
Financial instruments that potentially subject the Company to
concentrations of credit risk consist primarily of trade accounts receivables.
The risk is limited due to the large number of entities comprising the Company's
customer base and the dispersion of those entities across many different
industries and geographical areas. Credit is extended based on evaluation of the
customer's financial condition and generally collateral is not required.
Anticipated credit losses are provided for in the consolidated financial
statements and have been within management's expectations.
38
<PAGE> 39
NETWORKS AND EQUIPMENT
Networks and equipment are stated at cost. Leasehold improvements are
amortized using the straight-line method over their useful life or lease term,
whichever is shorter. Computer software costs are capitalized as part of office
equipment and furniture. Depreciation is calculated using the straight-line
method over the estimated useful lives of the assets as follows:
<TABLE>
<CAPTION>
YEARS
-------
<S> <C>
Telecommunications equipment................... 5-8
Fiber optic cable.............................. 20
Leasehold improvements......................... 10-15
Office furniture and equipment................. 3-7
</TABLE>
In March 1998, the AICPA issued Statement of Position ("SOP") No. 98-1
Accounting for Costs of Computer Software Developed or Obtained for Internal
Use. SOP 98-1 requires that certain internal-use software costs be capitalized
once certain criteria are met. The adoption of SOP 98-1 during the fourth
quarter of 1998 did not have a material effect on the Company's consolidated
financial statements. Capitalized computer software costs are reported as part
of office furniture and equipment.
Costs directly related to the construction of network systems and
facilities, including interest, are capitalized. Interest expense capitalized in
connection with construction projects amounted to $2,295,721 and $2,013 in 1998
and 1997, respectively. Repairs and maintenance costs are expensed as incurred.
The Company had firm commitments for capital expenditures of approximately
$7,000,000 at December 31, 1998.
LONG-LIVED ASSETS
The Company periodically reviews long-lived assets for impairment by
comparing the carrying value of the assets to their estimated future
undiscounted cash flows. If such assets are considered to be impaired, the
impairment to be recognized is measured by the amount by which the carrying
amount of the assets exceeds the fair value of the assets.
REVENUE RECOGNITION
Revenues are recognized as services are provided to customers.
ADVERTISING COSTS
Costs for advertising, which were approximately $2,020,000 and $180,000
for the years ended December 31, 1998 and 1997, respectively, are expensed as
incurred within the fiscal year. No advertising costs were incurred in 1996.
INCOME TAXES
The Company is treated as a partnership for U.S. federal income tax
purposes. Income and losses are reported on the respective tax returns of the
members, therefore, no provision for federal income taxes has been made in these
consolidated financial statements.
39
<PAGE> 40
USE OF ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the amounts reported in the financial statements and
accompanying notes. Actual results could differ from those estimates.
COSTS OF START-UP ACTIVITIES
In March 1998, the AICPA issued Statement of Position ("SOP") No. 98-5,
Reporting on the Costs of Start-Up Activities. The SOP requires that costs of
start-up activities and organization costs be expensed as incurred. The adoption
of SOP98-5 during the fourth quarter of 1998 did not have a material effect on
the Company's consolidated financial statements.
NEW ACCOUNTING STANDARDS
In June 1998, the Financial Accounting Standards Board issued SFAS No.
133, Accounting for Derivative Instruments and Hedging Activities. SFAS No. 133
requires companies to recognize all derivative contracts as either assets or
liabilities in the balance sheet and to measure them at fair value. It is
effective for all fiscal quarters of fiscal years beginning after June 15, 1999.
Historically, the Company has not entered into derivative contracts and,
therefore, does not expect that adoption of this statement will affect its
consolidated financial statements.
2. RESTRICTED INVESTMENTS
Restricted investments consist of U.S. government securities and money
market funds plus accrued interest thereon purchased in connection with the 15%
Notes (see Note 3) to secure the first three years' (six semi-annual) interest
payments on these notes. All these investments are classified as
held-to-maturity securities. Such investments are stated at cost, which
approximates fair value, and are reported in both current and long-term assets,
based upon the maturity dates of the individual securities.
3. LONG-TERM DEBT
On June 25, 1998, the Company completed a sale of $200 million principal
amount of 15% Senior Notes due 2008 (the "15% Notes"). Of the total net proceeds
approximating $193.1 million, the Company placed approximately $82.5 million,
representing funds, together with interest thereon, sufficient to pay the first
six semi-annual interest payments on the 15% Notes, into an escrow account for
the benefit of the holders. Issuance costs approximating $7 million are being
amortized ratably over the term of the debt. Interest on the 15% Notes is
payable semi-annually, on January 1 and July 1, commencing January 1, 1999. The
15% Notes are non-callable and mature in full on July 1, 2008.
The 15% Notes are unsubordinated, unsecured senior indebtedness of the
Company. The Company's subsidiaries have no obligation to pay amounts due on the
15% Notes and do not guarantee the 15% Notes. Therefore, the 15% Notes are
effectively subordinated to all existing and future liabilities (including trade
payables) of the Company's subsidiaries.
The 15% Notes are subject to certain covenants that, among other things,
restrict the ability of the Company and certain subsidiaries to incur additional
indebtedness, pay dividends or make distributions or redemptions in respect of
membership interests.
40
<PAGE> 41
On August 28, 1997, the Company entered into a credit facility agreement
with a local bank that provided for borrowings of up to $4,000,000 for the
acquisition of office furniture, equipment and computer software and for
construction costs related to leasehold improvements of office and switch site
locations. In March 1998, the credit facility was fully utilized and converted
into a term note payable in 60 equal monthly installments commencing April 1998.
Amounts borrowed bear interest at 1/2% under the bank's prime rate or 2% over
the bank's cost of funds, at the Company's option. The effective rate was 7.1%
at December 31, 1998. Specific assets and the guarantee of an affiliated company
owned by the Company's majority member secure all borrowings. The credit
facility also provides that the affiliated company maintains minimum debt to
tangible net worth and current ratio levels. At December 31, 1998, the
affiliated company was in compliance with the covenant requirements.
The aggregate principal repayments of long-term debt over the next five
years:
<TABLE>
<CAPTION>
YEAR ENDING DECEMBER 31,
=====================================================
<S> <C>
1999................................................. $ 800,000
2000................................................. 800,000
2001................................................. 800,000
2002................................................. 800,000
2003................................................. 133,000
</TABLE>
4. RELATED PARTY TRANSACTIONS
In connection with the Company's issuance of the 15% Notes, advances from
an affiliated company owned by the Company's majority member of $21.1 million
were converted to members' capital as of March 31, 1998. Under an expense
sharing agreement with the affiliated company, the Company incurred $346,198 and
$257,474 relating to management and administrative services for 1998 and 1997,
respectively. No expense was incurred for these services in 1996.
In June 1997, the Company entered into a lease agreement with another
affiliated company owned by the majority member for aircraft transportation
services. Total travel costs incurred under this arrangement for 1998 and 1997
was $111,422 and $69,083, respectively.
5. EMPLOYEE BENEFIT PLAN
In May 1997, the Company established a 401(k) plan which covers
substantially all employees. Employees who are 21 years of age or older are
eligible to participate in the 401(k) plan upon completion of three months of
service, at which time they may voluntarily contribute a percentage of
compensation. Participants are eligible to receive Company matching
contributions after completion of 12 months of service. The Company will match
50% of the participant's contribution up to a maximum of 3% of such
participant's eligible annual compensation. Matching contributions vest to the
participant over a five-year period. The cost of the plan in 1998 was $51,411.
The Company was not required to make a contribution to the plan for 1997.
6. LEASES
The Company leases administrative and sales office facilities, operating
sites and certain equipment under noncancelable operating leases having initial
or remaining terms of more than one year. Certain of the Company's facility
leases include renewal options, and most leases include provisions for rent
escalation to reflect increased operating costs and/or require the Company to
pay certain maintenance and utility costs. Rental expense under these operating
leases was $1,723,093 and $83,459 1998 and 1997, respectively. No rents were
paid in 1996.
41
<PAGE> 42
Future minimum lease payments under noncancelable operating leases at
December 31, 1998, were as follows:
<TABLE>
<CAPTION>
YEAR ENDING OFFICE OPERATING SITE
DECEMBER 31, FACILITIES FACILITIES EQUIPMENT TOTAL
-------------------------------- ------------ -------------- ---------- ------------
<S> <C> <C> <C> <C>
1999............................ $ 1,571,632 $ 576,382 $ 906,156 $ 3,054,170
2000............................ 2,072,571 596,306 872,987 3,541,864
2001............................ 2,054,331 603,752 396,789 3,054,873
2002............................ 1,844,086 592,205 132,932 2,569,223
2003-2007....................... 1,732,473 1,271,141 -- 3,003,614
2008-2012....................... -- 176,281 -- 176,281
============ ============= ========== ============
</TABLE>
7. SUBSEQUENT EVENT
On March 19, 1999, the Company received a commitment from a commercial
financing institution for a $50 million senior secured credit facility to be
used by subsidiaries of the Company for the acquisition of telecommunications
network equipment and for working capital.
8. QUARTERLY FINANCIAL DATA (UNAUDITED)
<TABLE>
<CAPTION>
1998
---------------------------------------------------------------------------------
First Quarter Second Quarter Third Quarter Fourth Quarter
--------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Revenues $ 565,203 $ 1,419,200 $ 2,144,552 $ 2,886,356
Operating loss (5,260,764) (8,569,793) (12,702,127) (14,729,372)
Net loss (5,321,499) (8,927,589) (16,782,715) (19,591,131)
--------------------------------------------------------------------------------------------------------------
</TABLE>
<TABLE>
<CAPTION>
1997
---------------------------------------------------------------------------------
First Quarter Second Quarter Third Quarter Fourth Quarter
--------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Revenues $ -- $ -- $ 28,308 $ 178,374
Operating loss (196,971) (634,023) (1,533,947) (3,432,975)
Net loss (196,971) (634,023) (1,533,947) (3,463,427)
--------------------------------------------------------------------------------------------------------------
</TABLE>
9. YEAR 2000 ISSUE (UNAUDITED)
Like other companies, US Xchange, L.L.C. could be adversely affected if
the computer systems the Company, its suppliers or customers use do not properly
process and calculate date-related information and data from the period
surrounding and including January 1, 2000. This is commonly known as the "Year
2000" issue. Additionally, this issue could impact non-computer systems and
devices such as elevators, other office equipment, etc. At this time, because of
the complexities involved in the issue, management cannot provide absolute
assurances that the Year 2000 issue will not have an impact on the Company's
operations.
42
<PAGE> 43
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
Not applicable.
43
<PAGE> 44
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
EXECUTIVE OFFICERS
The following table sets forth certain information concerning the
executive officers and other key management personnel of US Xchange, including
their ages as of December 31, 1998:
NAME AGE POSITION(S)
------------------- --- ---------------------------------------
Ronald H. VanderPol 47 Co-Chairman
Richard Postma 48 Co-Chairman and Chief Executive Officer
David J. Easter 40 Executive Vice President of Planning &
Business Development
Donald Offringa 48 Vice President of Finance
Barry Raterink 33 Vice President of Engineering & Network
Operations
Lee Thibaudeau 47 Regional President of US Xchange of Wisconsin,
L.L.C.
Daniel Fabry 36 Vice President of Marketing
Rick G. Pigeon 34 Vice President of Technology Development
Kara Chasteen 33 Vice President of Sales
Ronald H. VanderPol, Co-Chairman and co-founder of US Xchange, has over
15 years of experience in forming and operating successful telecommunications
companies including Teledial America, Inc. (which he founded in 1983 and which
later became known as US Signal), a switch-based long distance reseller
headquartered in Grand Rapids, MI, which was acquired by LCI International, Inc.
in 1996. In 1989, Mr. VanderPol formed City Signal, Inc., one of the earliest
providers of competitive local exchange services in the United States with
competitive local telephone company operations in eight cities, the Michigan
operations of which were acquired by Brooks Fiber Properties, Inc. in 1996 and
other components of which were acquired by Nextlink Communications Inc. and
Teleport Communications Group Inc. Other telecommunications operations which
were started by Mr. VanderPol and were spun-off over the same period of time
include Digital Signal, Inc., Teledial America of North Carolina and ATS Network
Services of Memphis, Tennessee.
Richard Postma, Co-Chairman, Chief Executive Officer and co-founder of US
Xchange, has over 15 years of experience in the telecommunications industry,
having served as the General Counsel to Teledial America, Inc., Teledial America
of North Carolina, Digital Signal, Inc., City Signal, Inc. and US Signal for
various periods between 1983 and 1996. As General Counsel, he served as the lead
individual in both the formation process and subsequent sale of those
operations. During the period from 1983 to December 1997, Mr. Postma was a
partner in the Grand Rapids, Michigan law firm of Miller, Johnson, Snell &
Cummiskey, P.L.C. Mr. Postma has extensive regulatory, legal and management
experience in the telecommunications arena and was instrumental in implementing
the first competitive access provider and competitive local telephone company
strategy in Michigan.
David J. Easter, Executive Vice President of Planning & Business
Development, has over 12 years of experience in the telecommunications industry.
Prior to joining us in September 1996, Mr. Easter was a principal of Telecom
Services, Inc., a telecommunications consultant, since February 1996. From
February
44
<PAGE> 45
1994 to January 1996, Mr. Easter was the Vice President of Network Services of
US Signal and previously held the position of Director of Network Services of US
Signal since March 1993.
Donald Offringa, CPA, Vice President of Finance, has overseen the
financial, tax and risk management matters of US Xchange and our affiliates
since our inception in August 1996. In June 1995, Mr. Offringa joined Mr.
VanderPol's management team as the Vice President of Finance of RVP Development
Corporation, a position he currently holds. Prior to that time, Mr. Offringa had
been a partner with BDO Seidman, LLP since 1986, where he had worked with US
Signal on various financial advisory matters. He has over 24 years of accounting
experience with both private and public companies.
Barry Raterink, Vice President of Engineering & Network Operations, has
over 12 years of experience in the telecommunications industry. Prior to joining
US Xchange in September 1997, Mr. Raterink was Manager of Engineering, Planning
and Provisioning for the Great Lakes regional operations of Brooks Fiber
Properties, Inc. since February 1996. From 1986 to January 1996, Mr. Raterink
was Manager of the network planning and provisioning groups for Teledial
America, Inc., US Signal and City Signal, Inc., after having implemented and
managed long distance switch sites for Teledial America, Inc.
Lee Thibaudeau, Regional President of US Xchange of Wisconsin, L.L.C., a
wholly-owned subsidiary of US Xchange, has over 14 years of experience in the
telecommunications industry. Prior to joining us in March 1997, Mr. Thibaudeau
was Director of Program Management of Schneider National, Inc., a trucking
company, since February 1996. Mr. Thibaudeau served as Vice
President--Operations of Schneider Communications Incorporated, a regional
facilities-based long distance company that was headquartered in Wisconsin and
is now a part of Frontier Communications Corporation, a major long distance
company, from 1983 to January 1996.
Daniel Fabry, Vice President of Marketing, has over 14 years of
experience in the telecommunications industry. Prior to joining US Xchange in
March 1997, Mr. Fabry held the position of Director of Marketing for Schneider
Logistics, Inc., a provider of transportation logistics services, since February
1996. From December 1994 until February 1996, Mr. Fabry was the Vice President
of Product Development of Schneider Communications and Frontier Communications.
From February 1993 to December 1994, Mr. Fabry was the Director of Product
Development of Schneider Communications.
Rick G. Pigeon, Vice President of Technology Development, has over 13
years of experience in the telecommunications industry. Prior to joining us in
March 1997, Mr. Pigeon was the Director of Product Development for Airadigm
Communications Inc. , a PCS provider, from April 1996. Prior to joining Airadigm
Communications, Mr. Pigeon was Senior Manager, Local Operations for Frontier
Communications from August 1995 to April 1996. From October 1993 to August 1995,
Mr. Pigeon was Product Manager at Schneider Communications. Prior thereto, Mr.
Pigeon was Manager of Network Systems at Schneider Communications.
Kara Chasteen, Vice President of Sales, has over 11 years of experience
in the telecommunications industry. Prior to joining US Xchange in December
1997, Ms. Chasteen spent nine years with MCI, serving as a Regional Sales
Manager from January 1993 to December 1997 and as a Local Sales Manager prior to
1993.
LIMITED LIABILITY COMPANY OPERATING AGREEMENT
The Operating Agreement of US Xchange became effective as of August 1,
1996, and provides that our maximum duration is until December 31, 2030. The
Operating Agreement provides that our members
45
<PAGE> 46
will manage our business. Messrs. VanderPol and Postma, our Co-Chairmen and
co-founders, are currently the only members, holding 99% and 1%, respectively,
of the membership interests in US Xchange. See Item 12, "Security Ownership of
Certain Beneficial Owners and Management." Members must act collectively through
meetings or written consents and vote in proportion to their relative membership
interests. Except as the Operating Agreement, our Articles of Organization or
applicable law specifically provide otherwise, all decisions of the members
require the affirmative vote of the holders of a majority in interest of the
membership interests. The Operating Agreement provides for annual meetings of
the members to be held at the dates, times and places that the members
determine. The holders of at least 25% of the membership interests may call
special meetings of the members for any proper purpose at any time.
Except as otherwise specifically provided in the Operating Agreement, a
member does not have the right to sell, assign, pledge, create a security
interest in, exchange or otherwise transfer all or any part of his or her
membership interest without the prior written consent of all the members. A
person or entity may be admitted as an additional member only with the unanimous
consent of the then-current members and upon compliance with the conditions
imposed, if any, by unanimous consent of the then-current members. Admission of
a new member may occur by (i) issuance of additional membership interests for
consideration to be unanimously determined by the then-current members or (ii)
as a transferee of a member's membership interest or any portion thereof,
subject to the terms and conditions of the Operating Agreement.
SUMMARY COMPENSATION TABLE
The following table sets forth the compensation paid to our Chief Executive
Officer and the four executive officers of US Xchange whose total annual salary
and bonus exceeded $100,000 during 1998.
<TABLE>
<CAPTION>
LONG TERM
ANNUAL COMPENSATION COMPENSATION
------------------------------------------------- ---------------------------
OTHER ANNUAL SECURITIES ALL OTHER
NAME AND COMPENSATION UNDERLYING COMPENSATION
PRINCIPAL POSITION YEAR SALARY($) BONUS($) ($) OPTIONS(#) ($)
---------------------------------- ----------- ---------- ------------ ------------ ------------
<S> <C> <C> <C> <C> <C> <C>
Richard Postma.............. 1998 --(1) --(1) -- -- --
Co-Chairman and 1997 --(1) --(1) -- -- --
Chief Executive Officer
David J. Easter............. 1998 $120,000 $30,000(2) -- -- $ 3,650(4)
Executive Vice President of 1997 111,667 25,000(2) -- -- --
Planning & Business
Development
Lee Thibaudeau.............. 1998 131,516 20,000(3) -- -- 2,763(4)
Regional President of US 1997 102,917 20,000(3) -- -- --
Xchange of Wisconsin,
L.L.C.
Daniel Fabry................ 1998 120,000 20,000(3) -- -- 3,300(4)
Vice President of Marketing 1997 90,461 20,000(3) -- -- --
Rick G. Pigeon.............. 1998 105,000 15,000(2) -- -- 2,213(4)
Vice President of 1997 64,077 15,000(2) -- -- --
Technology
Development
</TABLE>
- -------------------
(1) Mr. Postma did not receive any salary or bonus for his services as Chief
Executive Officer of the Company during 1998 or 1997. During 1997, Mr.
Postma was a member of a law firm that provided legal services to US
Xchange.
(2) As determined by the Co-Chairmen of US Xchange, at their discretion. Such
officer does not have an employment agreement.
(3) As determined by management in accordance with such officer's employment
agreement. See "--Employment Agreements" below.
(4) Matching contributions to the Company's 401(k) Plan.
46
<PAGE> 47
EMPLOYMENT AGREEMENTS
US Xchange has an employment agreement with each of Lee Thibaudeau,
Regional President of US Xchange of Wisconsin, L.L.C., a wholly-owned subsidiary
of US Xchange, Daniel Fabry, Vice President of Marketing, and Rick G. Pigeon,
Vice President of Technology Development. The terms of the employment agreements
of Messrs. Thibaudeau, Fabry and Pigeon expire on March 16, 2003, March 31, 2003
and April 20, 2000, respectively. The term of each employment agreement is
automatically renewable for successive one-year periods unless terminated by
either party by written notice at least 90 days prior to the applicable
anniversary date of the agreement. Pursuant to these employment agreements, we
must pay Messrs. Thibaudeau, Fabry and Pigeon an annual salary of not less than
$130,000, $120,000 and $85,000, respectively. Each of such officers is eligible
under his employment agreement for an annual bonus in such amount as is approved
by management, which the respective employment agreement provides is anticipated
at a minimum of $20,000 for each of Messrs. Thibaudeau and Fabry and a maximum
of $15,000 for Mr. Pigeon. In the event that we terminate the employment of Mr.
Thibaudeau or Mr. Fabry for any reason other than "just cause" (as defined in
his employment agreement), we must continue to pay his salary and benefits for a
period of one year following the date of termination. Such continuing salary and
benefits obligations are personally guaranteed by Ronald H. VanderPol, our
Co-Chairman and co-founder. See Item 13, "Certain Relationships and Related
Transactions." The employment agreements contain customary confidentiality,
non-competition and non-solicitation provisions which are effective during the
term of the employment agreement and for a period of one year thereafter, unless
we terminate the executive's employment without "just cause."
Additionally, the employment agreements of Messrs. Thibaudeau and Fabry
provide that upon the first to occur of: (i) the sale of our Wisconsin region
assets; (ii) the sale of all of our assets or equity interests; (iii) the
completion of an initial public offering of our equity interests; or (iv) a
merger of US Xchange with another entity in which we are not the surviving
entity (each, a "Triggering Event"), we will pay Messrs. Thibaudeau and Fabry
the first $1.5 million and $500,000, respectively, of the net equity of the
Wisconsin region (after subtracting our capitalization and outstanding debt
related to the Wisconsin region) ("Equity Guarantee"). We will also pay Messrs.
Thibaudeau, Fabry and Pigeon a specified share (the "Equity Share") of the total
net equity following the occurrence of a Triggering Event, provided, however,
that the respective Equity Guarantee payments described above shall be included
in calculating the applicable Equity Share of Messrs. Thibaudeau and Fabry.
Messrs. Thibaudeau, Fabry and Pigeon's applicable Equity Shares are 5%, 2% and
1%, respectively. Notwithstanding the above, if the executive's employment is
terminated for any reason during the first five years of his employment
agreement, the executive will forfeit 20% of the Equity Guarantee and 20% of the
Equity Share for each year or partial year less than five that we employ the
executive. Upon the occurrence of a Triggering Event, the executive must execute
an employment agreement and non-compete agreement with the purchaser for a
period of not less than one year, provided that the salary to be paid Messrs.
Thibaudeau, Fabry and Pigeon during such period will not be less than such
executive's annual salary immediately prior to the sale, and further provided
that such employment agreement and non-compete agreement must be consistent with
the terms and conditions of such executive's employment agreement with US
Xchange.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
Ronald H. VanderPol, our Co-Chairman and co-founder, beneficially owns
99% of our membership interests. Richard Postma, our Co-Chairman, Chief
Executive Officer and co-founder, owns 1% of the
47
<PAGE> 48
membership interests in US Xchange. See Item 10, "Directors and Executive
Officers of the Registrant--Limited Liability Company Operating Agreement."
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Ronald H. VanderPol, our Co-Chairman and co-founder, has provided us our
initial equity capital of $60 million. Of such amount, approximately $26 million
was invested at December 31, 1997, and the balance was invested during the first
four months of 1998. We have used these funds to acquire capital assets and fund
operating costs. Of the amounts invested by Mr. VanderPol, (i) approximately
$346,000 and $257,000 represented the value of management and administrative
services provided to us during 1998 and 1997, respectively, by RVP Development
Corporation, a holding company wholly-owned by Mr. VanderPol, pursuant to an
Expense Sharing Agreement dated February 1, 1997 between us and RVP and (ii)
$3,283,750 represented securities contributed by Mr. VanderPol to US Xchange.
Pursuant to the Expense Sharing Agreement, RVP billed us for our pro rata share
of employee compensation costs and facilities expenses for our principal
executive offices in Grand Rapids, Michigan, which were funded by RVP in 1997.
Richard Postma, our Co-Chairman and Chief Executive Officer, also serves as
Co-Chairman of RVP, and Donald Offringa, our Vice President of Finance, also
serves as the Vice President of Finance of RVP. RVP has guaranteed our payment
obligations under our bank credit facility. See Item 7, "Management's Discussion
of Financial Condition and Results of Operations--Liquidity and Capital
Resources."
We also lease a corporate aircraft from an entity controlled by Mr.
VanderPol under a lease that is terminable by either party upon 10 days' prior
written notice. We made payments to this entity for the aircraft totaling
approximately $111,000 and $69,000 during 1998 and 1997, respectively.
We have made arrangements for the development of a new 65,000 square foot
addition to our existing 44,000 square foot headquarters facility in Grand
Rapids, Michigan and will accommodate our need for additional headquarters
office space. We expect to enter into a long-term lease and occupy the new
facility during the third quarter of 1999. The new facility is being developed
as a partnership between RVP Development Corporation and the property owner.
We believe that the above transactions were and, with respect to the new
facility, will be on terms no less favorable to us than we could have been
obtained in transactions with independent third parties.
Pursuant to employment agreements between us and certain of our executive
officers, Mr. VanderPol has personally guaranteed the payment of salary and
continuation of benefits for a period of one year following the date of
termination of employment of any of such persons in the event that we terminate
the employment agreements for any reason other than "just cause." See Item 10,
"Directors and Executive Officers of the Registrant--Management--Employment
Agreements."
48
<PAGE> 49
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) Documents filed (or incorporated by reference) as a part of this
report:
1. The financial statements set forth in Item 8, "Financial
Statements and Supplementary Data."
2. Financial Statement Schedules:
The following consolidated financial statement schedule is
included in this report in accordance with Item 8 and paragraph (d) of Item 14:
(i) Report of Independent Certified Public Accountants on
Financial Statement Schedule; and
(ii) Schedule II. Valuation and Qualifying Accounts.
3. Exhibits filed with (or incorporated by reference into) this
report:
3.1 Articles of Organization of US Xchange, L.L.C.
3.2 Operating Agreement of US Xchange, L.L.C. dated as of
August 1, 1996
4.1 Indenture dated as of June 25, 1998 between US
Xchange, L.L.C. and The Bank of New York, as Trustee
4.2 Collateral Pledge and Security Agreement dated as of
June 25, 1998 among US Xchange, L.L.C., as Pledgor,
and The Bank of New York, as Trustee and Collateral
Agent
4.3 The Company has not filed certain instruments with
respect to long-term debt since the total amount of
securities authorized thereunder does not exceed 10%
of the total assets of US Xchange, L.L.C. and our
subsidiaries on a consolidated basis. US Xchange,
L.L.C. agrees to furnish a copy of any such agreement
to the Commission upon request.
10.1 Expense Sharing Agreement dated February 1, 1997
between US Xchange, L.L.C. and RVP Development
Corporation
*10.2 Employment Agreement dated March 3, 1997 between US
Xchange, L.L.C. and Lee Thibaudeau
*10.3 Employment Agreement dated February 22, 1997 between
US Xchange, L.L.C. and Daniel Fabry
*10.4 Employment Agreement dated March 29, 1997 between US
Xchange, L.L.C. and Rick G. Pigeon
12.1 Statement re Computation of Ratio of Earnings to Fixed
Charges
21.1 Subsidiaries of the Registrant
27.1 Financial Data Schedule
99.1 Risk Factors
--------------
* Management contract filed pursuant to Item 14(c) of Form 10-K.
(b) Reports on Form 8-K:
The Registrant filed no reports on Form 8-K during the last quarter of
the fiscal year ended December 31, 1998.
49
<PAGE> 50
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
ON FINANCIAL STATEMENT SCHEDULE
US Xchange, L.L.C.
Grand Rapids, Michigan
The audits referred to in our report to US Xchange, L.L.C. and subsidiaries
dated February 25, 1999, relating to the consolidated financial statements of US
Xchange, L.L.C., which is contained in Item 8 of this Form 10-K for the year
ended December 31, 1998, included the audit of Schedule II - Valuation and
Qualifying Accounts. This financial statement schedule is the responsibility of
the Company's management. Our responsibility is to express an opinion on the
financial statement schedule based upon our audits.
In our opinion, such financial statement schedule presents fairly, in all
material respects, the information set forth therein.
/s/ BDO SEIDMAN, LLP
Grand Rapids, Michigan
February 25, 1999
50
<PAGE> 51
Schedule II -- VALUATION AND QUALIFYING ACCOUNTS
US XCHANGE, L.L.C.
<TABLE>
<CAPTION>
BALANCE CHARGED TO BALANCE
AT BEGINNING COSTS AND AT END
OF PERIOD EXPENSES DEDUCTIONS(1) OF PERIOD
---------------------------------------------------------------------
<S> <C> <C> <C> <C>
Period Ended December 31, 1996
Reserves and allowances deducted from asset accounts:
Allowance for uncollectible accounts $ - $ - $ - $ -
Year Ended December 31, 1997
Reserves and allowances deducted from asset accounts:
Allowance for uncollectible accounts $ - $ 2,000 $ - $ 2,000
Year Ended December 31, 1998
Reserves and allowances deducted from asset accounts:
Allowance for uncollectible accounts $2,000 $227,949 $55,949 $174,000
</TABLE>
(1) Uncollectible accounts charged off, net of recoveries
51
<PAGE> 52
SIGNATURES
Pursuant to the requirements of the 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 by the undersigned thereunto duly authorized.
US XCHANGE, L.L.C.
March 30, 1999 By: /s/ Richard Postma
--------------------------------
Richard Postma
Co-Chairman and Chief Executive
Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed by the following persons on behalf of the registrant and
in the capacities and on the dates indicated.
<TABLE>
<CAPTION>
SIGNATURE TITLE DATE
----------------------------- ------------------------------------ --------------
<S> <C> <C>
/s/ Richard Postma Co-Chairman, Chief Executive Officer March 30, 1999
----------------------------- and Member
Richard Postma
/s/ Ronald H. VanderPol Co-Chairman and Member March 30, 1999
-----------------------------
Ronald H. VanderPol
/s/ Donald Offringa Vice President of Finance (Principal March 30, 1999
----------------------------- Financial Officer and Principal
Donald Offringa Accounting Officer)
</TABLE>
SUPPLEMENTAL INFORMATION TO BE FURNISHED WITH REPORTS FILED PURSUANT TO SECTION
15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 BY REGISTRANTS WHICH HAVE NOT
REGISTERED SECURITIES PURSUANT TO SECTION 12 OF THE SECURITIES EXCHANGE ACT OF
1934.
No annual report or proxy material has been sent to the Registrant's
security holders with respect to fiscal 1998 or any other annual or special
meeting of security holders, and the Registrant does not intend to send to
holders of its securities any such materials relating to fiscal year 1998.
52
<PAGE> 53
INDEX TO EXHIBITS
EXHIBIT
NUMBER DESCRIPTION
------- ----------------------------------------------------
3.1 Articles of Organization of US Xchange, L.L.C.
(incorporated by reference to Exhibit 3.1 to our
registration statement on Form S-4 (Commission File
No. 333-64717) filed September 26, 1998, the "Form
S-4")
3.2 Operating Agreement of US Xchange, L.L.C. dated as of
August 1, 1996 (incorporated by reference to Exhibit
3.2 to the Form S-4)
4.1 Indenture dated as of June 25, 1998 between US
Xchange, L.L.C. and The Bank of New York, as Trustee
(incorporated by reference to Exhibit 4.3 to the Form
S-4)
4.2 Collateral Pledge and Security Agreement dated as of
June 25, 1998 among US Xchange, L.L.C., as Pledgor,
and The Bank of New York, as Trustee and Collateral
Agent (incorporated by reference to Exhibit 4.4 to the
Form S-4)
4.3 US Xchange, L.L.C. has not filed certain instruments
with respect to long-term debt since the total amount
of securities authorized thereunder does not exceed
10% of the total assets of US Xchange, L.L.C. and its
subsidiaries on a consolidated basis. US Xchange,
L.L.C. agrees to furnish a copy of any such agreement
to the Commission upon request.
10.1 Expense Sharing Agreement dated February 1, 1997
between US Xchange, L.L.C. and RVP Development
Corporation (incorporated by reference to Exhibit 10.1
to the Form S-4)
10.2 Employment Agreement dated March 3, 1997 between US
Xchange, L.L.C. and Lee Thibaudeau (incorporated by
reference to Exhibit 10.2 to the Form S-4)
10.3 Employment Agreement dated February 22, 1997 between
US Xchange, L.L.C. and Daniel Fabry (incorporated by
reference to Exhibit 10.3 to the Form S-4)
10.4 Employment Agreement dated March 29, 1997 between US
Xchange, L.L.C. and Rick G. Pigeon (incorporated by
reference to Exhibit 10.4 to the Form S-4)
12.1 Statement re Computation of Ratio of Earnings to Fixed
Charges
21.1 List of Subsidiaries
27.1 Financial Data Schedule
99.1 Risk Factors
1
<PAGE> 1
EXHIBIT 12.1
US XCHANGE, L.L.C
STATEMENT RE COMPUTATION OF
RATIO OF EARNINGS TO FIXED CHARGES
<TABLE>
<CAPTION>
FISCAL YEAR ENDED
DECEMBER 31,
1998 1997 1996
------------ ----------- ---------
<S> <C> <C> <C>
SELECTED HISTORICAL DATA
Earnings were calculated as follows:
Income (loss) before taxes $(50,622,933) $(5,828,368) $(137,810)
Add: Fixed charges 17,052,965 93,146 -
Deduct: Capitalized interest 2,295,721 2,103 -
------------ ----------- ---------
Earnings $(35,865,689) $(5,737,325) $(137,810)
------------ ----------- ---------
Fixed charges were calculated as follows:
Interest expense 13,486,996 30,452 -
Amortization of debt issuance costs 351,722 - -
Portion of rentals attributable to interest 918,526 60,591 -
Capitalized interest 2,295,721 2,103 -
------------ ----------- ---------
Fixed charges $ 17,052,965 $ 93,146 -
------------ ----------- ---------
Ratio of earnings to fixed charges 0 0 0
------------ ----------- ---------
Deficiency $ 52,918,654 $ 5,830,471 $ 137,810
------------ ----------- ---------
</TABLE>
<PAGE> 1
EXHIBIT 21.1
Subsidiaries of the Registrant
Name of Subsidiary State of Incorporation
------------------ ----------------------
US Xchange of Wisconsin LLC Wisconsin
US Xchange of Indiana LLC Indiana
US Xchange of Illinois LLC Illinois
US Xchange of Michigan LLC Michigan
US Xchange of Minnesota LLC Minnesota
US Xchange of Washington LLC Washington
US Xchange of South Carolina LLC South Carolina
US Xchange of North Carolina LLC North Carolina
US Xchange of Missouri LLC Missouri
US Xchange of California LLC California
US Xchange of Georgia LLC Georgia
US Xchange of Florida LLC Florida
US Xchange of Oregon LLC Oregon
US Xchange of Kentucky LLC Kentucky
US Xchange of Ohio LLC Ohio
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
FINANCIAL STATEMENTS OF US XCHANGE, L.L.C. AND IS QUALIFIED IN ITS ENTIRETY BY
REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<CIK> 0001070677
<NAME> US XCHANGE LLC
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> DEC-31-1998
<CASH> 40,018,552
<SECURITIES> 84,731,847
<RECEIVABLES> 2,039,503
<ALLOWANCES> 174,000
<INVENTORY> 0
<CURRENT-ASSETS> 71,109,575
<PP&E> 103,776,699
<DEPRECIATION> 3,432,193
<TOTAL-ASSETS> 234,715,917
<CURRENT-LIABILITIES> 28,771,695
<BONDS> 202,533,333
0
0
<COMMON> 60,000,000
<OTHER-SE> (56,589,111)
<TOTAL-LIABILITY-AND-EQUITY> 3,410,889
<SALES> 0
<TOTAL-REVENUES> 7,015,310
<CGS> 0
<TOTAL-COSTS> 48,627,308
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 13,486,996
<INCOME-PRETAX> (50,622,933)
<INCOME-TAX> 0
<INCOME-CONTINUING> (50,622,933)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (50,622,933)
<EPS-PRIMARY> 0
<EPS-DILUTED> 0
</TABLE>
<PAGE> 1
EXHIBIT 99.1
RISK FACTORS
From time to time, US Xchange, L.L.C. may make written or oral
"forward-looking statements" within the meaning of the Private Securities
Litigation Reform Act of 1995. Written forward-looking statements may appear in
documents we file with the Securities and Exchange Commission, in press
releases, and in reports to our securityholders. The Private Securities
Litigation Reform Act of 1995 contains a safe harbor for forward-looking
statements on which we rely in making these disclosures. You can identify
forward-looking statements through our use of words such as "believe,"
"anticipate," "plan," "expect," "may," "will," "intend," "estimate" (and the
negatives of these words) and similar expressions. Certain of our
forward-looking statements may also discuss items such as:
- our current development plans and business strategies;
- anticipated revenues and demand in our markets;
- the growth of our operations and the markets for our services and
products;
- our anticipated capital expenditures;
- possible changes in regulatory requirements;
- our competition and competitive challenges; and
- changes in technology.
In this exhibit we identify some important risk factors that could cause our
actual results to differ materially from those contemplated by any of our
forward-looking statements. All of our forward-looking statements are qualified
by reference to the following risk factors.
WE HAVE A LIMITED HISTORY OF OPERATIONS AND EXPECT TO CONTINUE TO INCUR
SIGNIFICANT LOSSES, NEGATIVE CASH FLOW FROM OPERATIONS AND NEGATIVE EBITDA AS WE
EXPAND OUR OPERATIONS
We commenced commercial operations in July 1997. As a result of our
limited operating history, you have limited operating and financial data about
us upon which you can evaluate our performance and an investment in US Xchange.
Our business plan requires that we make significant capital expenditures and
incur significant operating expenses as we enter and establish our
facilities-based services in each of our markets. To date, we have generated
only limited revenues from our operations and we have incurred significant
operating losses, negative EBITDA and negative cash flows from operating and
investing activities. We expect to continue to incur negative cash flows and
negative EBITDA in each of our markets for approximately 24 to 36 months after
we commence facilities-based switched operations in each such market. As a
result, we expect to experience increasing consolidated losses as we expand our
operations, build our networks and switching facilities, and develop our
customer base. None of our markets currently generates positive operating cash
flow or EBITDA. We cannot assure you that we will sufficiently increase our
revenues, achieve or sustain positive EBITDA or profitability or generate
sufficient operating cash flow to meet our working capital and debt service
requirements.
1
<PAGE> 2
WE NEED SUBSTANTIAL CAPITAL TO DEVELOP AND EXPAND OUR BUSINESS
We need significant capital to continue to develop and expand our
networks, services and customer base, and to continue to fund our expected
losses. As of December 31, 1998, we estimate that our future capital
requirements for our current networks will aggregate approximately $ 85 million.
Our estimated capital requirements include capital expenditures, working
capital, debt service and operating losses that we will need to incur to
install, deploy and operate the networks and switching systems in our current
markets and to construct or acquire long-haul fiber routes to interconnect such
networks. At December 31, 1998, we had unrestricted cash totaling approximately
$40 million, and on March 19, 1999, we secured a binding commitment from a
commercial financing institution for a senior secured credit facility totaling
$50 million (this commitment is subject to the execution and delivery of
definitive financing documents and is expected to close by April 30, 1999). We
expect that these capital resources, together with cash expected to be generated
from future revenues, will be sufficient to fully fund the planned development
of our current markets. However, the actual amount of our capital requirements
may vary significantly from our estimates based upon a number of factors,
including, among other things:
- the timing and success of our current development plans;
- shortfalls in our revenue and cost projections;
- demand for our services;
- regulatory, technological and competitive developments;
- any decision to expand our operations into additional commercial
regions or markets; and
- any acquisitions or joint ventures that we decide to undertake.
WE ARE HIGHLY LEVERAGED AND MAY INCUR SUBSTANTIAL ADDITIONAL INDEBTEDNESS
As of December 31, 1998, on a pro forma basis after giving effect to $50
million of borrowings under the pending senior secured credit facility, we would
have had total indebtedness of $253.3 million, and $60.0 million of contributed
equity. The terms of our pending senior secured credit facility and of our
existing 15% Senior Notes limit, but do not prohibit, us from incurring
additional indebtedness. In particular, we and our subsidiaries may, subject to
certain restrictions, incur an unlimited amount of indebtedness (including
secured indebtedness) to finance the cost of equipment, inventory and network
assets, including the cost to design, develop, acquire, construct, install,
improve, transport and integrate any of those items.
Our relatively high level of indebtedness could have important consequences
to our future prospects. For example, it could:
- limit our ability to obtain any necessary financing in the future for
working capital, capital expenditures, debt service requirements or
other purposes;
- require that we dedicate a substantial portion of our cash flow from
operations, if any, to paying principal of and interest on our
indebtedness;
- limit our flexibility in planning for, or reacting to changes in, our
business;
- make us more highly leveraged than some of our competitors, which may
place us at a competitive disadvantage; and
2
<PAGE> 3
- increase our vulnerability in the event of a downturn in our business.
We cannot assure you that our consolidated operating cash flows and
capital resources will be sufficient to pay our indebtedness. In fact, we may
need to refinance a substantial portion of our debt because of a deficiency. We
cannot assure you that we will be able to refinance any of our debt on
commercially reasonable terms or at all. Our ability to meet our debt service
requirements and to refinance any debt will depend upon, among other things, our
future performance, which, in turn, will depend upon prevailing economic
conditions and financial, business, regulatory and other factors, many of which
are beyond our control. Further, we cannot assure you that we will have
sufficient funds available at the time of certain change of control events to
make any required debt repayments, including required repurchases of our 15%
Senior Notes.
DEBT RESTRICTIONS LIMIT OUR FINANCIAL AND OPERATIONAL FLEXIBILITY
The terms of our pending senior secured credit facility and of our
existing 15% Senior Notes impose certain financial and operating restrictions on
us and our restricted subsidiaries. These restrictions limit, among other
things, our ability to:
- incur additional indebtedness;
- create liens;
- engage in sale-leaseback transactions;
- sell assets;
- effect consolidations or mergers;
- make investments and certain other restricted payments;
- pay dividends and make distributions in respect of membership
interests;
- redeem membership interests;
- issue or sell membership interests of our restricted subsidiaries; and
- enter into transactions with any of our members or affiliates.
While these limitations are subject to a number of important
qualifications and exceptions, if we were to fail to comply with these
restrictions and, in some cases, were to fail to cure our noncompliance, we
would be in default under the terms of our pending senior secured credit
facility and of our existing 15% Senior Notes. In addition, the terms of any
additional debt or equity financings that we might obtain could further restrict
our financial and operational flexibility.
OUR HOLDING COMPANY STRUCTURE MAY LIMIT OUR ABILITY TO MAKE DEBT PAYMENTS
US Xchange is a holding company, and our principal assets consist of our
equity interests in our subsidiaries. We rely upon payments from our
subsidiaries to generate the funds necessary to meet our obligations, including
our payment obligations under our 15% Senior Notes and our existing bank credit
facility. Our subsidiaries, however, are legally distinct from us and have no
obligation, contingent or otherwise, to pay amounts due or make funds available
for payment under our parent company indebtedness. Our subsidiaries have not
guaranteed any of our indebtedness. Moreover, the borrower under our pending
senior secured credit facility will be a wholly-owned subsidiary of US Xchange
and US Xchange will be a guarantor of such indebtedness. The ability of our
subsidiaries to make payments to us will be subject to, among other things, the
availability of funds and the terms of the indebtedness of our parent company
subsidiaries. The indenture governing our 15% Senior Notes and our existing bank
credit
3
<PAGE> 4
facility permits our subsidiaries to incur substantial amounts of indebtedness.
Claims of our subsidiaries' creditors, including trade creditors, will generally
have priority as to the assets of the subsidiaries over the claims of the
holders of indebtedness of US Xchange. Accordingly, our parent company
indebtedness, including our 15% Senior Notes and our existing bank credit
facility, are effectively subordinated to the liabilities (including trade
payables) of our subsidiaries. As of December 31, 1998, on a pro forma basis
after giving effect to $50 million in borrowings under our pending senior
secured credit facility, our subsidiaries would have had approximately $58.6
million of liabilities (excluding intercompany payables).
WE FACE SIGNIFICANT COMPETITION
The telecommunications industry is highly competitive, and one of the
primary purposes of the Telecommunications Act of 1996 is to foster additional
competition. We expect to experience declining prices and increasing price
competition. We cannot assure you that we will be able to achieve or maintain
adequate market share or margins, or compete effectively, in any of our markets.
In each of our markets, we compete principally with the incumbent local
exchange carrier serving such market, either Ameritech or GTE. We expect to face
significant competitive product and pricing pressure from these companies
because the incumbent has
- long-standing relationships with its customers,
- financial, technical, marketing, personnel and other resources,
including brand name recognition, substantially greater than ours,
- the potential to fund competitive services with cash flows from a
variety of businesses, and
- a nearly monopolistic market share.
In each of our commercial regions, we also face significant competition from
other facilities-based competitive local telephone companies and long distance
carriers, which further increases the pricing pressures on our business. After
the investment and expense of establishing a network and support services in a
given market, the marginal cost of carrying an additional call is negligible. We
believe that Tier III markets will support only a limited number of competitors
and that operations in Tier III markets with multiple competitive providers are
likely to be unprofitable for one or more of the competitive providers.
Prices in both the long distance business and the data transmission business
have declined significantly in recent years and we expect them to continue to
decline. We face competition from large long distance carriers such as AT&T
Corp., MCI WorldCom, Inc. and Sprint Corporation, as well as smaller carriers,
who have begun to offer integrated local, long distance and data
telecommunications services. AT&T recently acquired Teleport Communications
Group, Inc., a major competitive local exchange carrier, and
Tele-Communications, Inc., a major cable television company, and MCI WorldCom
has recently acquired local networks in approximately 100 cities. These
combinations have enhanced the ability of these carriers to offer bundled local
and long distance telecommunications services. Regional Bell operating companies
are also making concerted efforts to gain regulatory permission to offer their
own bundled local and long distance telecommunications services.
As telecommunications technologies continue to change rapidly, we expect
increasing competition in our markets from other potential competitors who may
be considered less traditional providers of telecommunications services,
including:
- cable television companies;
4
<PAGE> 5
- microwave, satellite and other wireless telecommunications providers;
- providers of internet telephony services;
- electric utilities; and
- resellers.
In particular, companies offering or preparing to offer internet-protocol-based
voice and data transmission services, such as Qwest Communications
International, Inc., Level 3 Communications, Inc., and Williams Communications
Group are building nationwide networks that can access each of our markets.
Electric utilities and cable companies are likely competitors given their
existing rights of way. Electric utilities using Digital Line Power technologies
can transmit internet and data services over their power lines at speeds faster
than those achievable by telephone companies on their digital subscriber or
integrated services digital network lines. Other new technologies such as
internet telephony, cable modem service and wireless networks utilizing local
multi-point distribution services and satellite transmission, which can be used
to provide high capacity wireless local loop, local area network, internet
access and interactive services, have also created significant new competitors
that may have a lower cost basis than ours. We believe that there may also be an
increasing level of agent and distributor resale initiatives in our markets,
which may add further to competitive pricing pressures.
WE MAY BE UNABLE TO MANAGE OUR GROWTH SUCCESSFULLY
We must achieve substantial growth in order to meet our payment
obligations on our existing indebtedness. To grow our business we will need to
control our costs, maintain regulatory compliance, maintain effective quality
controls, develop and retain a sufficient customer base, and attract, assimilate
and retain qualified management, technical and sales personnel. See "--We Depend
on Qualified Personnel" below. If we decide to grow by acquiring other companies
or entering into joint ventures with other businesses, we will need to
successfully identify, finance, complete and assimilate such acquisitions or
joint ventures. See "--We Face Additional Risks If We Pursue Any Acquisitions or
Joint Ventures" below.
If we cannot successfully manage the continued development and expansion
of our operations, we may not be able to sufficiently expand our customer base
and service offerings. We cannot assure you that we will be able to successfully
maintain the needed systems, procedures and controls, or obtain, integrate and
utilize the operational, technical, financial and human resources necessary to
manage a developing and expanding business in an evolving, highly regulated and
increasingly competitive industry.
WE DEPEND ON QUALIFIED PERSONNEL
A small number of key executive officers, most notably Mr. Ronald H.
VanderPol, our Co-Chairman and co-founder, and Mr. Richard Postma, our
Co-Chairman, Chief Executive Officer and co-founder, manage our business. The
loss of services of one or more of these key executive officers, particularly
Mr. VanderPol or Mr. Postma, could materially harm our business and our
prospects. We believe that our success will depend in large part on our ability
to continue to develop a large and effective sales force and attract and retain
highly skilled and qualified management, technical and sales personnel. Only
three of our executive officers have employment agreements, and we do not
maintain key person life insurance for any of our executive officers, other than
Messrs. VanderPol and Postma. Although we have been successful to date in
attracting and retaining a sufficient number of qualified personnel, the
competition for qualified personnel in the telecommunications industry is
intense. For this reason, we cannot assure you that we will
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be able to continue to attract and retain the qualified management, technical
and sales personnel necessary to achieve our business objectives.
WE DEPEND ON THE RELIABILITY OF SOPHISTICATED INFORMATION AND PROCESSING SYSTEMS
Sophisticated back office information and processing systems are vital to
our growth and our ability to monitor costs, bill customers, provision customer
orders and achieve operating efficiencies. Our operations support systems, which
we have either acquired from or developed with third-party vendors, are
scaleable, may be employed either centrally or in more than one location, and
automate many of the functions which previously required multiple manual entries
of customer information to accomplish order management, provisioning, switch
administration and billing. We have recently completed the integration of our
provisioning, order entry and billing systems. However, we cannot assure you
that these systems will produce the anticipated operational solutions or that
these systems will perform as expected. As we expand our customer base, deploy
our networks and provide our own switch-based services, we will continue to face
several risks with respect to our systems, including:
- these systems might fail to perform as expected;
- these systems might fail to interface with the legacy systems of other
carriers; and
- we could fail to adequately identify all of our information and
processing needs or to upgrade our systems as necessary.
In addition, our right to use certain of these systems is dependent upon license
agreements with third party vendors, certain of which they may cancel. We cannot
assure you that a third-party vendor will not cancel (or fail to renew) these
agreements.
OUR SYSTEMS AND OUR VENDORS' SYSTEMS MIGHT NOT ACCOMMODATE THE YEAR 2000
The year 2000 issue is a matter of particular worldwide concern for
telecommunications carriers because it affects many aspects of
telecommunications technology, including the computer systems and software
applications that are essential for network administration and operations. A
significant portion of telecommunications voice and data networking and network
management devices have date-sensitive processing in them which affect network
administration and operations functions such as service activation, service
assurance and billing processes. However, because we have recently commenced
operations and acquired our key processing systems, our costs relating to year
2000 issues historically have not been material. Lucent and the other vendors of
telecommunications network equipment and information and processing systems have
represented to us that such equipment and systems are year 2000 compliant
without any required modification. We will require confirmation of year 2000
compliance in our future requests for proposals from Lucent and any other
equipment and software vendors. Pursuant to our strategic year 2000 compliance
plan, we have modified and tested all of our mission-critical systems and
believe they are now fully year 2000 compliant. However, until the year 2000, we
cannot assure you that our computer systems and software applications will
accommodate the year 2000.
The failure of our computer systems and software applications to
accommodate the year 2000 could have a material adverse effect on our business
and financial condition. Further, if the networks and systems of the incumbent
local telephone companies, long distance carriers and others on whose services
we depend and with whom our networks and systems must interface are not year
2000 functional, it could have a material adverse effect on the operation of our
networks and, as a result, on our business and customers. The Telco Year 2000
Forum, a group representing the nation's largest local telephone companies, has
announced, based upon six months of interoperability testing, that such
companies remain
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confident that the public will be able to place telephone calls at the start of
2000. However, other domestic and international carriers may not be year 2000
functional. We have not yet established a contingency plan that addresses our
response to any potential failure of our systems, or those of other entities on
whose services we depend or with whom our networks and systems must interface,
to accommodate year 2000 issues. However, we have been participating in industry
interoperability testing processes and plan to implement the contingency plans
being put in place by industry organizations. We intend to continue to monitor
the performance of our accounting, information and processing systems and
software applications and those of our third-party constituents to identify and
resolve any year 2000 issues.
OUR ABILITY TO IMPLEMENT OUR BUSINESS STRATEGY IS SUBJECT TO NUMEROUS RISKS
US Xchange is a recent entrant into the competitive local telephone
industry. There are numerous operating complexities associated with providing
facilities-based local exchange services. We will be required to develop and
enhance services, products and systems and will need to implement effective
marketing initiatives to sell these services and products. We will also need to
maintain the equipment to provide such services and products.
Our services may not be profitable due to, among other factors, lack of
customer demand, inability to secure and maintain access to the incumbent local
telephone companies' facilities on acceptable terms, competition and pricing
pressure from the incumbent local telephone companies and other competitive
providers, and cost overruns in connection with network build-outs. We expect to
face significant competitive product and pricing pressure in each of our
markets. We cannot assure you that our networks will generate sufficient
revenues, achieve or sustain positive EBITDA or profitability, or generate
sufficient operating cash flow to meet our working capital and debt service
requirements.
Our business is highly dependent on our ability to interconnect with and
obtain unbundled network elements from the incumbent local telephone companies
in our markets. In each of our markets, we rely on incumbent local telephone
companies to permit us to collocate our equipment in the incumbent local
telephone company's central offices as a means of connecting to our customers.
Under the 1996 Act, the incumbent local telephone companies are required to
permit us to effect such collocations and interconnections and to purchase only
the origination and termination services and network elements that we need.
While we believe that this regulatory requirement allows us to avoid certain
operating expenses, we cannot assure you that the incumbent local telephone
companies will effect such collocations and interconnections and such unbundling
of network elements in a timely manner or at rates, and on terms and conditions,
that will permit us to profitably offer switched services.
To the extent we interconnect with and use an incumbent local telephone
company's network to service our customers, we will be dependent upon the
technology and capabilities of the incumbent. We will also be required to
interface with the incumbent's legacy systems in order to properly provision and
service our customers. Many competitive local telephone companies, including US
Xchange, have experienced difficulties in working with the incumbent local
telephone companies with respect to provisioning, interconnection, collocation
and implementation of the systems used by competitive carriers to order and
receive unbundled network elements and wholesale services from the incumbent
local telephone companies. Coordination with incumbent local telephone companies
to gain access to network elements, complete the necessary operations support
system interfaces and secure reasonable and affordable collocation is necessary
for us to provide integrated local services to customers on a timely and
competitive basis. If we experience difficulties in obtaining high quality,
reliable and reasonably priced services from the incumbent local telephone
companies, the attractiveness of our services to our customers could be
impaired. The FCC has created a task force that is examining the problems that
have slowed the development of local telephone
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competition. On March 18, 1999, the FCC issued an order permitting "cageless"
and shared collocation of the equipment of competitive providers, rather than
the more costly collocation methods theretofore required by the incumbent
carriers, and requiring the incumbent carriers to follow certain procedures
before denying collocation. We cannot predict the other changes, if any, that
the FCC might adopt after the task force has completed its examination.
WE FACE RISKS RELATED TO THE LONG DISTANCE BUSINESS
We offer long distance services to our customers as part of our "one-stop
shopping" offering of bundled telecommunications services. The long distance
business is extremely competitive, and prices have declined substantially in
recent years and are expected to continue to decline. In addition, the long
distance industry has a high average churn rate, as customers frequently change
long distance providers in response to the offering of lower rates or
promotional incentives by competitors. We provide our own facilities-based long
distance services and we also purchase wholesale long distance services from
other carriers for resale to our customers. Our agreements with these other
carriers typically provide for the resale of long distance services on a
per-minute basis and contain minimum volume commitments. When we negotiate these
agreements, we must estimate future supply and demand for transmission capacity
as well as the calling patterns and traffic levels of our future customers. If
we fail to meet minimum volume commitments, we may have to pay underutilization
charges, and if we underestimate our need for transmission capacity, we may have
to obtain capacity through more expensive means.
PROVIDING SERVICES TO OUR RESIDENTIAL CUSTOMERS INVOLVES RISKS
In each of our markets we target creditworthy residential customers who
we believe are likely to have needs for multiple services through various
affinity group and other cost-effective marketing programs. Our success in
providing services to residential customers will depend, among other things,
upon our ability to:
- cost-effectively market our services to residential customers;
- maintain competitive prices and attractive service packages and thus
minimize the churn rate of our residential customers;
- provide high quality customer care services without incurring
significant additional costs;
- accurately evaluate the creditworthiness of prospective residential
customers;
- collect amounts owed by such customers in a timely, cost-effective
manner; and
- limit the amount of uncollectible bad debt from such customers.
We cannot assure you that we will be able to achieve acceptable profit margins
on our residential business.
WE FACE RISKS RELATED TO DATA TRANSMISSION BUSINESS
As part of our complete range of telecommunications services offerings, we
offer data transmission services in markets where our networks and switches have
become commercially operational. We target these services at large and
medium-sized businesses with substantial data communications requirements. The
success of our data transmission business will depend upon, among other things,
our ability to hire, train and retain qualified personnel, the effectiveness of
our sales personnel in the promotion and sale of our data transmission services,
the acceptance of such services by potential customers, our ability to control
our costs, and our ability to further enhance our services in response to future
technological changes. We cannot assure you that we will be able to profitably
provide our data transmission services.
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WE WILL NEED TO ADAPT TO RAPID TECHNOLOGICAL CHANGES
The telecommunications industry is subject to rapid and significant
changes in technology. We rely primarily on third parties for the development of
and access to new technologies. We believe our future success will depend, in
part, on our ability to anticipate or adapt to technological developments and to
offer, on a timely basis and at competitive prices, services that meet customer
demands for lower costs and better-integrated voice and data services. We cannot
assure you that we will obtain access to new technologies on a timely basis or
on satisfactory terms. We believe that, for the foreseeable future,
technological changes will neither materially affect the continued use of fiber
optic cable and circuit-switched transmission, nor materially hinder us from
acquiring necessary technologies. However, we cannot predict the effect of
technological changes on our operations. Other providers are building fiber
optic communications networks that are based on packet-switched technologies and
are designed to be cheaper and faster than networks using circuit switching
technologies such as our networks. These packet-switched networks are designed
with capabilities to transmit voice, data, fax and video communications
simultaneously over the same lines. Additionally, local multi-point wireless
service has bandwidth characteristics that are well suited for simultaneous
voice, data and video transmission, and digital subscriber line technology can
increase the carrying capacity of the incumbent local telephone companies'
copper wire networks. These new technologies could provide competitive
alternatives to the fiber optic circuit-switched transmission technologies that
we are deploying. The success of any of these new technologies and our failure
to adapt to them could materially harm our business.
WE NEED TO COMPLY WITH SIGNIFICANT GOVERNMENT REGULATION
Our networks and the provision of our telecommunications services are
subject to significant regulation at the federal, state and local levels. Delays
in receiving required regulatory approvals, or new adverse regulations or
regulatory or judicial requirements, may have a material adverse effect upon our
business.
The Telecommunications Act of 1996 provides for a significant
deregulation of the domestic telecommunications industry. The 1996 Act remains
subject to judicial review and additional FCC rulemaking. As a result, it is
difficult to predict what effect the legislation will have on us and our
operations. There are currently many regulatory actions underway and being
contemplated by federal and state authorities, and there is significant pending
litigation, regarding interconnection, pricing and other issues that could
result in significant changes affecting our business. Some of the pending issues
and possible developments include:
- the ability of regional Bell operating companies to provide long
distance services within their own local service regions, which, if
permitted, would allow them to bundle local and long distance
services; this would eliminate a marketing advantage we currently have
over such companies;
- further rules governing the provision of unbundled network elements;
- price cap regulation reform;
- changes in tariff filing requirements;
- access charge reform;
- reciprocal compensation for calls to internet service providers;
- universal service reform; and
- additional developments regarding the obligations of incumbent
carriers to provide interconnection and collocation.
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See "Business--Regulation." We cannot assure you that these changes will not
have a material adverse effect upon our business.
State regulatory commissions exercise jurisdiction over us because we
provide intrastate telecommunications services. As such a provider, we must
obtain regulatory authorizations and file tariffs with state agencies in each of
the states in which we operate. Local authorities regulate our access to
municipal rights-of-way. Network buildouts are also subject to numerous local
regulations, such as building codes and licensing requirements. Such regulations
vary on a city-by-city and county-by-county basis. See "Business--Regulation."
We cannot assure you that we will be able to maintain required
authorizations from the FCC and state and local authorities or that such
authorities will not take actions adverse to our interests. If we do not
maintain the necessary authorities and maintain the required tariffs, and if we
do not meet other regulatory obligations, third parties and regulators could
challenge our ability to operate. Any such challenge could cause us to incur
substantial legal and administrative expenses and sanctions.
WE RELY PRIMARILY ON LUCENT FOR THE SUPPLY, INSTALLATION AND MONITORING OF
EQUIPMENT
We have contracted with Lucent to supply our host and remote switches and
transmission and related electronic equipment and to install and turn up our
network systems. We cannot assure you that Lucent will continue to meet our
equipment and service requirements on a timely basis. We believe that there are
alternative sources of supply and that our Lucent-based switching systems are
compatible with alternative suppliers' equipment and platforms. However, a
number of factors could disrupt our operations and materially harm our business,
including any:
- extended interruption in the supply of fiber optic cable, switches or
other network equipment;
- material increases in cable, switch or equipment prices;
- significant delay or interruption in the installation, turn-up,
monitoring and maintenance of our networks; or
- extended delay in transitioning the products or services of an
alternative supplier, if necessary.
WE FACE ADDITIONAL RISKS IF WE PURSUE ANY ACQUISITIONS OR JOINT VENTURES
As part of our business strategy, we might acquire other businesses that
complement our existing businesses. We are unable to predict whether or when any
prospective acquisitions will occur or the likelihood of financing or completing
any acquisition on favorable terms and conditions. We expect to face a number of
risks if we pursue any acquisition, including:
- difficulty in assimilating the acquired operations and personnel;
- the potential disruption of our ongoing business and diversion of
resources and management attention;
- management's inability to maintain uniform standards, controls,
procedures and policies;
- the risks of entering markets in which we have little or no direct
prior experience; and
- the potential impairment of relationships with employees, suppliers or
customers as a result of changes in management following any
acquisition.
We may also enter into joint venture transactions. These transactions
present many of the same risks involved in acquisitions. However, they also may
involve the risk that we will not have control over the
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joint venture and that a joint venture partner may have economic, business or
legal interests or objectives that are inconsistent with ours. Joint venture
partners may also be unable to meet their economic or other obligations, thereby
forcing us to fulfill these obligations or abandon or curtail the venture.
We have no definitive agreement with respect to any material acquisition or
joint venture, although we have discussions with other companies from time to
time and assess opportunities on an ongoing basis.
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