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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, 1999
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ___________ to ___________
Commission file number 333-64717
US XCHANGE, L.L.C.
(Exact name of registrant as specified in its charter)
MICHIGAN 38-3305418
(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) 988-7000
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]
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At March 30, 2000, all of the membership interests of the registrant were
held by one affiliate of the registrant.
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 in the Company and has also
agreed to provide up to $50 million under a subordinated secured line of credit
agreement. 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) 988-7000.
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
resold the services of the incumbent local telephone company. As each of our
local networks and switching systems have become commercially operational in
that market, we have been transitioning our resale customers to our own
facilities-based services. As of December 31, 1999, we had deployed and were
commercially operating switches and local fiber optic networks in all of our
initially targeted markets, including Appleton, Green Bay, Milwaukee, Madison
and Oshkosh, Wisconsin; South Bend, Bloomington, Ft. Wayne, Elkhart and
Evansville, Indiana; Rockford, Illinois and Kalamazoo and Grand Rapids,
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Michigan. 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. 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 some "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, 1999, US Xchange had:
- approximately $136.1 million in net networks and equipment;
- approximately 2,000 route miles of local and long haul optical fiber
deployed;
- approximately 53,000 access lines in service (of which approximately
60% were served by our own facilities);
- 12 local sales offices; and
- 495 full-time employees, including approximately 160 employees engaged
full time in our sales and marketing efforts.
We have 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;
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(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 offering switched local, long distance and centrex services on a
resale basis in July 1997. With all of our local networks and switching systems
now commercially operational, we are able to provide customers in each of our
markets with 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 switched
SERVICES 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.
ADVANCED LOCAL The advanced software and equipment on our networks
FEATURES also allow us to offer advanced local features to
supplement our local switched services, including:
- 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.
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TYPE OF SERVICE WHAT WE PROVIDE
ADVANCED DATA We offer high speed, digital packet-switched data
SERVICES transmission services, such as Integrated Services
Digital Network, or "ISDN," and 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.
LONG DISTANCE We provide a full range of domestic, international
SERVICES 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 turnkey internet
services to our business customers, including web
page hosting and design. We offer 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.
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.
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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 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, 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 2,048 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.
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Our owned networks consist of digital fiber optic cable backbones that
typically contain 72 fiber strands for local fiber networks and 48 fiber strands
for long haul fiber networks. 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 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 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.
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.
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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 5 2 97,660 433,000
Oshkosh, WI 3Q/97 2Q/98 21 1 42,711 --
Green Bay, WI 3Q/97 2Q/98 122 4 114,196 337,000
MILWAUKEE, WI 3Q/97 3Q/98 3 7 260,876 1,799,000
Kenosha, WI 3Q/97 2Q/01 6 2 50,065 --
Racine, WI 3Q/97 2Q/01 4 2 61,085 --
MADISON, WI 3Q/97 3Q/98 28 5 156,984 649,000
Beloit, WI 3Q/97 2Q/01 12 1 25,031 --
Janesville, WI 3Q/97 2Q/01 1 1 41,808 234,000
SOUTH BEND, IN 1Q/98 4Q/98 28 4 137,580 349,000
Elkhart, IN 2Q/98 1Q/99 30 2 74,888 252,000
BLOOMINGTON, IN 2Q/98 1Q/99 8 1 75,193 235,000
FT. WAYNE, IN 2Q/98 1Q/99 70 8 183,900 680,000
EVANSVILLE, IN 3Q/98 1Q/99 20 2 74,888 518,000
ROCKFORD, IL 4Q/98 1Q/99 23 3 126,878 439,000
KALAMAZOO, MI 4Q/98 3Q/99 50 2 84,213 377,000
Battle Creek, MI 4Q/98 3Q/99 32 2 58,111 233,000
Grand Rapids, MI 1Q/99 3Q/99 45 5 234,386 1,009,000
</TABLE>
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(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, 1999, we had deployed approximately 500 route miles of local
fiber and approximately 1,500 route miles of long haul fiber and we plan to
deploy approximately 200 additional route miles of local and long haul
fiber by the end of 2000.
(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.
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 established a local sales force in each market which offers switched local,
long distance and centrex services on a resale basis until our own networks
become commercially operational, at which point we have begun to switch
customers to our own facilities. By initially reselling other carriers'
services, we built brand name recognition in each of our markets and a customer
base that we have been transitioning to our own networks. 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.
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
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also have inside sales staff located in Green Bay, Wisconsin and at our
headquarters in Grand Rapids, Michigan. 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.
As of May 26, 2000, we had approximately 170 employees engaged full time
in our sales and marketing efforts staffing local sales offices in Wisconsin,
Indiana, Illinois and Michigan. Approximately 120 of these employees were
quota-bearing sales executives marketing our facilities-based services. In an
effort to better service our current and future customers, we have made
improvements during 1999 to our sales order management and customer care systems
that have allowed us to better manage our business and to reduce our sales
support staffing levels.
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:
- 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
- building 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
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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 offer our
local and internet access services on a wholesale basis to internet service
providers in certain of our markets. We have already established and expect to
establish additional strategic alliances with, and supply wholesale services to,
electric utility companies and other selected telecommunications providers for
resale to their own customers. We also expect to generate revenues from the sale
of dark fiber along our long-haul routes and certain of our local network rings.
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 developed them with,
third party vendors with proven software and extensive knowledge of these
systems. Our provisioning, order entry and billing systems are fully integrated
which allows 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 substantially all 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
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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
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.
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 acquisition of Ameritech by SBC
Communications, Inc. and the acquisition of GTE by Bell Atlantic Corporation. We
expect that, as telecommunications providers continue to consolidate and form
additional
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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 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.
<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 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 and has agreed to acquire Sprint. 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.
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<PAGE> 13
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.
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 DSL,
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.
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,
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<PAGE> 14
- 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
- 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
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<PAGE> 15
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. Bell Atlantic
recently received permission from the FCC to begin providing in-region long
distance services in New York, and SBC Communications has applied for similar
authority in Texas. 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 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. On November 5, 1999, the FCC issued revised rules that largely
reaffirmed, and in some respects expanded, the duty of incumbent carriers to
offer unbundled network elements. These rules may be subject to further court
appeals, and we cannot predict the outcome of such proceedings.
The Eighth Circuit decisions and reversal by the Supreme Court continue
to create uncertainty about the rules governing pricing terms and conditions of
interconnection agreements. This uncertainty makes it difficult to predict
whether US Xchange will be able to rely on existing interconnection agreements
or have the ability to negotiate acceptable interconnection agreements in the
future.
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
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<PAGE> 16
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 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 December 9, 1999, the FCC released an order requiring the incumbent
carriers to offer "line sharing" arrangements that will permit competitors like
US Xchange to offer DSL service over the same copper wires used by the
incumbent to provide voice service. The specific prices and terms of these
arrangements will be determined by future decisions of state utility
commissions, and cannot be predicted at this time. The FCC's ruling may also be
challenged in court. US Xchange expects, however, that once US Xchange begins
offering DSL services, and if this order is implemented, it will allow US
Xchange to offer DSL services at a significantly lower cost than is now
possible.
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.
On March 17, 2000, the U.S. Court of Appeals for the District of Columbia
Circuit vacated certain FCC rules relating to collocation of competitors'
equipment in ILEC central offices. This decision requires the FCC to limit
collocation to equipment that is "necessary" for interconnection with the ILEC
or access to the ILEC's unbundled network elements. US Xchange believes that
all of the equipment it currently places in collocation arrangements is
necessary for these purposes, and therefore its collocation arrangements should
not be adversely affected by the court decision. Any disputes over the
"necessary" status of particular items of equipment, however, may have to be
resolved by the FCC or by state commissions, and such disputes could result in
delays or changes in US Xchange's collocation plans.
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 were 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.
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<PAGE> 17
- 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 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 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. In August 1999, the FCC issued an Order that provided
substantial new pricing flexibility to ILECs, primarily with respect to special
access and dedicated transport, and proposed further pricing flexibility for
those services and for switched access. In some cases, ILECs may offer
deaveraged rates, contract tariffs, and non-cost volume discounts. The order
also initiated a rulemaking to determine whether the FCC should regulate the
access charges of CLEC's.
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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
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, over 30 state commissions (including Wisconsin, Illinois and
Michigan), and several federal and state courts have ruled that reciprocal
compensation arrangements do apply to calls between end users and internet
service providers within the same local calling area. At least eight of these
decisions have been upheld on appeal, including the Seventh Circuit on June 18,
1999. A number of other state decisions are subject to appeal, and 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. 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. On March 24, 2000, the U.S. Court of Appeals for
the District of Columbia issued a decision to vacate the ruling. The Court
concluded that the FCC failed to provide a rational basis for its findings that
calls delivered to ISPs from local exchanged carriers are not "local"
telecommunications traffic, and failed to explain why such traffic is "exchange
access" rather than "telephone access service." US Xchange views this decision
as favorable, but the court's direction to the FCC to re-examine the issue will
likely result in further delay in the resolution of pending compensation
disputes, and there can be no assurance as to the ultimate outcome of these
proceedings.
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 with an
annual cap of $2.25 billion for telecommunications and information services
provided to qualifying schools and libraries and $400 million for services
provided to rural healthcare providers. The May 8th Order has been upheld by
the U.S. Court of Appeals for the Fifth Circuit.
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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 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 were not
required to make subsidy payments in any material amount during 1998 or 1999,
and we anticipate the same result in 2000. 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 GTE 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
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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 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 May 26, 2000, US Xchange had approximately 475 full-time employees,
including approximately 170 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 August 2002(2)(5) 44,000
June 2004(2)(5) 65,000
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) Lessor is an affiliated company. 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.
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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 appeal was
terminated and a registered service mark was obtained through filing of an
amended application.
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, 1999.
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<PAGE> 23
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, 1999, 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>
YEAR ENDED DECEMBER 31, PERIOD FROM
AUGUST 5, 1996(1)
1999 1998 1997 TO DECEMBER 31, 1996
-------------- -------------- ------------ --------------------
<S> <C> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Revenues............................... $ 26,429,789 $ 7,015,310 $ 206,682 $ --
-------------- -------------- ------------ --------------------
Cost and expenses:
Cost of communication services....... 37,739,781 16,338,583 749,662 --
Selling, general and administrative.. 40,554,373 28,679,670 5,065,589 137,810
Depreciation and amortization........ 13,190,549 3,257,055 189,347 --
-------------- -------------- ------------ --------------------
Total costs and expenses.......... 91,484,703 48,275,308 6,004,598 137,810
-------------- -------------- ------------ --------------------
Loss from operations................... (65,054,914) (41,259,998) (5,797,916) (137,810)
Interest expense, net(2)............... (29,537,206) (13,838,966) (30,452) --
Interest income........................ 3,944,625 4,476,061 -- --
-------------- -------------- ------------ --------------------
Net loss............................... $ (90,647,495) $ (50,622,933) $ (5,828,368) $137,810
============== ============== ============ ====================
</TABLE>
<TABLE>
<CAPTION>
AS OF DECEMBER 31,
1999 1998 1997
-------------- -------------- ------------
<S> <C> <C> <C>
BALANCE SHEET DATA:
Cash and cash equivalents................ $ 189,304 $ 40,018,552 $ 100,590
Restricted investments(3)................ 57,669,199 84,731,847 --
Networks and equipment, net.............. 136,106,432 100,344,506 27,967,741
Total assets............................. 210,100,023 234,715,917 28,385,270
Advances from affiliate.................. -- -- 21,038,789
Long-term debt, less current maturities.. 216,546,750 202,533,333 2,189,000
Member's capital (deficit)............... (87,236,606) 3,410,889 (966,178)
</TABLE>
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31, PERIOD FROM
AUGUST 5, 1996(1)
1999 1998 1997 TO DECEMBER 31, 1996
-------------- -------------- ------------ --------------------
<S> <C> <C> <C> <C>
OTHER DATA:
Capital expenditures..................... $ 48,906,624 $ 75,619,611 $ 28,157,088 $ --
EBITDA(4)................................ (51,864,365) (38,002,943) (5,608,569) (137,810)
Cash flows for operating activities..... (82,264,871) (29,087,976) (395,530) (163,485)
Cash flows for investing activities..... (20,297,716) (158,465,165) (28,168,184) --
Cash flows from financing activities..... 62,733,339 227,471,103 28,664,304 163,485
Ratio of earnings to fixed charges(5).... -- -- -- --
Deficiency of earnings to cover fixed
charges(5)............................... 94,621,915 52,918,654 5,830,471 137,810
</TABLE>
----------
(1) US Xchange was organized on August 5, 1996.
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<PAGE> 24
(2) Excludes capitalized interest of approximately $4.0 million for 1999, $2.3
million for 1998 and $2,000 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.
Since July 1997, we have established local exchange telecommunications
networks in selected markets, primarily Tier III cities, in the northern portion
of the Midwestern United States and interconnected our local networks through
our long-haul fiber networks. Our customers are currently offered a bundled
package of local, long distance and other enhanced services. We operate 13
facilities-based local networks and provide switched local and long distance
services within the states of Wisconsin, Illinois, Indiana and Michigan. We also
made a strategic decision to build a high capacity long-haul fiber optic network
that was sufficient not only to meet our own long term capacity needs but also
would allow us to make any remaining excess capacity available to other
providers of telecommunications services.
The construction, expansion and operating of our local and long haul
networks have required substantial expenditures, significant portions of which
have been incurred before the realization of revenues. These expenditures to
date have resulted in significant losses, negative cash flows and negative
EBITDA, which we believe will continue until an adequate customer base is
established. As our customer base grows, we expect
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<PAGE> 25
that incremental revenues can be generated with decreasing incremental operating
expenses which may provide positive contributions to cash flow.
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 resold incumbent carrier services to establish a market
presence and enhance our market penetration efforts. As our network switching
systems have become commercially operational, we have begun to transition our
resale customers to our own switch-based networks. 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 offer our
local and internet access services on a wholesale basis to internet service
providers in certain of our markets. We have established and expect to establish
additional strategic alliances with, and supply wholesale services to, electric
utility companies and other selected telecommunications providers for resale to
their own customers. We also expect to generate revenues from the sale of dark
fiber along our long-haul routes and certain of our local network rings. During
1999, we sold indefeasible rights to use ("IRUs") our fiber to several other
carriers and are pursuing similar arrangements with certain other carriers as a
source of additional revenues. We have not yet earned any revenues from IRUs,
which revenues we will earn over the life of the IRU as services are provided.
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. With an
expanding customer base and the continued conversion of those customers to our
own facilities-based
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<PAGE> 26
switches, we expect that cost of communication services will represent a smaller
percentage of revenues. 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.
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 15 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 relating to our 15%
Senior Notes, senior secured credit facility, subordinated line of credit and
bank credit facility. We amortize our debt issuance costs using the straight-
line method over the life of the related debt agreement.
RESULTS OF OPERATIONS
1999 Compared to 1998
Our revenues increased 377% to $26.4 million in 1999 from $7 million in
1998. The increase is attributable to both our expansion into one additional
market, Grand Rapids, Michigan, in 1999 and to the continued growth in our
customer base and their use of our services in all of our markets. Revenues
derived from our facilities-based switched operations grew to $10.2 million in
1999 compared to $559,000 in 1998. This increase was due to thirteen switches
being commercially operational during all or a portion of 1999 compared to only
six switches being in service during 1998 and to the continued conversion of
resale customers onto our own switches in all of our facilities-based markets.
During 1999 we installed approximately 30,000 total local access lines compared
to 21,000 in 1998. At December 31, 1999, we had approximately 53,000 installed
local access lines in service, of which approximately 60% were served by our own
facilities.
Cost of communication services increased to $37.7 million in 1999, or 143%
of revenues, from $16.3 million, or 131% of revenues, in 1998. The increase of
233% related primarily to the costs of leased telecommunications facilities and
our own network operating costs in connection with the expansion of our customer
base in all of our markets.
Selling, general and administrative expenses grew to $40.6 million in 1999,
or 153% of revenues, compared to $28.7 million in 1998, or 409% of revenues.
This increase of 41% was primarily due to the increase in employees during the
first three quarters of 1999 and the other costs associated with the expansion
of our services in our existing markets.
Depreciation and amortization expenses increased to $13.2 million in 1999
from $3.3 million in 1998 primarily due to the placement in service of
additional telecommunications network assets, including switches, fiber optic
26
<PAGE> 27
networks, and related equipment. Depreciation expense is expected to increase as
a result of continuing capital expenditures related to the expansion of our
networks and operations.
Gross interest expense increased $17.4 million to $33.5 million in 1999 from
$16.1 million in 1998 due primarily to the Company's increased average
outstanding indebtedness during the current year over the comparable prior year.
Interest expense will increase in future periods in conjunction with additional
borrowings under the subordinated secured line of credit from Mr. VanderPol.
Interest costs of $4 million in 1999 and $2.3 million in 1998 were capitalized
as part of the construction costs of its networks.
Interest income is derived primarily from earnings on excess cash and the
U. S. government securities that were purchased from the net proceeds on the
sale of the 15% Senior Notes and used to fund our first six scheduled interest
payments on such Notes. The decrease in interest income for 1999 from 1998 is
expected to continue in future periods as the U. S. government securities are
liquidated in conjunction with the payment of the semi-annual interest payments
on the 15% Senior Notes.
Net loss increased to $90.6 million in 1999 from $50.6 million in 1998. The
increase in the 1999 losses is attributable to the significant expenditures we
incurred before the realization of revenues, due to the expansion of our network
operations, the added depreciation expense relating to the expansion of our
networks and the increased interest expense on our indebtedness to fund our
network development and 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 that 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 $3.3 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.
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<PAGE> 28
Gross interest expense was $16.1 million for 1998 and $32,600 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 below. Interest costs of approximately $2.3 million and $2,000 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.
LIQUIDITY AND CAPITAL RESOURCES
We experienced a deficiency in net cash from operations of $82.3 million
for 1999, $29.1 million for 1998 and $396,000 for 1997. The increase in the
deficiency is primarily due to the significant cash outlays required to develop
and operate our networks and the resulting increased operating losses in
connection with our expansion into our planned markets. With a growing customer
base, we expect that accounts receivable will increase and negatively impact
cash from operations consistent with the $4.8 million in 1999. 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 was $20.3 million for 1999,
$158.5 million for 1998 and $28.2 million for 1997. We invested $48.9 million in
1999, $75.6 million in 1998 and $28.2 million in 1997 to acquire network-related
equipment, information systems software and office furniture and to construct
local and long haul fiber optic networks to support the growth of our business.
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. In 1999 we paid $30.5 million from these
funds to the holders of the Notes.
Our financing activities provided net cash totaling $62.7 million in 1999,
$227.5 million in 1998 and $28.7 million in 1997. A significant portion of the
change from 1998 relates to the approximately $193.0 million received during the
second quarter of 1998, which came from the net proceeds of the sale of our 15%
Senior Notes. In 1999 we received $50 million through our senior secured credit
facility with GE Capital and $14.5 million through a subordinated secured line
of credit from Mr. Ronald VanderPol, our Co-Chairman. Member capital
contributions and advances from RVP Development Corporation, a holding company
wholly-owned by
28
<PAGE> 29
Mr. VanderPol, totaling $33.9 million and $26.1 million were received in 1998
and 1997, respectively. During the first quarter of 1998, we also received $1.2
million of proceeds from our bank credit facility referred to below. Repayments
of the bank credit facility commenced in the second quarter of 1998 and totaled
$.7 million for both 1998 and 1999.
In August 1997, we obtained 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, 1999, we had $2.6 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 8.0% and 7.1% at December 31, 1999 and 1998, 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, 1999, 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 these 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 these Notes.
The Company made interest payments of $15.5 million and $15 million on January
1, 1999 and July 1, 1999, respectively, to the holders of the Notes. During 1998
and the first half of 1999, we spent the entire 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;
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<PAGE> 30
- 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
indenture. Under the indenture, we are also required to file certain reports
with the Securities and Exchange Commission and to deliver these reports to the
trustee and the holders of the 15% Senior Notes. We have not timely delivered
our Annual Report on Form 10-K for the year ended December 31, 1999 or our
Quarterly Report on Form 10-Q for the quarter ended March 31, 2000 and,
accordingly, have failed to comply with our reporting obligations under the
indenture. However, in connection with the merger discussed below, all the
holders of the 15% Senior Notes have agreed that the 15% Senior Notes may be
redeemed on the merger closing date. If the merger were not to be completed,
the trustee or holders of 25% of the outstanding principal of the 15% Senior
Notes could declare the outstanding principal and accrued and unpaid interest
to be immediately due and payable. We cannot give any assurance that we would
have sufficient cash resources or be able to obtain any additional financing to
meet these payment obligations.
On April 30, 1999 we obtained a $50 million eight-year senior secured
credit facility, pursuant to a Loan and Security Agreement among our
wholly-owned subsidiary, US Xchange Finance Company, L.L.C., as borrower, US
Xchange and our operating subsidiaries, as guarantors, and General Electric
Capital Corporation ("GE Capital"), as Administrative Agent and lender. As of
December 31, 1999, we had fully borrowed the $50 million available under this
facility. All outstanding borrowings 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. The
effective rate was 10.45% as of December 31, 1999. Interest is payable at least
on a quarterly basis. Unused portions of this facility were subject to a
commitment fee ranging between .75% and 1.25% of the unused amount. The
aggregate outstanding principal is repayable in quarterly installments,
commencing July 31, 2002 and continuing through April 30, 2007, based upon the
following annual debt reduction formula: 10%, 15%, 20%, 25% and 30%. Borrowings
are secured by all present and future real and personal property, assets and
revenues of borrower and its subsidiaries. US Xchange and the subsidiaries of
the borrower have guaranteed the repayment of all indebtedness under this
facility.
The terms of our indebtedness under the senior secured credit facility
impose certain financial and operating restrictions on our restricted
subsidiaries and us. 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 interest;
- redeem membership interests;
- issue or sell membership interest of our restricted subsidiaries; and
- enter into transactions with any of our members or affiliates.
These limitations are subject to a number of important qualifications and
exceptions. However, if we fail to comply with these restrictions or other
covenants under the facility and, in some cases, fail to cure our
noncompliance, GE Capital, as the administrative agent and sole lender under
the facility, could declare a default or a default could be deemed immediately
to occur and GE Capital would be entitled to make all borrowings immediately
due and payable. As of and for the quarter and year ended December 31, 1999, we
were not in compliance with certain financial performance covenants under the
facility, and we do not expect to be in compliance with these covenants for
subsequent periods.
However, on May 15, 2000, we announced that US Xchange, Inc., the newly
formed parent of US Xchange, L.L.C. and a corporation wholly owned by our sole
member, signed a definitive merger agreement with Choice One Communications,
Inc. ("Choice One"), a publicly held integrated communications provider that
offers local exchange and long distance telecommunications services, high-speed
data, Internet and DSL solutions, and web design and hosting primarily to small
and medium-sized businesses in second and third tier markets in the Northeast
United States. Under the terms of the agreement, Choice One will pay
approximately $311 million in net cash and issue approximately 7,000,000 shares
of its common stock to Mr. VanderPol, the sole stockholder of our parent. The
merger is subject to certain conditions, including Hart-Scott-Rodino clearance
and other regulatory approvals. In addition, all of the holders of our
outstanding 15% Senior Notes have executed and delivered to Choice One a letter
agreement pursuant to which they have agreed that the surviving corporation
upon completion of the merger may redeem the 15% Senior Notes on the merger
closing date at a redemption price equal to 109% of their principal amount plus
accrued interest, if any, to the closing date. The bond holders also have
agreed to an amendment to the Indenture, to take effect on the redemption date,
providing for the deletion of certain covenants and other provisions of the
Indenture.
In connection with the merger, GE Capital has agreed to forbear from
exercising its rights and remedies relating to our non-compliance with
financial performance covenants until the earlier of (i) July 31, 2000 or (ii)
the occurrence of any of the following events:
- the occurrence of an event of default, or the occurrence of an event
or the happening of a condition which with the passing of time or the
giving of notice or both would constitute an event of default, under
the loan agreement, other than the events of default for the periods
ending December 31, 1999 and March 31, 2000;
- certain events of bankruptcy;
- termination of the merger.
We currently expect to complete this merger by July 31, 2000. Pursuant
to the merger agreement, we will receive sufficient cash consideration to pay
the obligations under the senior secured credit facility and the 15% Senior
Notes in full. However, we can give no assurance that any of the events listed
above will occur, that we will complete the merger by July 31, 2000 or that GE
Capital will again agree to forbear from exercising its rights under the senior
secured credit facility. If GE Capital exercises its remedies under the senior
secured credit facility, we may be required to repay all or any portion of the
outstanding borrowings under the facility. If this occurs prior to the
completion of the merger and we cannot otherwise satisfy our payment
obligations under the senior secured credit facility, our business would be
materially adversely affected and we would also be in default of the indenture
governing the 15% Senior Notes.
30
<PAGE> 31
On August 26, 1999, the Company entered into a Line of Credit Agreement
with our Co-Chairman, Mr. VanderPol, for up to $50 million in subordinated debt
financing. Borrowings under this arrangement totaled $14.5 million at December
31, 1999. Interest accrues on outstanding borrowings under this line of credit
at a floating rate equal to prime rate less 1.25%. The effective interest rate
was 7.25% at December 31, 1999. All borrowings are secured by all present and
future assets of the Company and are subordinated to the indebtedness under the
Company's current and any future secured credit facilities. Repayment of
borrowed amounts and all accrued interest thereon will commence upon the
repayment of all obligations under our current and any future secured credit
facilities.
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, 1999,
we have spent approximately $152.8 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 borrowings under our GE Capital senior
secured credit facility, our subordinated secured line of credit from Mr.
VanderPol and our bank credit facility.
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, 1999, 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 $73.4
million. We plan to finance these capital requirements with available borrowings
under our subordinated line of credit (approximately $35.5 million as of
December 31, 1999), cash expected to be generated from future revenues, and
interim debt financing of up to $25 million provided by Choice One under the
merger agreement, and possibly through sales of dark fiber along our local and
long-haul networks. We currently have no commitments for additional debt or
equity financing, and we can give no assurance that additional debt or equity
financing will be available to us on terms we consider acceptable or at all. If
we are unable to complete the merger with Choice One, to secure additional debt
or equity financing or to sell any dark fiber on acceptable terms, we may be
required to modify or delay some of our planned capital expenditures, which
could have a material adverse effect on our business.
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
- 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.
31
<PAGE> 32
YEAR 2000 READINESS DISCLOSURE
We experienced no Y2K problems on or after January 1, 2000, and do not
anticipate any future material problems related to Y2K. The incremental costs
relating to our Y2K readiness project were not significant.
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 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, as amended by SFAS
137 issued in June 1999, is effective for fiscal quarters of all fiscal years
beginning after June 15, 2000, 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.
We are exposed to market risk related to changes in interest rates because
the interest rate on approximately $67 million of our debt is indexed to
floating interest rates. We monitor the risk associated with interest rates on
an ongoing basis, but we have not entered into any interest rate swaps or other
financial instruments to actively hedge the risk of changes in prevailing
interest rates.
In June 1998, we issued $200 million of 15% Senior Notes, which mature on
July 1, 2008, and pay interest semi-annually on January 1 and July 1 of each
year, beginning January 1, 1999. The effective interest rate is 15.35%. As of
December 31, 1999, the fair market value of the 15% Senior Notes was
approximately $161 million. As a result of issuing fixed interest securities,
we are less sensitive to market rate fluctuations.
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................... 34
Consolidated Balance Sheets, December 31, 1999 and 1998.............. 35
Consolidated Statements of Operations, Years Ended
December 31, 1999, 1998 and 1997 .................................. 36
Consolidated Statements of Member's Capital (Deficit),
Years Ended December 31, 1999, 1998 and 1997 ...................... 37
Consolidated Statements of Cash Flows, Years Ended
December 31, 1999, 1998 and 1997 .................................. 38
Notes to Consolidated Financial Statements........................... 39-44
</TABLE>
32
<PAGE> 33
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
US Xchange, L.L.C.
Grand Rapids, Michigan
We have audited the accompanying consolidated balance sheets of US Xchange,
L.L.C. and subsidiaries as of December 31, 1999, and 1998, and the related
consolidated statements of operations, member's capital (deficit) and cash flows
for each of the years in the three-year period ended December 31, 1999. 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, L.L.C.
and subsidiaries at December 31, 1999 and 1998, and the results of their
operations and their cash flows for each of the years in the three-year period
ended December 31, 1999, in conformity with generally accepted accounting
principles.
/s/ BDO SEIDMAN, LLP
Grand Rapids, Michigan
May 17, 2000
33
<PAGE> 34
US XCHANGE, L.L.C.
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
DECEMBER 31,
--------------------------------------
1999 1998
------------- ------------
<S> <C> <C>
ASSETS
CURRENT ASSETS
Cash and equivalents.................................... $ 189,304 $ 40,018,552
Restricted investments.................................. 28,795,226 28,525,109
Accounts receivable, less allowance for doubtful
accounts of $792,000 and $174,000..................... 5,995,466 1,865,503
Other................................................... 1,003,960 700,411
------------- ------------
TOTAL CURRENT ASSETS................................. 35,983,956 71,109,575
------------- ------------
NETWORKS AND EQUIPMENT
Networks and networks in process (cost to
complete of $5,337,000)............................... 125,797,486 85,821,872
Furniture and equipment................................. 19,423,809 14,017,604
Leasehold improvements.................................. 7,451,545 3,937,223
------------- ------------
152,672,840 103,776,699
Less accumulated depreciation and amortization.......... 16,566,408 3,432,193
------------- ------------
NET NETWORKS AND EQUIPMENT........................... 136,106,432 100,344,506
------------- ------------
OTHER ASSETS
Restricted investments.................................. 28,873,973 56,206,738
Debt issuance costs, net................................ 7,029,423 6,793,770
Miscellaneous........................................... 2,106,239 261,328
------------- ------------
TOTAL OTHER ASSETS................................... 38,009,635 63,261,836
------------- ------------
TOTAL ASSETS......................................... $ 210,100,023 $234,715,917
============= ============
LIABILITIES AND MEMBER'S CAPITAL
(DEFICIT)
CURRENT LIABILITIES
Accounts payable........................................ $ 9,286,552 $ 11,264,241
Accrued interest........................................ 15,191,526 15,521,634
Accrued other liabilities............................... 2,105,387 1,185,820
Current maturities of long-term debt.................... 800,000 800,000
Senior Secured Facility................................. 50,000,000 --
------------- ------------
TOTAL CURRENT LIABILITIES............................ 77,383,465 28,771,695
UNEARNED REVENUES......................................... 3,406,414 --
LONG-TERM DEBT, less current maturities:
15% Senior Notes........................................ 200,000,000 200,000,000
Member subordinated debt (including accrued interest)... 14,746,750 --
Notes payable........................................... 1,800,000 2,533,333
------------- ------------
TOTAL LIABILITIES.................................... 297,336,629 231,305,028
------------- ------------
MEMBER'S CAPITAL (DEFICIT)
Capital contributions................................... 60,000,000 60,000,000
</TABLE>
34
<PAGE> 35
<TABLE>
<S> <C> <C>
Accumulated deficit..................................... (147,236,606) (56,589,111)
------------- ------------
TOTAL MEMBER'S CAPITAL (DEFICIT)..................... (87,236,606) 3,410,889
------------- ------------
TOTAL LIABILITIES AND MEMBER'S CAPITAL (DEFICIT).......... $ 210,100,023 $234,715,917
============= ============
</TABLE>
See accompanying notes to consolidated financial statements.
35
<PAGE> 36
US XCHANGE, L.L.C.
CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
1999 1998 1997
-------------- ------------ -----------
<S> <C> <C> <C>
REVENUES.............................................. $ 26,429,789 $ 7,015,310 $ 206,682
-------------- ------------ -----------
COSTS AND EXPENSES
Cost of communication services (excluding
depreciation and amortization, shown separately
below).............................................. 37,739,781 16,338,583 749,662
Selling, general and administrative................. 40,554,373 28,679,670 5,065,589
Depreciation and amortization....................... 13,190,549 3,257,055 189,347
-------------- ------------ -----------
TOTAL COSTS AND EXPENSES......................... 91,484,703 48,275,308 6,004,598
-------------- ------------ -----------
Loss from operations................................ (65,054,914) (41,259,998) (5,797,916)
-------------- ------------ -----------
INTEREST EXPENSE...................................... (29,537,206) (13,838,996) (30,452)
-------------- ------------ -----------
INTEREST INCOME....................................... 3,944,625 4,476,061 --
-------------- ------------ -----------
NET LOSS.......................................... $ (90,647,495) $(50,622,933) $(5,828,368)
============== ============ ===========
</TABLE>
See accompanying notes to consolidated financial statements.
36
<PAGE> 37
US XCHANGE, L.L.C.
CONSOLIDATED STATEMENTS OF MEMBER'S CAPITAL (DEFICIT)
<TABLE>
<CAPTION>
CAPITAL ACCUMULATED
CONTRIBUTIONS DEFICIT TOTAL
<S> <C> <C> <C>
Balance, January 1, 1997 $ -- $ (137,810) $ (137,810)
Member 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)
Member 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
Net loss for the year -- (90,647,495) (90,647,495)
------------- ------------- ------------
Balance, December 31, 1999 $ 60,000,000 $(147,236,606) $(87,236,606)
============= ============= ============
</TABLE>
See accompanying notes to consolidated financial statements.
37
<PAGE> 38
US XCHANGE, L.L.C.
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER,
1999 1998 1997
------------ ------------ ------------
<S> <C> <C> <C>
OPERATING ACTIVITIES
Net loss.............................................. $(90,647,495) $(50,622,933) $ (5,828,368)
Adjustments to reconcile net loss to net cash used in
operating activities
Depreciation and amortization....................... 13,988,549 3,609,055 189,347
Provision for uncollectible accounts................ 698,488 227,949 2,000
Increase in unearned revenues....................... 3,406,414 -- --
Accrued interest on member subordinated debt........ 246,750 -- --
Interest earned on restricted investments........... (3,437,351) (2,262,063) --
Changes in assets and liabilities:
Accounts receivable.............................. (4,828,448) (1,948,217) (147,235)
Other current assets............................. (303,550) (539,803) (134,933)
Accounts payable................................. (1,977,689) 5,945,748 5,318,493
Accrued liabilities.............................. 589,461 16,502,288 205,166
------------ ------------ ------------
NET CASH USED IN OPERATING ACTIVITIES............ (82,264,871) (29,087,976) (395,530)
------------ ------------ ------------
INVESTING ACTIVITIES
Purchase of restricted investments.................... -- (82,469,784) --
Decrease in restricted investments.................... 30,500,000
Purchase of networks and equipment.................... (48,906,624) (75,619,611) (28,157,088)
Increase in other assets.............................. (1,891,092) (375,770) (11,096)
------------ ------------ ------------
NET CASH USED IN INVESTING ACTIVITIES............ (20,297,716) (158,465,165) (28,168,184)
------------ ------------ ------------
FINANCING ACTIVITIES
Proceeds from long-term debt.......................... 64,500,000 201,211,000 2,789,000
Direct costs of financing............................. (1,033,327) (7,034,441) --
Repayment of long-term debt........................... (733,334) (666,667) --
Advances from affiliated company...................... -- 61,211 20,875,304
Member capital contributions........................ -- 33,900,000 5,000,000
------------ ------------ ------------
NET CASH PROVIDED BY FINANCING ACTIVITIES........ 62,733,339 227,471,103 28,664,304
------------ ------------ ------------
NET INCREASE(DECREASE) IN CASH AND EQUIVALENTS... (39,829,248) 39,917,962 100,590
CASH AND EQUIVALENTS, beginning of year............. 40,018,552 100,590 --
------------ ------------ ------------
CASH AND EQUIVALENTS, end of year................... $ 189,304 $ 40,018,552 $ 100,590
============ ============ ============
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Interest paid (net of amounts capitalized).......... $ 28,572,890 $ 279,209 $ 12,334
============ ============ ============
SUPPLEMENTAL DISCLOSURE OF NON-CASH FINANCING ACTIVITIES
Conversion of advances to member's capital............ $ -- $ 21,100,000 $ --
============ ============ ============
</TABLE>
See accompanying notes to consolidated financial statements.
38
<PAGE> 39
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 (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 and its maximum duration is until December 2030.
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 sole member and an affiliated company of the member provided
equity funding to the Company of $60 million. In August 1999, the member agreed
to provide up to $50 million in subordinated debt financing (see Note 3).
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 fair value of long-term
debt, including the senior secured facility, is estimated based on quoted market
rates for similar financial instruments.
<TABLE>
<CAPTION>
1999 1998
----------------------------- ------------------------------
Carrying Amount Fair Value Carrying Amount Fair Value
--------------- ----------- --------------- ------------
<S> <C> <C> <C> <C>
Long term debt $267,346,750 $228,346,750 $203,333,333 $203,333,333
</TABLE>
CASH AND EQUIVALENTS
The Company considers all highly liquid investments with a maturity of
three months or less when purchased to be cash equivalents.
39
<PAGE> 40
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.
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. 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>
Costs directly related to the construction of network systems and
facilities, including interest, are capitalized. Uncompleted portions of fiber
optic networks are reported as networks in progress. Upon completion, the
construction costs will be classified as fiber optic networks and depreciated
over their useful lives. Interest expense capitalized in connection with
construction projects amounted to approximately $4 million, $2.3 million and
$2,000 in 1999, 1998 and 1997, respectively. Repairs and maintenance costs are
expensed as incurred. The Company had firm commitments for capital expenditures
of approximately $3.8 million at December 31, 1999.
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. Sales of
indefeasible rights to use fiber or capacity (IRU) are recorded as unearned
revenue at the earlier of the acceptance of the applicable portion of the
network by the customer or the receipt of cash. The revenue is recognized over
the life of the agreement as services are provided beginning on the date of
customer acceptance. There were no IRU revenues in 1999, 1998 or 1997.
ADVERTISING COSTS
Costs for advertising, which were approximately $2.1 million, $2 million
and $180,000 for the years ended December 31, 1999 and 1998, and 1997
respectively, are expensed as incurred within the fiscal year
40
<PAGE> 41
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.
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.
RECLASSIFICATIONS
Certain prior year amounts have been reclassified to conform to the 1999
presentation.
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. This
standard, as amended by SFAS 137 issued in June 1999, is effective for all
fiscal quarters of all fiscal years beginning after June 15, 2000. Historically,
the Company has not entered into derivative contracts and, therefore, does not
expect that adoption of this standard will have a material impact on 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' interest payments on these
notes. Interest payments are made semi-annually and commenced on January 1,
1999. 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 August 26, 1999, the Company entered into a line of credit agreement
with its sole member for up to $50 million in subordinated debt financing.
Borrowings under this arrangement totaled $14.5 million at December 31, 1999.
Under this subordinated line of credit, interest accrues on outstanding
borrowings at a floating rate equal to prime rate less 1.25% (effectively 7.25%
at December 31, 1999), and borrowings are secured by all present and future
assets of the Company and are subordinated to the indebtedness under the
Company's current and any future secured credit facilities. Repayment of
borrowings under this line of credit and all accrued interest will commence upon
the repayment of all obligations under the Company's current and future secured
credit facilities.
41
<PAGE> 42
On April 30, 1999, the Company obtained a $50 million senior secured credit
facility pursuant to a loan and security agreement among the Company's
wholly-owned subsidiary, US Xchange Finance Company, L.L.C., as borrower, the
Company and its operating subsidiaries, as guarantors, and General Electric
Capital Corporation (GE Capital), as Administrative Agent and lender. As of
December 31, 1999 the full $50 million was outstanding. Issuance costs
approximating $1 million are being ratably amortized over the term of the
facility. Loans under this facility bear interest at a floating rate equal to
either a defined base rate plus 3% or at LIBOR plus 4%, at the borrower's
option. The effective interest rate was 10.45 % at December 31, 1999. Interest
is payable at least on a quarterly basis. During 1999 unused portions of this
facility were subject to a commitment fee ranging between .75% and 1.25% of the
unused amount. The aggregate outstanding principal is repayable in quarterly
installments, commencing July 31, 2002 and continuing through April 30, 2007,
based upon the following annual debt reduction formula: 10%, 15%, 20%, 25% and
30%. Borrowings are secured by all present and future real and personal
property, assets and revenues of the borrower and its subsidiaries. The Company
and the subsidiaries of the borrower have guaranteed the repayment of all
indebtedness under this facility.
The senior secured revolving credit facility contains financial performance
covenants regarding minimum quarterly revenues, maximum quarterly EBITDA losses
and maximum annual capital expenditures, with which the Company did not comply
for the quarter and the year ended December 31, 1999. (EBITDA consists of
earnings (losses) before net interest, income taxes, depreciation and
amortization.) GE Capital has agreed to forbear from exercising any remedies
against the Company as a result of the non-compliance with these covenants
through the earlier of a Termination Event, as defined in the forbearance
agreement, or July 31, 2000 (the "forbearance period"). As a result, the
Company has classified the GE Capital senior secured credit facility as a
current liability since there is no assurance that GE Capital will not require
repayment of this credit facility after the forbearance period expires.
However, it is anticipated that this credit facility will be settled as a
result of the impending merger of the Company's new parent (see footnote 8).
On June 25, 1998, the Company completed a sale of $200 million principal
amount of 15% Senior Notes due 2008 (15% Notes). Of the total net proceeds
approximating $193 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
Company made interest payments of $15.5 million and $15 million on January 1,
1999 and July 1, 1999, respectively, to the holders of the 15% Notes. 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.
On August 28, 1997, the Company entered into a credit facility agreement
with a local bank that provided for borrowings of up to $4 million 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 8.0%
at December 31, 1999. Specific assets and the guarantee of an affiliated company
owned by the Company's sole 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, 1999, the affiliated company was
in compliance with the covenant requirements.
The aggregate principal repayments of long-term debt over the next five
years is as follows:
42
<PAGE> 43
YEAR ENDING DECEMBER 31,
2000................................................. 800,000
2001................................................. 800,000
2002................................................. 800,000
2003................................................. 200,000
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 sole member of $21.1 million were
converted to member's capital as of March 31, 1998. Under an expense sharing
agreement with the affiliated company, the Company incurred $318,500, $346,200
and $257,500 relating to management and administrative services for 1999, 1998
and 1997, respectively. In October 1999, the Company entered into a lease
agreement with the affiliated company for certain office furniture in its
corporate administrative offices. Total lease costs under this agreement for
1999 was $48,750. The Company also leases its corporate administrative offices
from two companies each of which is 50% controlled by the same affiliated
company owned by the Company's sole member. Rents paid under these lease
agreements during 1999 and 1998 were $822,200 and $198,600, respectively. There
were no rents for 1997.
In June 1997, the Company entered into a lease agreement with another
affiliated company owned by the member for aircraft transportation services.
Total travel costs incurred under this arrangement for 1999, 1998 and 1997 was
$75,200, $101,200 and $69,100, respectively.
5. EMPLOYEE BENEFIT PLAN
In May 1997, the Company established a 401(k) plan that 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 1999 and 1998 was
approximately $267,000 and $51,000, respectively. 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 $3.4 million, $1.7 million and $83,500 for 1999, 1998 and 1997,
respectively
Future minimum lease payments under noncancelable operating leases at
December 31, 1999, were as follows:
<TABLE>
<CAPTION>
YEAR ENDING OFFICE OPERATING SITE
DECEMBER 31, FACILITIES FACILITIES EQUIPMENT TOTAL
<S> <C> <C> <C> <C>
2000 $ 2,210,557 $ 631,785 $ 1,095,945 $ 3,938,287
</TABLE>
43
<PAGE> 44
<TABLE>
<S> <C> <C> <C> <C>
2001 2,192,213 640,750 615,439 3,448,401
2002 1,980,657 634,812 307,200 2,922,669
2003 1,397,028 329,964 5,378 1,732,370
2004 580,073 237,739 -- 817,812
2005-2009 -- 865,822 -- 865,822
</TABLE>
7. QUARTERLY FINANCIAL DATA (UNAUDITED)
<TABLE>
<CAPTION>
1999
-------------------------------------------------------------------
First Quarter Second Quarter Third Quarter Fourth Quarter
---------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Revenues $ 4,339,438 $ 5,947,990 $ 7,480,351 $ 8,662,010
Operating loss (15,985,086) (16,429,878) (17,188,349) (15,451,601)
Net loss (20,808,244) (22,222,439) (24,386,946) (23,229,866)
---------------------------------------------------------------------------------------------------
</TABLE>
<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 $ 2,886,355
Operating loss (5,260,764) (8,569,793) (12,969,746) (14,732,695)
Net loss (5,321,499) (8,927,589) (16,782,717) (19,591,128)
---------------------------------------------------------------------------------------------------
</TABLE>
At December 31, 1999, the Company reclassified amortization of debt
issuance costs to interest expense. These costs had previously been classified
as depreciation and amortization expense. This reclassification changed the
previously reported quarterly operating losses for 1999 and 1998 as follows:
<TABLE>
<CAPTION>
First Quarter Second Quarter Third Quarter Fourth Quarter
------------- -------------- ------------- --------------
<S> <C> <C> <C> <C>
1999
As previously reported $ (16,184,586) $ (16,629,376) $ (17,387,849)
Reclassification 199,500 199,500 199,500
------------- ------------- -------------
$ (15,985,088) $ (16,429,878) $ (17,188,349)
============= ============= =============
1998
As previously reported $ (5,260,764) $ (8,569,793) $ (12,872,746) $ (14,908,695)
Reclassification - - 176,000 176,000
------------- ------------- ------------- --------------
$ (5,260,764) $ (8,569,793) $ (12,696,746) $ (14,732,695)
============= ============= ============= ==============
</TABLE>
8. SUBSEQUENT EVENT.
On May 14, 2000, the new parent of the Company, a corporation wholly-owned
by the Company's sole member, entered into a definitive merger agreement with
Choice One Communications, Inc. (Choice One), a publicly-held company. Under
terms of the agreement, Choice One will exchange 7 million shares of its common
stock and $311 million in net cash for all of the outstanding common stock of
the Company's parent. In addition, as a condition of the merger, all of the
holders of the 15% Senior Notes have agreed to a redemption price equal to 109%
of their principal amount plus accrued interest, if any, to the closing date of
the merger. Based on the price of Choice One's stock as of the close of
business on the day before the merger announcement, the merger is valued at
approximately $518 million. The merger is subject to regulatory approvals and
other customary conditions.
44
<PAGE> 45
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
Not applicable.
45
<PAGE> 46
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, 1999:
<TABLE>
<CAPTION>
NAME AGE POSITION(S)
------------------- --- -------------------------------------------------
<S> <C> <C>
Ronald H. VanderPol 48 Co-Chairman
Richard Postma 49 Co-Chairman and Chief Executive Officer
Joseph J. Miglore 54 Executive Vice President and Chief
Financial Officer
Donald Offringa 49 Treasurer
Barry Raterink 34 Executive Vice President of Operations
Lee Thibaudeau 47 Regional President of US Xchange of Wisconsin,
L.L.C.
Daniel Fabry 36 Vice President of Business Development
Rick G. Pigeon 35 Vice President of Technology and Revenue
Assurance
Stephen Oyer 35 Vice President of Sales and Marketing
</TABLE>
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 that 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.
Joseph J. Miglore, Executive Vice President and Chief Financial Officer,
brings a vast amount of management and financial experience and expertise to US
Xchange. Prior to joining the Company in July 1999, Mr. Miglore served as
President and Chief Operating Officer of Batts, Inc. from April 1996 to January
1999 and was responsible for its worldwide operations. Mr. Miglore has during
his career participated in
46
<PAGE> 47
numerous domestic and international acquisitions and divestitures. From April
1990 to January 1996, Mr. Miglore was with Ameriwood Industries International
Corporation and served as its President and Chief Operating Officer.
Donald Offringa, CPA, Treasurer, 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, Executive Vice President of 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 21 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 transportation
and third-party logistics management 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 which was recently acquired by
Global Crossing Ltd., from 1983 to January 1996.
Daniel Fabry, Vice President of Business Development, 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.
Stephen Oyer, Vice President of Sales and Marketing, has 13 years of
experience in the telecommunications industry. Prior to joining us in December
1997, Mr. Oyer was the Senior Director of Sales for Centennial Wireless from
March 1995 to November 1996. From June 1993 to February 1995, Mr. Oyer was the
Regional General Manager for Centennial Wireless. From August 1990 to May 1992,
Mr. Oyer served as National Sales Manager for Centennial Wireless.
47
<PAGE> 48
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 will manage our business.
Recently, Mr. VanderPol, our Co-Chairman and co-founder, transferred 100% of the
membership interests in US Xchange to an S-corporation, US Xchange, Inc., of
which Mr. VanderPol is the sole stockholder. 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.
ITEM 11. EXECUTIVE COMPENSATION.
SUMMARY COMPENSATION TABLE
The following table sets forth the compensation paid to our Chief Executive
Officer and the six executive officers of US Xchange whose total annual salary
and bonus exceeded $100,000 during 1999.
<TABLE>
<CAPTION>
LONG TERM
ANNUAL COMPENSATION COMPENSATION
------------------------------------------------ ------------
OTHER ANNUAL SECURITIES ALL OTHER
NAME AND COMPENSATION UNDERLYING COMPENSATION
PRINCIPAL POSITION YEAR SALARY($) BONUS($) ($) OPTIONS(#) ($)
----------------------------------- ---- ----------- --------- ------------ ------------ ------------
<S> <C> <C> <C> <C> <C> <C>
Richard Postma..................... 1999 -- (1) -- (1) -- -- --
Co-Chairman and 1998 -- (1) -- (1) -- -- --
Chief Executive Officer 1997 -- (1) -- (1) -- -- --
Barry Raterink..................... 1999 $115,788 -- -- -- --
Executive Vice President 1998 97,708 $15,000(3) -- -- --
of Operations 1997 22,032 5,000(3) -- -- --
David J. Easter.................... 1999 $122,769 -- -- -- --
Executive Vice President of 1998 $120,000 $30,000(3) -- -- --
Planning & Business 1997 111,667 25,000(3) -- -- --
Development(2)
Lee Thibaudeau..................... 1999 $137,802 -- -- -- --
Regional President of US 1998 131,516 $20,000(4) -- -- --
Xchange of Wisconsin, L.L.C. 1997 102,917 20,000(4) -- -- --
Daniel Fabry....................... 1999 $120,461 -- -- -- --
Vice President of Business 1998 120,000 $20,000(4) -- -- --
Development 1997 90,461 20,000(4) -- -- --
Rick G. Pigeon..................... 1999 $108,096 -- -- -- --
Vice President of Technology 1998 105,000 $15,000(4) -- -- --
and Revenue Assurance 1997 64,077 15,000(4) -- -- --
Stephen Oyer....................... 1999 $121,949 $ 4,000(3) -- -- --
Vice President of Sales 1998 86,434 -- -- -- --
and Marketing
</TABLE>
-------------------
48
<PAGE> 49
(1) Mr. Postma did not receive any salary or bonus for his services as Chief
Executive Officer of the Company during 1999, 1998 or 1997. During 1997,
Mr. Postma was a member of a law firm that provided legal services to US
Xchange.
(2) Mr. Easter's employment with the Company terminated in November 1999.
(3) As determined by the Co-Chairmen of US Xchange, at their discretion.
(4) As determined by management in accordance with such officer's employment
agreement. See " -- Employment Agreements" below.
EMPLOYMENT AGREEMENTS
US Xchange has an employment agreement with Joseph J. Miglore, Executive
Vice President and Chief Financial Officer. The term of this employment
agreement expires on July 12, 2000. The term of this 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 Mr. Miglore's employment
agreement, we must pay Mr. Miglore an annual salary of not less than $175,000.
Mr. Miglore is eligible for additional benefits and for an annual bonus in such
amount as is approved by management. In the event that we terminate the
employment of Mr. Miglore for any reason other than "just cause" (as defined in
the employment agreement), we must continue to pay his salary and benefits for a
period of one year following the date of termination. In the event of: (i) the
sale of a majority of US Xchange's assets or equity interests; (ii) the
completion of an initial public offering of US Xchange's equity interest; or
(iii) a merger of US Xchange with another entity where US Xchange is not the
surviving entity, Mr. Miglore must execute an employment agreement with the
purchaser/successor for a period of not less than one year, provided that the
salary to be paid to Mr. Miglore during such period is not less than Miglore's
annual salary immediately prior to the sale, and further provided that the
employment agreement must be consistent with the terms and conditions of the
employment agreement with US Xchange.
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 Business Development, and Rick G.
Pigeon, Vice President of Technology and Revenue Assurance. The terms of the
employment agreements of Messrs. Thibaudeau, Fabry and Pigeon expire on March
16, 2002, March 31, 2002 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. Ronald H. VanderPol, our Co-Chairman and co-founder personally
guarantee such continuing salary and benefits obligations. See Item 13, "Certain
Relationships and Related Transactions." The employment agreements contain
customary confidentiality, non-competition and non-solicitation provisions that
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.
49
<PAGE> 50
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
Ronald H. VanderPol, our Co-Chairman and co-founder, beneficially owns 100%
of our membership interests through his ownership of the sole member. 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 and up to $50 million under a secured line
of credit. Of such amounts, approximately $74.5 million was used as of December
31, 1999 to acquire capital assets and fund operating costs. Of the amounts
provided by Mr. VanderPol, (i) approximately $318,500, $346,200 and $257,500
represented the value of management and administrative services provided to us
during 1999, 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 1999, 1998 and 1997. In
October 1999 we entered into a lease agreement with RVP for certain office
furniture in our corporate administrative offices in Grand Rapids, Michigan.
Total rents paid under this agreement in 1999 were $48,750. Richard Postma, our
Co-Chairman and Chief Executive Officer, also serves as Co-Chairman of RVP, and
Donald Offringa, our Treasurer, 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 $75,200, $101,200 and $69,100 during 1999, 1998 and 1997,
respectively.
The Company moved into its expanded corporate administrative offices in
Grand Rapids, Michigan during September 1999. These office facilities are leased
under agreements with two companies each of which is 50% controlled by RVP
Development Corporation. Rents paid under these arrangements were $822,200,
$198,600 and $25,000 in 1999, 1998 and 1997, respectively.
We believe that the above transactions were and will be on terms no less
favorable to us than we could have 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."
50
<PAGE> 51
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.
4.4 Loan and Security Agreement dated as of April 29, 1999, among
US Xchange Finance Company, L.L.C., as Borrower, US Xchange,
L.L.C., and certain operating subsidiaries of US Xchange,
L.L.C., as Guarantors, and General Electric Capital
Corporation, as Administrative Agent and lender thereunder
(incorporated by reference to Exhibit 4.1 to the registrant's
Quarterly Report on Form 10-Q for the quarter ended March 31,
1999, as amended)
4.5 Schedules to Loan and Security Agreement (incorporated by
reference to the registrant's Current Report on Form 8-K dated
August 23, 1999)
4.6 Amendment No. 1 to Loan and Security Agreement dated as of
February 9, 2000
4.7 Intercreditor Agreement dated as of February 9, 2000 among US
Xchange, L.L.C., US Xchange Finance Company, L.L.C., General
Electric Capital Corporation, as Administrative Agent and
Ronald H. VanderPol.
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
10.5 Business Loan Agreement dated as of August 26, 1999 between US
Xchange, L.L.C. and Ronald H. VanderPol
51
<PAGE> 52
10.6 Security Agreement dated as of August 26, 1999 between US
Xchange, L.L.C. and Ronald H. VanderPol
10.7 $50,000,000 Promissory Note of US Xchange, L.L.C. dated as of
August 26, 1999 payable to Ronald H. VanderPol
10.8 Lease dated May 8, 1997, as amended by Addendum No. 1 (Revised)
dated December 23, 1997, between US Xchange, L.L.C. and Market
Square Group, L.L.C.
10.9 Lease dated January 29, 1999 between US Xchange, L.L.C. and 56
Grandville, L.L.C.
*10.10 Employment Agreement dated August 1, 1999 between US Xchange,
L.L.C. and Joseph J. Miglore
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, 1999.
52
<PAGE> 53
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 March 3, 2000, 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, 1999, 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
May 17, 2000
53
<PAGE> 54
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
<TABLE>
<CAPTION>
Balance Charged to Balance
at beginning Costs and at end
of Period Expenses Deductions(1) of Period
------------ ---------- ------------- ---------
<S> <C> <C> <C> <C>
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
Year Ended December 31, 1999
Reserves and allowances deducted from asset accounts:
Allowance for uncollectible accounts $174,000 $698,488 $80,488 $792,000
</TABLE>
(1) Uncollectible accounts charged off, net of recoveries
54
<PAGE> 55
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.
June 6, 2000 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.
SIGNATURE TITLE DATE
/s/ Richard Postma Co-Chairman, Chief Executive Officer June 6, 2000
Richard Postma
/s/ Ronald H. VanderPol Co-Chairman June 6, 2000
Ronald H. VanderPol
/s/ Joseph J. Miglore Executive Vice President June 6, 2000
Joseph J. Miglore and Chief Financial Officer
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 1999 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 1999.
55
<PAGE> 56
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.
4.4 Loan and Security Agreement dated as of April 29, 1999,
among US Xchange Finance Company, L.L.C., as Borrower, US
Xchange, L.L.C., and certain operating subsidiaries of US
Xchange, L.L.C., as Guarantors, and General Electric Capital
Corporation, as Administrative Agent and lender thereunder
(incorporated by reference to Exhibit 4.1 to the
registrant's Quarterly Report on Form 10-Q for the quarter
ended March 31, 1999, as amended)
4.5 Schedules to Loan and Security Agreement (incorporated by
reference to the registrant's Current Report on Form 8-K
dated August 23, 1999)
4.6 Amendment No. 1 to Loan and Security Agreement dated as of
February 9, 2000
4.7 Intercreditor Agreement dated as of February 9, 2000 among
US Xchange, L.L.C., US Xchange Finance Company, L.L.C.,
General Electric Capital Corporation, as Administrative
Agent and Ronald H. VanderPol.
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)
1
<PAGE> 57
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)
10.5 Business Loan Agreement dated as of August 26, 1999 between
US Xchange, L.L.C. and Ronald H. VanderPol
10.6 Security Agreement dated as of August 26, 1999 between US
Xchange, L.L.C. and Ronald H. VanderPol
10.7 $50,000,000 Promissory Note of US Xchange, L.L.C. dated as
of August 26, 1999 payable to Ronald H. VanderPol
10.8 Lease dated May 8, 1997, as amended by Addendum No. 1
(Revised) dated December 23, 1997, between US Xchange,
L.L.C. and Market Square Group, L.L.C.
10.9 Lease dated January 29, 1999 between US Xchange, L.L.C. and
56 Grandville, L.L.C.
10.10 Employment Agreement dated August 1, 1999 between US
Xchange, L.L.C. and Joseph J. Miglore
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
2
