<PAGE> 1
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
{X} QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2000
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:
000-29515
NET2000 COMMUNICATIONS, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 51-0384995
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
2180 FOX MILL ROAD 20171
HERNDON, VA (Zip Code)
(Address of principal executive offices)
Registrant's telephone number, including area code: (800) 825-2000
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.
(1) Yes {X} (2) No { }
The number of shares outstanding of the Registrant's common stock as of October
31, 2000, was 38,433,738.
================================================================================
i
<PAGE> 2
INDEX
<TABLE>
<CAPTION>
Page
<S> <C>
PART I - FINANCIAL INFORMATION
ITEM 1. Financial Statements
Consolidated Balance Sheets at September 30, 2000 (Unaudited) and December
31, 1999. 1
Consolidated Statements of Operations for the Three and Nine Months Ended
September 30, 2000 (Unaudited) and 1999 2
Consolidated Statements of Cash Flows for the Nine Months Ended
September 30, 2000 (Unaudited) and 1999 3
Notes to the Unaudited Consolidated Financial Statements 4
ITEM 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 10
ITEM 3. Quantitative and Qualitative Disclosures About Market Risk 23
PART II - OTHER INFORMATION
ITEM 1. Legal Proceedings 23
ITEM 2. Changes in Securities and Use of Proceeds 23
ITEM 3. Defaults upon Senior Securities 24
ITEM 4. Submission of Matters to a Vote of Security Holders 24
ITEM 5. Other Information 24
ITEM 6. Exhibits and Reports on Form 8-K 24
Signature 25
</TABLE>
ii
<PAGE> 3
PART I. -- FINANCIAL INFORMATION
NET2000 COMMUNICATIONS, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AMOUNTS)
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
2000 1999
------------- ------------
(Unaudited)
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents .................................................. $ 17,707 $ 5,523
Investments available for sale ............................................. 48,717 --
Restricted cash ............................................................ 4,582 3,517
Accounts receivable, net of allowance for doubtful
accounts of approximately $4,436 and $1,919 at
September 30, 2000 and December 31, 1999, respectively ................... 19,281 7,595
Other current assets ....................................................... 2,697 1,528
--------- ---------
Total current assets ......................................................... 92,984 18,163
Property and equipment, net of accumulated
depreciation ............................................................... 144,603 72,592
Other noncurrent assets ...................................................... 24,446 3,598
Unamortized debt discount .................................................... 2,089 7,315
--------- ---------
Total assets ................................................................. $ 264,122 $ 101,668
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current liabilities:
Accounts payable ........................................................... $ 5,568 $ 792
Accrued expenses and other current liabilities ............................. 34,944 21,635
--------- ---------
Total current liabilities .................................................... 40,512 22,427
Related party noncurrent liabilities ......................................... 7,514 26,428
Other noncurrent liabilities ................................................. -- 215
Long-term debt ............................................................... 55,651 46,039
Redeemable convertible Series A, B and C preferred stock,
$0.01 par value; 11,738,437 shares authorized, no shares
and 11,738,437 issued and outstanding at September 30, 2000
and December 31, 1999 respectively ......................................... -- 80,940
Stockholders' equity (deficit):
Common stock, $0.01 par value; 200,000,000 shares
Authorized, 38,413,347, and 10,189,562 shares issued and outstanding
September 30, 2000 and December 31, 1999, respectively ................... 384 102
Additional capital ........................................................... 321,849 16,707
Deferred stock compensation .................................................. (7,433) (7,002)
Accumulated deficit .......................................................... (154,355) (84,188)
--------- ---------
Total stockholders' equity (deficit) ................................ 160,445 (74,381)
--------- ---------
Total liabilities and stockholders' equity (deficit) ................ $ 264,122 $ 101,668
========= =========
</TABLE>
See accompanying notes that are an integral part of these condensed consolidated
Financial Statements.
1
<PAGE> 4
NET2000 COMMUNICATIONS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
FOR THE THREE MONTHS FOR THE NINE MONTHS ENDING
ENDING SEPTEMBER 30, SEPTEMBER 30,
----------------------------- -----------------------------
2000 1999 2000 1999
------------ ------------ ------------ ------------
(Unaudited) (Unaudited) (Unaudited)
<S> <C> <C> <C> <C>
Revenues ...................................................... $ 16,628 $ 7,582 $ 40,416 $ 18,670
Operating costs and expenses:
Operating costs ............................................. 12,412 6,108 31,153 15,497
Selling, general and administrative (exclusive of non-cash
compensation expense shown below) ........................ 23,836 10,626 58,160 26,288
Non-cash compensation expense ............................... 572 192 2,202 232
Depreciation and amortization ............................... 5,890 1,030 11,658 2,125
------------ ------------ ------------ ------------
Loss from operations .......................................... (26,082) (10,374) (62,757) (25,472)
Other income (expenses):
Interest income ............................................. 2,009 255 5,949 914
Interest expense ............................................ (1,471) (769) (4,863) (1,052)
Settlement of supplier dispute .............................. -- 3,500 -- 3,500
Miscellaneous (expenses) income ............................. (19) 69 (14) 77
------------ ------------ ------------ ------------
Loss before provision for income taxes ........................ (25,563) (7,319) (61,685) (22,033)
Provision for income taxes .................................... -- -- -- --
------------ ------------ ------------ ------------
Loss before extraordinary item ................................ (25,563) (7,319) (61,685) (22,033)
Extraordinary debt extinguishment loss ........................ -- -- (4,724) --
------------ ------------ ------------ ------------
Net loss ...................................................... (25,563) (7,319) (66,409) (22,033)
Preferred stock accretion ..................................... -- (5,125) (3,759) (15,778)
------------ ------------ ------------ ------------
Net loss available to common stockholders ..................... $ (25,563) $ (12,444) $ (70,168) $ (37,811)
============ ============ ============ ============
Pro forma net loss available to common stockholders ........... $ (7,319) $ (66,409) $ (22,033)
============ ============ ============
Basic and diluted loss per shares:
Available to common stockholders before extraordinary item .. $ (.67) $ (1.23) $ (2.09) $ (3.74)
Extraordinary loss .......................................... -- -- (.15) --
------------ ------------ ------------ ------------
Available to common stockholders ............................ $ (.67) $ (1.23) $ (2.24) $ (3.74)
============ ============ ============ ============
Pro forma basic and diluted loss per share:
Available to common stockholders before extraordinary item .. $ (.30) $ (1.76) $ (.89)
Extraordinary loss .......................................... -- (.14) --
------------ ------------ ------------
Available to common stockholders ............................ $ (.30) $ (1.90) $ (.89)
============ ============ ============
Shares used in calculation of loss per share:
Basic and diluted ............................................. 38,319,805 10,111,297 31,338,120 10,110,092
Pro forma basic and diluted ................................... 24,784,342 34,885,449 24,783,137
</TABLE>
See accompanying notes that are an integral part of these condensed consolidated
Financial Statements.
2
<PAGE> 5
NET2000 COMMUNICATIONS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
<TABLE>
<CAPTION>
FOR THE NINE MONTHS ENDED
SEPTEMBER 30,
-------------------------
2000 1999
---------- ---------
(Unaudited)
<S> <C> <C>
OPERATING ACTIVITIES
Net loss .................................................... $ (66,409) $(22,033)
Adjustments to reconcile net loss to net cash
used in operating activities:
Depreciation and amortization ............................. 11,658 2,327
Allowance for doubtful accounts ........................... 2,517 1,431
Deferred stock compensation ............................... 2,202 232
Amortization of debt discount ............................. 502 --
Extraordinary debt extinguishment loss .................... 4,724 --
Changes in operating assets and liabilities:
Accounts receivable .................................... (10,428) (3,289)
Other current assets ................................... 173 (688)
Other noncurrent assets ................................ (5,807) (2,751)
Accounts payable ....................................... 516 (930)
Accrued expenses and other current liabilities ......... 11,289 10,250
Other noncurrent liabilities ........................... (216) --
--------- --------
Net cash used in operating activities ....................... (49,279) (15,451)
INVESTING ACTIVITIES
Acquisition of property and equipment ....................... (95,871) (26,111)
Acquisition of Frebon ....................................... (8,292) --
Purchase of investments available for sale .................. (78,723) --
Sale of investments available for sale ...................... 30,006 --
Increase in restricted cash ................................. (1,065) (739)
--------- --------
Net cash used in investing activities ....................... (153,945) (26,850)
FINANCING ACTIVITIES
Proceeds from note payable .................................. 99,427 --
Repayments on note payable .................................. (94,113) --
Proceeds from issuance of common stock ...................... 212,052 --
Proceeds from notes payable to related party ................ -- 24,256
Proceeds from exercise of stock options ..................... 2,235 1
Repayment of capital leases ................................. (4,193) (2,075)
--------- --------
Net cash provided by financing activities ................... 215,408 22,182
Net increase (decrease) in cash ............................. 12,184 (20,119)
Cash at the beginning of period ............................. 5,523 33,439
--------- --------
Cash at the end of period ................................... $ 17,707 $ 13,320
========= ========
</TABLE>
See accompanying notes that are an integral part of these condensed consolidated
Financial Statements.
3
<PAGE> 6
NET2000 COMMUNICATIONS, INC.
CONDENSED NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
THREE AND NINE MONTHS ENDED
SEPTEMBER 30, 2000 AND SEPTEMBER 30, 1999
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
1. DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION
Net2000 Communications, Inc. (the "Company") is a rapidly-growing,
innovative provider of state-of-the-art broadband telecommunications services.
As a competitive local exchange carrier ("CLEC"), the Company offers businesses
located throughout the United States responsive solutions as an alternative to
traditional telephone companies. The Company focuses on high-end customers,
primarily large- and medium-sized businesses, and offers an integrated package
of high-speed data, internet access, local and long distance, and interactive
video services over a single, high capacity broadband connection.
The Company intends to offer services in major markets throughout the
United States in three phases. Our completed Phase I deployment consists of 13
switches that transfer data and long distance traffic and 5 switches that
transfer voice traffic in 10 markets in the telecommunications-rich Boston to
Washington, D.C. corridor. Our substantially completed Phase II deployment will
establish our national presence with 10 additional data switches and 2
additional voice switches in 10 new markets and is scheduled to be completed in
December 2000. Our Phase III deployment will entail adding 4 additional markets
and upgrading all of our existing data switches to Internet protocol-based (IP)
switches that can provide both data and voice services.
The accompanying consolidated financial statements as of September 30,
2000, and for the three and the nine months ended September 30, 2000 and
September 30, 1999, are unaudited and, in the opinion of management, include all
adjustments (consisting of normal recurring adjustments and accruals) necessary
to present fairly the results for the periods presented in accordance with
generally accepted accounting principles. Our results of operations for any
interim period are not necessarily indicative of the results of operations for
any other interim period or for a full fiscal year. These financial statements
should be read in conjunction with our audited financial statements for the year
ended December 31, 1999, included in the Company's final prospectus, dated March
6, 2000, filed with the Securities and Exchange Commission in connection with
the Company's initial public offering.
2. INVESTMENTS AVAILABLE FOR SALE
The Company classifies its investments as available-for-sale. Investments
in securities that are classified as available-for-sale and have readily
determinable fair values are measured at fair market value on the balance
sheets. Any unrealized gains or losses, net of taxes, are reported as a separate
component of stockholders' equity, if deemed material. Realized gains and losses
and declines in market value judged to be other than temporary are included in
investment income. Interest and dividends are included in interest income. As of
December 31, 1999 and September 30, 2000, there are no material unrealized gains
or losses on investments.
4
<PAGE> 7
NET2000 COMMUNICATIONS, INC.
CONDENSED NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
3. NET LOSS PER COMMON SHARE
Basic and diluted net loss per common share is calculated by dividing the
net loss by the weighted average number of common shares outstanding. Pro forma
net loss per share is computed using the weighted average number of shares used
for basic and diluted per share amounts and the weighted average redeemable
convertible preferred stock outstanding as if such shares were converted to
common stock at the time of issuance.
<TABLE>
<CAPTION>
FOR THE THREE MONTHS FOR THE NINE MONTHS
ENDING SEPTEMBER 30, ENDING SEPTEMBER 30,
------------------------------ ------------------------------
2000 1999 2000 1999
------------ ------------ ------------ ------------
<S> <C> <C> <C> <C>
Loss before extraordinary item ............................... $ (25,563) $ (7,319) $ (61,685) $ (22,033)
Preferred stock accretion .................................... -- (5,125) (3,759) (15,778)
------------ ------------ ------------ ------------
Loss available to common stockholders before
extraordinary item ......................................... (25,563) (12,444) (65,444) (37,811)
Extraordinary item ........................................... -- -- (4,724) --
------------ ------------ ------------ ------------
Net loss available to common stockholders .................... $ (25,563) $ (12,444) $ (70,168) $ (37,811)
============ ============ ============ ============
Weighted average of common shares, denominator
for basic loss per share ................................... 38,319,805 10,111,297 31,338,120 10,110,092
Effect of dilutive securities:
Stock options .............................................. -- -- -- --
Warrants ................................................... -- -- -- --
Convertible stock .......................................... -- -- -- --
------------ ------------ ------------ ------------
Denominator for diluted loss per share ....................... 38,319,805 10,111,297 31,338,120 10,110,092
============
Pro forma adjustment for redeemable preferred
stock ...................................................... 14,673,045 3,547,329 14,673,045
------------ ------------ ------------
Pro forma denominator for basic and diluted loss
per share .................................................. 24,784,342 34,885,449 24,783,137
============ ============ ============
Loss per share
Basic and diluted before extraordinary item ................ $ (.67) $ (1.23) $ (2.09) $ (3.74)
Extraordinary loss ......................................... -- -- (.15) --
------------ ------------ ------------ ------------
Basic and diluted .......................................... $ (.67) $ (1.23) $ (2.24) $ (3.74)
============ ============ ============ ============
Pro forma basic and diluted before extraordinary item ...... $ (.30) $ (1.76) $ (.89)
Extraordinary loss ......................................... -- (.14) --
------------ ------------ ------------
Pro forma basic and diluted ................................ $ (.30) $ (1.90) $ (.89)
============ ============ ============
</TABLE>
Due to their anti-dilutive effects, outstanding shares of preferred stock, stock
options and warrants to purchase shares of common stock were excluded from the
computation of diluted earnings per share for all periods presented.
5
<PAGE> 8
NET2000 COMMUNICATIONS, INC.
CONDENSED NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
4. PROPERTY AND EQUIPMENT
Property and equipment, including leasehold improvements, are recorded at
cost. Depreciation is calculated using the straight-line method over the
estimated useful life ranging between three and eight years. Leasehold
improvements are amortized over the lesser of the related lease term or the
useful life. Interest capitalized and included in the cost of switch equipment
was $1,712 and $790 for the nine months ended September 30, 2000 and the year
ended December 31, 1999, respectively.
Construction in process includes equipment and other costs of switches
which are not complete as of the balance sheet dates. When construction of a
switch is complete, the balance of the assets are transferred to switch
equipment and depreciated in accordance with the Company's policy.
Property and equipment consist of the following:
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
2000 1999
------------ ------------
(Unaudited)
<S> <C> <C>
Software............................................................... $ 19,787 $ 11,978
Computer equipment..................................................... 13,860 9,005
Office furniture and equipment......................................... 8,973 4,951
Leasehold improvements................................................. 23,237 7,973
Vehicles............................................................... 358 295
Switch equipment....................................................... 60,169 21,958
Construction in process................................................ 33,541 21,130
------------ ------------
159,925 77,290
Less accumulated depreciation and amortization (15,322) (4,698)
------------ ------------
$ 144,603 $ 72,592
============ ============
</TABLE>
5. DEBT
LONG TERM DEBT
Long-term debt consists of the following:
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
2000 1999
------------- ------------
(Unaudited)
<S> <C> <C>
Delayed draw term loan facility, face amount $100,000, due December 30,
2007, effective interest rate of approximately
12.75% ................................................................. $ 50,000 $ 41,390
Notes payable to bank...................................................... 229 118
Capital lease obligations.................................................. 9,457 8,554
------------- ------------
Total................................................................... 59,686 50,062
Less current maturities.................................................... (4,035) (4,023)
------------- ------------
Total long-term debt....................................................... $ 55,651 $ 46,039
============= ============
</TABLE>
Included in accrued expenses and other current liabilities at September
30, 2000 and December 31, 1999, is $4,035 and $4,023, respectively, currently
payable under capital lease obligations and notes payable to bank.
6
<PAGE> 9
NET2000 COMMUNICATIONS, INC.
CONDENSED NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
SECURED CREDIT FACILITIES
On June 29, 2000, the Company completed a $200,000 Senior Secured Credit
Facility ("Facility") transaction with TD Securities (USA), Inc., lead arranger
and syndicate manager for the Company. The new $200,000 Facility consists of a
$100,000 revolving credit facility and a $100,000 delayed draw term loan
facility, and replaces the existing $75,000 Senior Term Loan Facility. The new
Facility will be used to refinance indebtedness under the existing bank credit
facilities and will fund capital expenditures and working capital for general
corporate purposes, including permitted investments and acquisitions. The
Facility is secured by a first priority perfected security interest in all
existing and future assets and all equity interests of the Company. Interest on
both the revolving credit facility and the delayed draw term loan facility will
accrue at ranges (Prime plus 2% to 3.25% for Prime Rate loans or Eurodollar rate
plus 3% to 4.25% for Eurodollar loans) depending on certain debt to annualized
EBITDA ratios as defined in the terms of the Facility agreement. Repayment of
accrued interest on a Prime Rate loan is on each quarterly due date. Repayment
on accrued interest on a Eurodollar loan is on the last day of the interest
period and, in the case of interest period greater than three months, at three
months intervals after the first day of such interest period. The revolving
credit facility will be available on a revolving basis over a 7.5 year period
from the closing date (Revolver Maturity date). Availability of the revolving
credit facility will be permanently reduced beginning December 31, 2003, in
quarterly installments over the remaining four year term as defined in the
Facility agreement. On the Revolver Maturity date, the revolver commitments will
reduce to zero and all principal amounts outstanding will be due and payable.
The delayed draw term loan facility matures 7.5 years from the closing date
(Term Loan Maturity date) and provides for one $50,000 draw at closing and
availability of the remaining $50,000 through a six month period from closing.
Repayment of term loans outstanding begins December 31, 2003 in quarterly
installments over the remaining four-year term as defined in the Facility
agreement. The Facility carries restrictive covenants that, among other things,
require the Company to maintain certain operating and financial performance
measures. The Company was in compliance with all such restrictive covenants as
of September 30, 2000, except for the EBITDA financial performance covenant. On
November 10, 2000, the Company obtained a waiver for this violation for the
fiscal quarter ended September 30, 2000.
No advances have been made to the Company through the Facility as of
September 30, 2000. Upon closing, $50,000 of the new term loan facility was
drawn and $49,601 of principal, accrued interest, and commitment fees
outstanding on the existing $75,000 Senior Term Loan Facility was repaid. In
addition, underwriting and agency fees of $3,976 for the new Facility were paid.
The Company paid interest related to all outstanding debt of $1,471 and
$769, for the three months ended September 30, 2000 and 1999, respectively, and
$4,863 and $1,052 for the nine months ended September 30, 2000 and 1999,
respectively.
6. RELATED PARTY NON-CURRENT LIABILITIES
At September 30, 2000 and December 31, 1999, the Company had outstanding
purchases totaling $7,515 and $26,428, respectively, of goods and services which
have been classified as a non-current liability as these purchases are
subsequently financed under the Senior Secured Credit Facility.
7
<PAGE> 10
NET2000 COMMUNICATIONS, INC.
CONDENSED NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
7. EQUITY
EQUITY TRANSACTIONS
During the three and nine months ended September 30, 2000, the Company's
employees exercised options to purchase 109,034 and 1,601,383 shares of common
stock under its 1997 and 1999 stock option plans, respectively, for aggregate
proceeds of $210 and $1,421 for the three and nine months ended September 30,
2000, respectively.
During the three and nine months ended September 30, 2000, amortization
expense for stock based compensation of $572 and $2,202, respectively, relates
to employees whose salaries are included in selling, general and administrative
expense.
ACQUISITION
On July 10, 2000, the Company acquired FreBon International Corporation,
a privately-held provider of interactive video services. The purchase price at
closing consisted of 400,000 shares of common stock valued at $6,075 and cash
payments totaling $9,050. In addition, the Company assumed debt totaling $2,800.
Earnout provisions could provide for additional cash or stock consideration up
to $15,000 based on the achievement of certain revenue targets over the next
year as defined in the purchase agreement. The transaction was accounted for
using the purchase method of accounting and, accordingly, the net assets and
results of operations of the acquired company have been included in the
Company's consolidated financial statements since the acquisition date, with the
majority of the purchase price being allocated to acquired intangibles. Goodwill
and other intangibles are being amortized using the straight-line method over a
period of five years.
ACCRETION TO REDEMPTION VALUE OF SERIES A, SERIES B AND SERIES C
PREFERRED STOCK
The Company has accreted its preferred stock to its redemption value
based on the fair market value of the Company using the effective interest
method. The Company recorded accretion totaling $0 and $3,759 for the three and
nine months ended September 30, 2000, respectively, and $5,125 and $15,778 for
the three and nine months ended September 30, 1999, respectively. On March 10,
2000, all outstanding shares of preferred stock were converted into common stock
at the closing of the Company's initial public offering.
8
<PAGE> 11
NET2000 COMMUNICATIONS, INC.
CONDENSED NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)
8. COMMITMENTS
OPERATING LEASES
The Company currently leases office space and equipment under
non-cancelable operating lease agreements, with expirations through 2015. Rent
expense for the three and nine months ended September 30, 2000 and 1999 was
$2,354 and $6,028, respectively, and $564 and $1,419, respectively.
The future minimum lease payments under non-cancelable operating leases
at September 30, 2000 are as follows:
<TABLE>
<CAPTION>
FISCAL YEAR
<S> <C>
2000................................................................... $ 2,761
2001................................................................... 10,729
2002................................................................... 11,218
2003................................................................... 11,025
2004................................................................... 10,676
Thereafter............................................................. 59,222
------------
Total $ 105,631
============
</TABLE>
9. REVENUE RECOGNITION
In December 1999, the SEC issued Staff Accounting Bulleting No. 101,
"Revenue Recognition in Financial Statements" (SAB No. 101), which must be
adopted for the fourth quarter of 2000. SAB No. 101 provides guidance on revenue
recognition, revenue realization and the earnings process, and requirements for
deferral of incremental costs. The Company believes that SAB No. 101 will not
have a material effect on the Company's financial position or result from
operations.
9
<PAGE> 12
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
We are a rapidly-growing, innovative provider of state-of-the-art
broadband telecommunications services. We offer businesses located throughout
the United States responsive solutions as an alternative to traditional
telephone companies. We focus on high-end customers, primarily large- and
medium-sized businesses, typically business with 50 business access lines and
spending $50,000 annually for Internet access, data and voice telecommunications
services. Today, we offer an integrated package of high-speed data, Internet
access, local and long distance, and interactive video services primarily
delivered from our own network over a single, high capacity broadband connection
and conveniently billed on a single invoice.
We began operations in 1993 as a sales agent selling Verizon (formerly
known as Bell Atlantic) local telephone services to businesses. Under this
program, we received a one-time commission for selling complex and high-capacity
telecommunications services. From 1994 through 1997, we were the largest
producing Verizon sales agent based on annual sales revenue.
We initially used the resale of telecommunications services as a market
entry strategy while we began the build-out of our network. In January 1998, we
began offering long distance and non-local data services on a resale basis. In
June 1998, we left the Verizon sales agent program and began offering
Net2000-branded local telecommunications services on a resale basis directly to
large- and medium-sized businesses. We subsequently ceased acquiring new resale
customers in markets where we deployed our own network. In March 1999, we
deployed our first switch and began offering facilities-based telecommunications
services. In March 1999, we also ceased reselling Verizon local services in all
markets except New York City and Long Island, where we ceased reselling in
November 1999. We no longer use local resale as a primary customer acquisition
strategy, do not intend to do so in the future and plan to migrate as many of
our existing resale customers as possible to our network. In limited
circumstances, we use resale to satisfy customer needs for data and long
distance services outside our network area or to initiate service to new
customers until we migrate them onto our own network.
We have rapidly deployed our network since commencing services. As of
September 30, 2000, we have deployed a total of 25 switches in our network,
including six voice switches and 19 data switches throughout the United States
under Phase I and II of our network deployment schedule. Upon anticipated
completion of Phase II in December 2000, we are scheduled to have deployed a
total of seven voice and 23 data switches in major markets throughout the United
States, thereby completing our national data backbone network. Our Phase III
deployment will entail entering 4 additional markets and upgrading all of our
existing data switches to Internet protocol-based (IP) switches that can provide
both data and voice services. During the third quarter of 2000, we entered three
new on-net markets including San Francisco, Los Angeles, and Providence.
10
<PAGE> 13
GENERAL - RESULTS OF OPERATIONS
We have been successful in selling services to business customers, with
approximately 129,100 lines sold since beginning our Net2000-branded sales
efforts in June 1998. The table below provides additional selected key
operational data:
<TABLE>
<CAPTION>
AS OF AS OF AS OF
SEPTEMBER 30, JUNE 30, SEPTEMBER
2000 2000 30, 1999
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<S> <C> <C> <C>
On-Net Markets Served................................. 18 15 3
Number of Switches Deployed........................... 25 20 6
Addressable Market (Business Lines)................... 18,837,200 14,257,500 2,361,600
Total Lines Sold...................................... 129,100 109,500 60,000
Total Lines Installed................................. 100,900 85,700 44,800
Sales Force Employees................................. 255 225 108
Total Employees....................................... 736 613 348
Average Access Line Count Per Customer................ 67 67 66
</TABLE>
We are building our network by initially deploying lower-cost data
switches and leasing fiber optic lines from other carriers. As we experience
increases in customer traffic in a given market, we will consider deploying
voice switches and owning a portion of the fiber optic lines. By deploying this
"smart-build" network strategy, we believe it offers a number of competitive
advantages over the traditional build-out strategy by enabling us to:
- improve operating margins;
- broaden service offerings and enhance customer control by
providing more efficient service;
- reduce network capital requirements;
- improve speed to market and mitigate the risk associated with
investing capital in long term assets, thereby preserving capital
for other uses such as sales and marketing; and
- reduce operating expenses.
Although we believe our smart-build strategy will improve our results of
operations over the long-term, this strategy is expected to have a negative
effect on our financial condition and results of operations over the short-term.
We expect significant losses and negative cash flow for at least the next
several years, which we expect will be primarily attributable to the deployment
of our national network and expected expansion of our operations.
Additionally, during the third quarter of 2000, the three week strike by
the Communications Workers of America (CWA) and the International Brotherhood of
Electrical Workers (IBEW) against Verizon Communications impacted the Company's
ability to install new access lines. The Company has also experienced delays in
the availability of interoffice facilities provided by Verizon and such delays
have increased the time required to install new service to customers.
REVENUE
We generate most of our revenue from the sale of local, long distance,
Internet access, interactive video products and other data services to large-
and medium-sized businesses. We are currently offering our full suite of
services on our network in markets where we have deployed our voice and data
network. In markets where we have deployed data switches, we offer data and long
distance services on our network and in markets where we have not deployed
either a data or voice switch, we offer data and long distance services on a
resale basis to meet the needs of our customers.
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Our revenue consists of monthly recurring charges, usage charges, video
equipment, and initial, non-recurring charges. Monthly recurring charges include
the fees paid by our customers for lines in service, additional features on
those lines and collocation space. Usage charges consist of fees paid for each
call made generally measured by the minute but also measured by the call. Video
equipment revenue usually consists of one-time equipment sales. Non-recurring
revenue is typically derived from fees charged to install new customer lines.
In addition to revenue generated from end-user and carrier customers, we
also generate revenue from access fees charged to long distance companies for
the local origination and termination of long distance calls from or to our
customers. If an imbalance occurs based on inbound versus outbound local calls,
we may also be owed reciprocal compensation charges from the ILEC. We bill the
access and reciprocal compensation charges to the long distance companies and
local telephone companies on a monthly basis. Reciprocal compensation is
recognized as revenue when payment is received. Reciprocal compensation and
access charges are not significant components of our revenue and represented
less then 13% of the Company's year to date revenues. Although we expect revenue
from reciprocal compensation and access charges to increase as more customers
come onto our network, we anticipate deriving the majority of our revenue from
the sale of our telecommunications services to large- and medium-sized
businesses.
Since we began providing Net2000-branded telecommunications services on a
resale basis as a market entry strategy and because we only provisioned our
first customer on our network in May 1999, the majority of our revenue for the
year ended December 31, 1999 was derived from the resale of telecommunications
services. However, because we no longer use resale as a primary customer
acquisition strategy, we expect this revenue to quickly diminish in the future
as a percentage of revenue. Within the next 12 months, we expect to transition
our existing local resale customers to our network or sell such customers to
another carrier.
OPERATING COSTS AND EXPENSES
We expect that our primary operating costs and expenses will consist of
the cost of providing our services and selling, general and administrative
expenses.
OPERATING COSTS. Our most significant expense is the cost of leasing
certain elements of the full "bundle" of traditional telephone services for sale
to our local service subscribers, the cost of leasing part of the data network
being used by our data customers and the cost of leasing parts of the long
distance network being used by our long distance service customers.
We purchase local telephone service for our customers on a "wholesale"
basis pursuant to interconnection agreements with ILECs in our targeted markets.
Typically, these agreements establish the terms and conditions of the
interconnection arrangements along with the cost per minute to be charged by
each party for the calls that travel between each carrier's network. We also
purchase local telephone service for our customers on a "retail" basis from
ILECs in situations where interconnection arrangements are not in place due to
network or regulatory considerations.
We provide data services to our customers over our own switches in 18
markets and leased fiber optic lines, and in other areas by leasing part of the
data network requirements from various telecommunications companies pursuant to
written agreements.
We have entered into agreements with long distance providers in order to
originate or terminate long distance traffic in areas where we cannot do so over
our own network. These agreements provide for the origination or termination of
long distance services on a per-minute basis and contain minimum usage volume
commitments. If we fail to meet minimum volume commitments, we may be obligated
to pay underutilization charges. To date, we have met our usage volume
commitments and have not incurred any underutilization charges.
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To minimize our costs, we lease fiber optic lines between cities on a
fixed cost basis pursuant to written agreements with the providers of fiber
optic lines. These fiber optic lines interconnect our switches, enabling us to
cost-effectively provide much of the data and long distance network capacity of
our customers. During the second quarter, we entered into an agreement with
Level 3 Communications, Inc. to lease 7,300 miles of broadband backbone fiber
facilities over a five-year agreement to enhance our network and control network
operating costs. For the needs of our customers beyond our network coverage, we
purchase capacity on a wholesale basis from other telecommunications companies.
If we underestimate our need for fiber optic lines, we may be required to
obtain capacity through more expensive means. These costs are usage sensitive
and will increase as our customers' long distance calling volume increases. As
traffic on specific routes increases, we may lease flat-rated long distance
trunk capacity to reduce our variable costs and improve our gross margins.
In construction of a switch for a new market, we capitalize as a
component of property and equipment only the non-recurring charges associated
with our initial network facilities and monthly recurring costs of those network
facilities until the switch begins to carry revenue producing traffic. Once we
have deployed a switch in a particular market, maintenance expense will be a
significant part of our ongoing cost of services.
Our primary expense associated with providing Internet access to our
customers is the cost of interconnecting our network with a national Internet
service provider. Currently, we provide our customers direct connectivity to the
Internet through a national Internet access provider.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Our selling, general and
administrative expenses include our infrastructure costs, including selling and
marketing costs, customer care, billing, corporate administration, personnel and
network maintenance expenses. The nature of these costs have been generally
consistent throughout our history; however, these costs have increased to
support our growth as a telecommunications services provider. Our selling,
general and administrative expenses exclude non-cash compensation expense, which
is classified on our income statement as non-cash compensation expense.
We employ a direct sales force in each market where we deploy local voice
capability. To attract and retain a highly qualified sales force, we offer our
sales personnel a compensation package that emphasizes commissions. We expect to
incur significant selling and marketing costs as we continue to hire additional
personnel and expand our operations.
In addition to our direct sales force, we utilize sales agents who sell
our services and typically focus on specific niche markets or industries,
augmenting our direct sales initiatives. Customers acquired through agents are
serviced by our customer care representatives, are invoiced by us, and have the
same direct relationship with us as any of our other customers.
We have successfully achieved "electronic bonding" of T-1 circuits
between our operating support systems and Verizon. As a result, the Company may
achieve the following results:
- reduce errors and inefficiencies with manually processing orders;
- significantly reduce the installation interval from order to
billing;
- reduce customer turnover; and
- reduce operational expenses.
We have deployed a state-of-the-art billing system that provides
consolidated billing on a single invoice for all services we provide to our
customers. Using this system we began issuing convergent invoices (invoices
which consolidated local, internet access, long distance and other data
services) in the 3rd quarter of 1998.
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We have developed tailored systems and procedures for operational support
and other back office systems that are required to provision and track a
customer order from point of sale to the installation and testing of service.
These systems are operational on a stand alone basis today and will interface
automatically with trouble management, inventory, billing, collection and
customer care systems by the end of the second quarter of 2001. In October 1999,
we implemented e.mpower, our e-commerce, web-based customer interface. During
the third quarter of 2000, we continued to build on the robust feature set of
e.mpower by further enhancements and value-added customer capabilities.
In addition to the significant development and implementation cost of our
back office systems, we expect to incur expenses to maintain and enhance such
systems and capabilities. Such enhancements will be necessary to ensure our
systems remain current, effective, and meet the changing demands of the
marketplace. We will also incur ongoing expenses for customer care and billing.
As our strategy stresses the importance of personalized customer care, we expect
that the expenses related to our customer care department will remain a
significant part of our ongoing administrative expenses.
We incur other costs and expenses, including the costs associated with
the maintenance of our network, administrative overhead, office leases and bad
debt. We expect that these costs will grow significantly as we expand our
operations and that administrative overhead will be a large portion of these
expenses during the initial phases of our business expansion. However, we expect
these expenses to become smaller as a percentage of our revenue as we build our
customer base and increase revenues.
RESULTS OF OPERATIONS
THREE MONTHS ENDED SEPTEMBER 30, 2000 COMPARED TO THE THREE MONTHS ENDED
SEPTEMBER 30, 1999.
TOTAL REVENUE. Total revenue increased 119% to $16.6 million for the
three months ended September 30, 2000, from $7.6 million for the three months
ended September 30, 1999. The increase resulted primarily from increased volume
of providing telecommunications services to large and medium-sized businesses
and one-time video equipment sales. Revenue from resale telecommunication
activities increased 13% to $8.1 million for the three months ended September
30, 2000, from $7.2 million for the three months ended September 30, 1999.
Revenue from direct provision of telecommunications services increased 1,775% to
$7.5 million for the three months ended September 30, 2000, from $0.4 million
for the three months ended September 30, 1999. Revenue from one-time video
equipment sales increased 100% to $1.0 million for the three months ended
September 30, 2000, from zero for the three months ended September 30, 1999.
OPERATING COSTS. Operating costs increased 103% to $12.4 million for the
three months ended September 30, 2000, from $6.1 million for the three months
ended September 30, 1999. This increase was attributable to the cost of
providing the telecommunications services underlying the increased revenue from
telecommunications services and purchases of video equipment. Operating costs
for resale activities increased 14% to $6.7 million for the three months ended
September 30, 2000, from $5.9 million for the three months ended September 30,
1999. Operating costs for direct provision of telecommunications services
increased 2,400% to $5.0 million for the three months ended September 30, 2000,
from $0.2 for the three months ended September 30, 1999. Operating costs for
one-time video equipment sales for the three months ended September 30, 2000 was
$0.7 million.
SELLING, GENERAL AND ADMINISTRATIVE. Selling, general and administrative
expenses increased 124% to $23.8 million for the three months ended September
30, 2000, from $10.6 million for the three months ended September 30, 1999. This
increase was primarily attributable to the increase in sales, service delivery
and support associated with the increase in revenue discussed above, the launch
of our telecommunications services and the hiring of key senior management and
other personnel to develop and implement certain infrastructure initiatives to
support our new markets.
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DEPRECIATION AND AMORTIZATION. Depreciation and amortization expense
increased 472% to $5.9 million for the three months ended September 30, 2000,
from $1.0 million for the three months ended September 30, 1999. This increase
was primarily due to depreciation of network elements and amortization of back
office systems and software.
OTHER INCOME (EXPENSES). Interest income increased 688% to $2.0 million
for the three months ended September 30, 2000, from $0.3 million for the three
months ended September 30, 1999. This increase was due to investment income
generated from the net proceeds of the initial public offering and the Senior
Discount note. Interest expense increased 91% to $1.5 million for the three
months ended September 30, 2000, from $0.8 million for the three months ended
September 30, 1999. The increase was due to increased levels of debt.
NET LOSS. The net loss increased 105% to $25.6 million for the three
months ended September 30, 2000, from $12.4 million for the three months ended
September 30, 1999. The increase resulted primarily from the expansion of our
network, the growth of our sales force and support employees, and development of
our back office support systems.
NINE MONTHS ENDED SEPTEMBER 30, 2000 COMPARED TO THE NINE MONTHS ENDED SEPTEMBER
30, 1999.
TOTAL REVENUE. Total revenue increased 116% to $40.4 million for the nine
months ended September 30, 2000, from $18.7 million for the nine months ended
September 30, 1999. The increase resulted primarily from increased volume of
providing telecommunications services to large and medium-sized businesses and
one-time video equipment sales. Revenue from resale telecommunication activities
increased 34% to $24.6 million for the nine months ended September 30, 2000,
from $18.3 million for the nine months ended September 30, 1999. Revenue from
direct provision of telecommunications services increased 3,600% to $14.8
million for the nine months ended September 30, 2000, from $0.4 for the nine
months ended September 30, 1999. Revenue from one-time video equipment sales
increased 100% to $1.0 million for the nine months ended September 30, 2000,
from zero for the nine months ended September 30, 1999.
OPERATING COSTS. Operating costs increased 101% to $31.2 million for the
nine months ended September 30, 2000, from $15.5 million for the nine months
ended September 30, 1999. This increase was attributable to the cost of
providing the telecommunications services underlying the increased revenue from
telecommunications services. Operating costs for resale activities increased 36%
to $20.8 million for the nine months ended September 30, 2000, from $15.3
million for the nine months ended September 30, 1999. Operating costs for direct
provision of telecommunications services increased 4,750% to $9.7 million for
the nine months ended September 30, 2000, from $0.2 for the nine months ended
September 30, 1999. Operating costs for one-time video equipment sales for the
nine months ended September 30, 2000, was $0.7 million.
SELLING, GENERAL AND ADMINISTRATIVE. Selling, general and administrative
expenses increased 121% to $58.2 million for the nine months ended September 30,
2000, from $26.3 million for the nine months ended September 30, 1999. This
increase was primarily attributable to the increase in sales, service delivery
and support associated with the increase in revenue discussed above, the launch
of our telecommunications services and the hiring of key senior management and
other personnel to develop and implement certain infrastructure initiatives to
support our new markets.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization expense
increased 449% to $11.7 million for the nine months ended September 30, 2000,
from $2.1 million for the nine months ended September 30, 1999. This increase
was primarily due to depreciation of network elements and amortization of back
office systems and software.
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OTHER INCOME (EXPENSES). Interest income increased 551% to $6.0 million
for the nine months ended September 30, 2000, from $0.9 million for the nine
months ended September 30, 1999. This increase was due to investment income
generated from the net proceeds of the initial public offering and the Senior
Discount note. Interest expense increased 362% to $4.9 million for the nine
months ended September 30, 2000, from $1.1 million for the nine months ended
September 30, 1999. The increase was due to increased levels of debt.
NET LOSS AVAILABLE TO COMMON STOCKHOLDERS. The net loss available to
common stockholders increased 86% to $70.2 million for the nine months ended
September 30, 2000, from $37.8 million for the nine months ended September 30,
1999. The increase resulted primarily from the expansion of our network, the
growth of our sales force and support employees, and development of our back
office support systems.
LIQUIDITY AND CAPITAL RESOURCES
The development of our business, the deployment and start-up of switching
facilities in our targeted markets and the establishment of reliable operations
support systems will require significant capital to fund the following:
- capital expenditures,
- working capital needs,
- debt service, and
- the cash flow deficits generated by operating losses.
Our principal capital expenditure requirements include:
- the purchase and installation of digital switches,
- the development and licensing of operations support systems and
other automated back office systems,
- in certain cases, leasing excess fiber optic capacity where
projected traffic volume growth makes it economically attractive
to do so, and
- the consummation of potential strategic acquisitions.
To date, we have funded our expenditures through our initial public
offering, the private sale of equity securities, a Senior Term Loan Facility and
a Senior Secured Credit Facility. We raised approximately $212.0 million from
our initial public offering after the underwriters' discount and related
expenses. We have entered into a credit agreement with Nortel Networks whereby
Nortel provided funding under a term loan arrangement in an aggregate principal
amount of up to $75 million. On December 23, 1999, TD Securities (USA), Inc. and
Goldman Sachs Credit Partners L.P. purchased this facility. Outstanding under
the Senior Term Loan Facility as of March 31, 2000 and December 31, 1999, were
$48.4 million and $41.4 million, respectively. On June 28, 2000, we completed a
$200 million Senior Secured Credit Facility transaction with TD Securities
(USA), Inc., lead arranger and syndicate manager for the Company. This Facility
consists of a $100 million revolving credit facility and a $100 million delayed
term loan facility. Upon closing of the transaction, $50.0 million of the new
term loan facility was drawn and $49.6 million of principal, accrued interest
and commitment fees outstanding on then existing $75 million Senior Term Loan
Facility was repaid.
In July 1999, we issued to Nortel a Senior Discount note with a face
amount of $75 million. On January 7, 2000, we borrowed $41.5 million of
principal, the full amount available under this facility. In conjunction with
that borrowing, in July 1999, we issued to Nortel warrants to purchase 1,119,930
shares of common stock at $0.008 per share. The warrants may be exercised in
whole or in part during the ten year exercise period which is from July 30, 1999
to July 30, 2009. Our Senior Discount note was extinguished upon our initial
public offering, resulting in an extraordinary loss of approximately $4.7
million on the extinguishment of debt.
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Net cash used in operating activities was $49.3 million for the nine
months ended September 30, 2000 and $15.5 million for the nine months ended
September 30, 1999. The increase of $33.8 million is primarily due to an
increase in operating losses, offset by an increase in non-cash reconciling
items for deferred stock compensation, extraordinary debt extinguishment,
depreciation and amortization, an increase in accounts payable, and a decrease
in other noncurrent liabilities. Net cash used in investing activities was
$153.9 million for the nine months ended September 30, 2000 and $26.9 million
for the nine months ended September 30, 1999. The increase of $127.0 million is
due to an increase in purchases of investments available for sale, the
acquisition of Frebon, and capital expenditures resulting from expansion into
new markets as well as continued investment in our back office systems. Net cash
provided by financing activities was $215.4 million for the nine months ended
September 30, 2000 and $22.2 million for the nine months ended September 30,
1999. The increase of $193.2 million is primarily the result of net proceeds
received from the Company's initial public offering.
Many investment analysts use the measure of earnings before deducting
interest, taxes, depreciation and amortization, also commonly referred to as
"EBITDA," as a way of evaluating a company. EBITDA losses excluding non-cash
compensation expense and settlement of supplier dispute increased 114% to $19.6
million for the three months ended September 30, 2000, from $9.2 million for the
three months ended September 30, 1999. We expect to experience additional
operating losses and negative EBITDA as a result of our development and market
expansion activities.
We expect to make significant capital outlays for the foreseeable future
to continue the development activities called for in our current business plan
and to fund expected operating losses. Until such time as we begin to generate
positive cash flow from operations, these capital expenditures will need to be
financed with additional debt and equity capital. We believe that our current
resources will be sufficient to satisfy our liquidity needs for the succeeding
16 months; however, we cannot make any assurances to that effect. Thereafter, we
will need substantial additional capital. If our plans or assumptions change, if
our assumptions prove to be inaccurate, or if we experience unexpected costs or
competitive pressures, we will be required to seek additional capital sooner
than currently expected. In particular, if we elect to pursue significant
additional acquisition opportunities, our cash needs may be increased
substantially, both to finance any such acquisitions and to finance development
efforts in new markets. We cannot assure you that our current projection of cash
flow and losses from operations, which will depend upon numerous future factors
and conditions and many of which are outside of our control or unpredictable,
will be accurate. Actual results will almost certainly vary materially from our
current projections. It is likely that actual costs and revenues will vary from
expected amounts which will likely affect our future capital requirements. Our
cost of expanding our network services and sales efforts, funding other
strategic initiatives, and operating our business will depend on a variety of
factors, including, among other things:
- the number of subscribers and the services for which they
subscribe,
- the nature and penetration of services that may be offered by us,
- regulatory and legislative developments,
- response of our competitors to a loss of customers to us and
changes in technology, and
- the availability of network capacity from ILECs and other carries.
We believe that we have substantially funded Phases I and II of our
business plan with existing cash and borrowing capacity. We expect to fund the
capital expenditures and operating losses associated with Phase III by raising
additional capital from the equity or debt markets on an opportunistic basis. We
cannot assure you that we will be able to raise additional capital on
satisfactory terms or at all. If we decide to raise additional funds through the
incurrence of debt, our interest obligations will increase and we may become
subject to additional or more restrictive financial covenants. In the event that
we are unable to obtain such additional capital or to obtain it on acceptable
terms or in sufficient amounts, we may be required to delay the development of
our network and execution of our business plans or take other actions that could
materially and adversely affect our business, operating results and financial
condition.
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REGULATORY
GOVERNMENTAL REGULATIONS
Our telecommunications services are subject to regulation by federal,
state and local government agencies. Generally, Internet, video conferencing,
and certain data services are not directly regulated, although the underlying
telecommunications services may be regulated in certain instances. We hold
various federal, state and local regulatory authorizations for our regulated
service offerings. The FCC has jurisdiction over our facilities and services to
the extent those facilities are used in the provision of interstate or
international telecommunications services. State regulatory commissions also
have jurisdiction over our facilities and services to the extent they are used
in intrastate telecommunications services. Our network may also be subject to
certain local regulations such as licensing, building codes and generally
applicable public safety and welfare requirements. Many of the regulations
issued by these regulatory bodies may change and are the subject of various
judicial proceedings, legislative hearings and administrative proposals. We
cannot predict what impact, if any, these proceedings or changes will have on
our business or results of operations.
FEDERAL REGULATION
The FCC regulates us as a non-dominant common carrier. Non-dominant
carriers are subject to lesser regulation than dominant carriers but remain
subject to the general requirements that they offer just and reasonable rates
and terms of service and do not unreasonably discriminate in the provision of
services. We have obtained authority from the FCC to provide domestic,
interstate long distance services and international services between the United
States and foreign countries and have filed the required tariffs.
THE TELECOMMUNICATIONS ACT OF 1996
The Telecommunications Act of 1996 ("Telecommunications Act") was
designed to increase competition in the long distance and local
telecommunications industries. The Telecommunications Act imposes a variety of
duties on incumbent local exchange telephone carriers (ILECs) to facilitate
competition in the provision of local telecommunications and access services.
Like all local telecommunications carriers, where we provide local telephone
services, we are required to provide network interconnection, reciprocal
compensation, resale, number portability, and access to rights-of-way. ILECs,
such as the Regional Bell Operating Companies ("RBOCs"), are subject to
requirements in addition to these, including the duty to: undertake additional
obligations applicable to the interconnection of their networks; permit
collocation of competitors' equipment at their central offices; provide access
to individual network elements, including network facilities, features and
capabilities, on non-discriminatory and cost-based terms; and offer their retail
services for resale at wholesale rates.
The Telecommunications Act also eliminates certain pre-existing
prohibitions on the provision of traditional long distance services by the RBOCs
on a phased-in basis. RBOCs currently are permitted to provide long distance
service outside those states in which they provide local telecommunications
service. RBOCs will be permitted to provide traditional long distance service
within the regions in which they also provide local telecommunications service
upon demonstrating to the FCC that they have complied with a statutory checklist
of requirements intended to open local telephone markets to competition. To
date, only Verizon and SBC Communications ("SBC") have been granted approval to
provide long distance services in their local telephone service regions and that
is restricted to long distance calls originating in New York for Verizon and
Texas for SBC. Verizon and other RBOCs have initiated similar proceedings to
obtain in region long distance service authority in other states, including
Massachusetts. Entry of Verizon, SBC, and other RBOCs into the long distance
business could further increase competition to our services and may have a
material adverse effect on us.
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When the FCC permits the RBOCs to provide traditional long distance
service in their local telephone service regions, they will be able to offer
integrated local and long distance services and may enjoy a significant
competitive advantage. However, the Telecommunications Act imposes restrictions
on the RBOCs after they are permitted to enter the long distance services market
in their local service regions. Additional the FCC has imposed conditions on its
approval of the Verizon and SBC applications for authority to provide long
distance services in New York and Texas, respectively, that are intended to
prevent anti-competitive behavior. The FCC has imposed similar conditions on its
approval of various mergers involving RBOCs, and we expect the FCC to continue
such oversight of RBOCs seeking to enter the long distance market in their
operating regions.
The FCC is charged with establishing national rules implementing certain
portions of the Telecommunications Act. In August 1996, the FCC released an
order adopting an extensive set of regulations governing network
interconnection, network unbundling and resale of ILEC services, under the
Telecommunications Act. In July 1997, the United States Court of Appeals for the
Eighth Circuit issued a decision vacating substantial portions of these rules,
principally on the ground that the FCC had improperly intruded into matters
reserved for state jurisdiction. In January 1999, the United States Supreme
Court reversed many aspects of the Eighth Circuit's decision, concluding that
the FCC has jurisdiction to implement the local competition provisions of the
Telecommunications Act. In so doing, the Supreme Court found that the FCC has
authority to establish pricing guidelines applicable to the provision of
unbundled network elements and the resale of ILEC services, to prevent ILECs
from disaggregating existing combinations of network elements, and to establish
rules enabling competitors to select all or portions of any existing ILEC
interconnection agreements for use in their own interconnection agreements with
traditional telephone companies. The Supreme Court, however, did not evaluate
the specific pricing methodology adopted by the FCC and remanded the case to the
Eighth Circuit for further consideration. The Eighth Circuit subsequently upheld
the FCC's forward-looking cost methodology as the basis for establishing its
pricing standard, but overturned the FCC's pricing standard that was based on
the use of the most efficient technology available in the industry and, instead,
determined that prices should be based on actual costs. We cannot predict what
impact this decision will have on our business and we are unable to predict the
outcome of the FCC's reconsideration or an appeal of this decision. While the
Supreme Court resolved many issues, including the FCC's jurisdictional
authority, other issues remain subject to further consideration by the courts
and the FCC.
Although most of the FCC's interconnection rules were upheld by the
Supreme Court, the Court found that the FCC had not adequately considered
certain statutory criteria for requiring ILECs to make unbundled network
elements available to competitive telecommunications providers. The FCC then
conducted new proceedings to reexamine which unbundled network elements ILECs
must provide. On November 5, 1999, the FCC released an order in which it
required that ILECs make available most, but not all, of the network elements
specified in its initial order, as well as certain new network elements not
included on the original list. The FCC also clarified the obligation of ILECs to
provide certain combinations of network elements. Specifically, the FCC
determined that ILECs may not separate network elements that are currently
combined and purchased through special access tariffs. These special access
circuits can now be converted to combinations of unbundled loop and transport
elements, also known as enhanced extended links or EEL, subject to cost-based
pricing. Various parties have sought reconsideration and appeal of the FCC's
order. We are unable to predict the outcome of such reconsideration and
appellate proceedings.
In March 1999, the FCC adopted a further order strengthening the rights
of CLECs to obtain physical collocation for purposes of interconnecting with
ILEC networks. The order also requires ILECs to permit CLECs to collocate
equipment used for interconnection and/or access to unbundled network elements
even if such equipment includes certain switching or enhanced services
functions. Additionally, the FCC adopted rules designed to limit ILECs' ability
to deny CLECs the ability to deploy transmission hardware in collocation space
by purporting that the equipment will cause electrical interference with other
wires, and it proposed rules making these requirements more specific. In the
recent proceeding addressing unbundled network elements, however, the FCC
declined to require ILECs to provide CLECs with unbundled access to data
switching services, except in limited circumstances. The FCC's decisions on
these matters are currently subject or expected to be subject to judicial
review. On March 17, 2000, the United
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States Court of Appeals for the District of Columbia Circuit reversed
significant portions of the FCC's collocation order and rules, and remanded the
issue to the FCC for further proceedings. Among other things, the appeals court
decision seemingly overturns the FCC's decision to require ILECs to permit
competitors to collocate certain equipment that has enhanced services
functionality and allow collocating carriers to construct cross-connect
facilities between collocated equipment. We are unable to predict the ultimate
outcome or impact of these proceedings.
In October 2000, the FCC adopted rules to enhance the ability of CLECs to
provide services in commercial buildings or other multiple tenant environments.
Among other things, the FCC prohibited telecommunications carriers from entering
into exclusive contracts with commercial building owners and also required ILECs
to open up their equipment and wiring in buildings to use by CLECs.
ACCESS REGULATION
The FCC regulates the interstate access rates charged by ILECs for the
origination and termination of interstate long distance traffic. Over the past
few years, the FCC has implemented changes in interstate access rules that
result in the restructuring of the access charge system and changes in access
charge rate levels. On remand from an appeals court, the FCC is conducting
further proceedings to explain and refine its recent reforms affecting access
charge rate levels.
The FCC has also raised the issue of whether it should begin to regulate
the access charges imposed by CLECs. Currently, CLECs are free to charge access
rates at any level they deem appropriate, subject to overarching statutory
requirements that such rates must be just, reasonable and non-discriminatory. A
decision by the FCC to regulate CLECs access charges could result in the
reduction of those charges for all CLECs and thereby reduce our access charge
revenues.
Over the past few years, the FCC has granted ILECs significant
flexibility in pricing their interstate special and switched access services. We
anticipate that this pricing flexibility will result in ILECs lowering their
prices in high traffic density areas, the probable areas of competition with us.
We also anticipate that the FCC will grant ILECs increasing pricing flexibility
as the number of potential competitors increases in each of these markets. In
August 1999, the FCC released an order that granted substantial additional
pricing flexibility to ILECs for certain interstate services. Among other
things, the FCC granted immediate pricing flexibility to many ILECs and also
established a framework for granting greater flexibility in the pricing of all
interstate access services once they satisfy certain prescribed competitive
criteria. The FCC also invited public comment on proposals for additional ILEC
pricing flexibility.
In addition, in various contexts, certain ILECs have asked the FCC to
rule that certain calls made over the Internet are subject to regulation as
telecommunications services including the assessment of interstate switched
access charges and universal service fund assessments. Although the FCC has
suggested that Internet-based telephone-to-telephone calls may be considered
telecommunications services, it has not reached a final decision on that issue.
The FCC recently initiated an inquiry on issues surrounding high-speed Internet
access over cable modems, including the appropriate regulatory classification of
such services.
UNIVERSAL SERVICE
In 1997, the FCC established a significantly expanded universal service
regime to subsidize the cost of telecommunications services to high cost areas,
and to low-income customers and qualifying schools, libraries and rural health
care providers. Providers of telecommunications services, like us, as well as
certain other entities, must pay for these programs. Our share of the payments
into these subsidy funds will be based on our share of certain defined
telecommunications end-user revenues. Various states are also in the process of
implementing their own universal service programs. We are currently unable to
quantify the amount of subsidy payments we will be required to make in the
future or the effect that these required payments will have on our financial
condition. Moreover, the FCC's universal service rules remain subject to change,
which could increase our costs.
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DETARIFFING
In November 1996, the FCC issued an order that required non-dominant,
long distance carriers, like us, to cease filing tariffs for domestic, long
distance services. Tariffing is a traditional requirement of telephone companies
whereby such companies publish for public inspection at state and federal
regulatory agencies all terms, conditions, pricing, and available services
governing the sale of all such services to the public. The FCC's order
established a nine-month transition period to allow carriers sufficient time to
adjust for detariffing. The U.S. Court of Appeals for the District of Columbia
Circuit subsequently stayed the detariffing order, pending its decision on
challenges to the FCC's order by several long distance companies. In June 1997,
the FCC issued another order stating that non-dominant local services providers
may withdraw their tariffs for interstate access services provided to long
distance carriers. In March 1999, the FCC adopted further rules that, while
still maintaining mandatory detariffing, required long distance carriers to make
specific public disclosures on the services providers' Internet websites of
their rates, terms and conditions for domestic interstate services. The
effective date of these rules was also delayed until the appeals court rendered
a decision on the appeal of the FCC's detariffing order. In April 2000, the
appeals court affirmed the FCC's mandatory detariffing order in its entirety.
Consequently, the FCC implemented a transition period to allow carriers to
withdraw federal tariffs and move to contractual relationships with their
customers. Carriers must complete the process of detariffing domestic commercial
services by January 31, 2001 and must detariff consumer services by April 30,
2001. Long distance carriers will be required to comply with the new public
information requirements imposed by the FCC in lieu of tariff filings. In the
absence of tariffs, non-dominant, interstate services providers will no longer
be able to rely on the filing of tariffs with the FCC as a means of providing
notice to customers of prices, terms and conditions under which they offer their
domestic, interstate services, and will have to rely more heavily on
individually negotiated agreements with end-users. The FCC has also proposed to
eliminate tariffing requirements for international long distance carriers.
RECIPROCAL COMPENSATION
The Telecommunications Act of 1996 requires both CLECs and ILECs to
establish reciprocal compensation arrangements for the transport and termination
of telecommunications traffic. When two different carriers collaborate to
complete a call, these reciprocal compensation arrangements ensure compensation
both for the originating carrier, which receives payment from the customer, and
for the terminating carrier, which gets paid by the originating carrier.
In late 1998 and early 1999, the FCC determined that both dedicated
access and dial-up calls from a customer to an Internet service provider are
primarily interstate in nature and, therefore, subject to the FCC's
jurisdiction. The FCC initiated a proceeding to determine what effect this
regulatory classification will have on the obligation of a service provider to
pay reciprocal compensation for dial-up calls to Internet service providers and
other customers that originate on one local service provider's network and
terminate on another local service provider's network. The FCC also permitted
existing reciprocal compensation arrangements between service providers, as set
forth in interconnection agreements and approved by state regulatory
commissions, to remain intact. The FCC currently is determining whether a new
compensation mechanism should be implemented. The FCC Chairman announced that
the FCC intends to implement "bill and keep" for reciprocal compensation by the
end of the year. A decision which invalidates current reciprocal compensation
arrangements could result in the reduction, or elimination, of revenue we
receive from reciprocal compensation payments for traffic terminated over our
network to Internet service providers and other customers. On March 24, 2000,
the United States Court of Appeals for the District of Columbia Circuit vacated
the FCC's determination that dial-up calls to Internet service providers are not
"local" calls for purposes of charging reciprocal compensation, and remanded the
matter to the FCC for further consideration.
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STATE REGULATION
The Telecommunications Act preempts state and local statutes and
regulations that would tend to prohibit the provision of competitive
telecommunications services. As a result, we will be free to provide the full
range of local, long distance and data services in all states in which we
currently operate, and in any states into which we may wish to expand. While
this action greatly increases our potential for growth, it also increases the
amount of competition to which we may be subject.
Because we provide intrastate common carrier services, we are subject to
various state laws and regulations. Most state public utility and public service
commissions require some form of certification or registration before commencing
service. In most states, we are also required to file tariffs or price lists
setting forth the terms, conditions and prices for services that are classified
as intrastate. We are required to update or amend these tariffs when we adjust
our rates or add new products and are subject to various reporting and
record-keeping requirements in these states. Many states also require prior
approval for transfers of control of certified providers, corporate
reorganizations, acquisitions of telecommunications operations, assignment of
carrier assets, carrier stock offerings and incurrence of significant debt
obligations. States generally retain the right to sanction a service provider or
to revoke certification if a service provider violates applicable laws or
regulations.
We are authorized to provide intrastate long distance services in every
state except Alaska and are in the process of obtaining intrastate long distance
authority in that state. We have authority to provide competitive local
telecommunications services in California, Connecticut, Delaware, the District
of Columbia, Florida, Georgia, Illinois, Maryland, Massachusetts, New Hampshire,
New Jersey, New York, North Carolina, Pennsylvania, Rhode Island, Texas,
Virginia and West Virginia. We have also applied to obtain authority to provide
competitive local telecommunications services in Maine.
LOCAL INTERCONNECTION
The Telecommunications Act imposes a duty upon all ILECs to negotiate in
good faith with potential competitive telecommunications providers to provide
interconnection to their networks, exchange local traffic, make unbundled
network elements available and permit resale of most local telephone services.
If negotiations do not succeed, we have a right to seek arbitration with the
state regulatory authority of any unresolved issues. Arbitration decisions
involving interconnection arrangements in several states have been challenged
and appealed to federal courts. We have entered into interconnection agreements
with Verizon in Delaware, the District of Columbia, Maryland, Massachusetts, New
Jersey, New York, Pennsylvania, Rhode Island, Virginia and West Virginia, with
BellSouth in Alabama, Florida, Georgia, Kentucky, Louisiana, Mississippi, North
Carolina, South Carolina, and Tennessee, with Ameritech in Illinois, and with
SBC in Texas. We have begun to negotiate similar agreements in the other states
where we are authorized to provide competitive local telecommunications
services.
FORWARD-LOOKING STATEMENTS AND RISK FACTORS
Certain statements in this Management's Discussion and Analysis of
Financial Condition and Results of Operations constitute "forward-looking
statements" within the meaning of Section 27A of the Securities Act of 1933, as
amended, and we intend that such forward-looking statements be subject to the
safe harbors created thereby. The words "believes," "expects," "estimate,"
"anticipates," "will be," "should" and similar words or expressions identify
forward-looking statements made by us or on our behalf. These forward-looking
statements are subject to many uncertainties and factors that may cause our
actual results to be materially different from any future results expressed or
implied by such forward-looking statements. We do not undertake any obligation
to update or revise any forward-looking statements made by us or on our behalf,
whether as a result of new information, future events or otherwise.
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
We do not have operations subject to risks of foreign currency
fluctuations, nor do we use derivative financial instruments in our operations.
Our exposure to financial market risk, relates primarily to our investment
portfolio and outstanding debt. We typically do not attempt to reduce or
eliminate our market exposure on our investment securities because a substantial
majority of our investments are in fixed-rate, short-term securities. Our
earnings are affected by changes in interest rates as our long term debt has
variable interest rates based on either the Prime Rate or LIBOR. If interest
rates for our long term debt for the three months ended September 30, 2000
average 10% more than they did as of December 31, 1999, our interest expense
would increase, and loss before taxes would increase by approximately $1.3
million for the three months ended September 30, 2000. These amounts are
determined by considering the impact of the hypothetical interest rates on our
borrowing cost and outstanding debt balances. These analyses do not consider the
effects of the reduced level of overall economic activity that could exist in
such an environment. Further, in the event of a change of such magnitude,
management would likely take actions to further mitigate its exposure to the
change. However, due to the uncertainty of the specific actions that would be
taken and their possible effects, the sensitivity analysis assumes no changes in
our financial structure.
PART II. - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
From time to time, we are a party to routine litigation and regulatory
proceedings before various state commissions and the FCC in the ordinary course
of business. We are not aware of any material litigation against us.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
REPORT OF OFFERING OF SECURITIES AND USE OF PROCEEDS THEREFROM
In March 2000, we commenced and completed a firm commitment underwritten
initial public offering of 11,500,000 shares of our common stock at a price of
$20.00 per share, with net proceeds of $212 million. We used $49.6 million of
the proceeds to repay the outstanding principal and interest on our Nortel
facility, $11.9 million in acquiring FreBon International Corporation
("FreBon"), including the repayment of $2.8 million of debt that we assumed, and
approximately $83.2 million in our normal operations. As of September 30, 2000,
we had invested the remaining net proceeds of the initial public offering in
short term investments with durations less than one year. This use of proceeds
from the offering does not represent a material change in the use of proceeds
described in the Registration Statement. Other than for the repayment of our
Nortel facility and payment of compensation to officers in the ordinary course
of business, none of the net proceeds of the offering were paid directly or
indirectly to any of our directors or officers, or their associates, or persons
owning 10 percent or more of any class of our equity securities.
On July 10, 2000, we acquired FreBon, a privately-held provider of
interactive video services. The purchase price at closing consisted of 400,000
shares of common stock valued at $6.8 million and cash payments totaling $9.1
million. In addition, we assumed debt totaling $2.8 million. The shares of
common stock were issued in a transaction exempt from registration under Section
4(2) of the Securities Act, relating to sales by an issuer not involving any
public offering. The sale of securities was made without the use of an
underwriter and the certificates evidencing the shares bear a restrictive legend
permitting the transfer thereof only by means of a registration of an exemption
under the Securities Act.
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ITEM 3. DEFAULTS UPON SENIOR SECURITIES
The Senior Secured Credit Facility carries restrictive covenants that,
among other things, require the Company to maintain certain operating and
financial performance measures. We were in compliance with all such restrictive
covenants as of September 30, 2000, except for the EBITDA financial performance
covenant. On November 10, 2000, we obtained a waiver for this violation for the
fiscal quarter ended September 30, 2000
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None
ITEM 5. OTHER INFORMATION
Not applicable
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
EXHIBITS
<TABLE>
<CAPTION>
EXHIBIT NO. DESCRIPTION
----------- -----------------------------------------------------------
<S> <C>
27 Financial Data Schedule
</TABLE>
REPORTS ON FORM 8-K
On July 7, 2000, the Registrant filed as an Item 5 event, the execution
of a definitive agreement for the acquisition of FreBon International
Corporation ("Frebon").
On July 10, 2000, the Registrant filed as an Item 5 event, the closing of
the acquisition of FreBon.
On September 20, 2000, the Registrant filed as an Item 5 event, an
amended 8-K/A to the previously filed 8-K dated July 10, 2000, relating to the
Company's acquisition of Frebon.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Date: November 14, 2000 By: /s/ Donald E. Clarke
--------------------
Donald E. Clarke
Chief Financial Officer, Executive Vice
President and Treasurer
25
