FORM 10-Q
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended June 30, 1999
or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period______ to ______
Commission file number 0-15658
LEVEL 3 COMMUNICATIONS, INC.
(Exact name of registrant as specified in its charter)
Delaware 47-0210602
(State of Incorporation) (I.R.S. Employer
Identification No.)
1025 Eldorado Blvd., Broomfield, CO 80021
(Address of principal executive offices) (Zip Code)
(720) 888-1000
(Registrant's telephone number,
including area code)
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(s)), and (2) has been subject to
such filing requirements for the past 90 days. Yes X No
The number of shares outstanding of each class of the issuer's common stock, as
of July 30, 1999:
Common Stock 339,885,905 shares
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Part I - Financial Information
Item 1. Financial Statements:
Consolidated Condensed Statements of Operations
Consolidated Condensed Balance Sheets
Consolidated Condensed Statements of Cash Flows
Consolidated Statement of Changes in Stockholders' Equity
Consolidated Statements of Comprehensive Income
Notes to Consolidated Condensed Financial Statements
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations
Part II - Other Information
Item 4. Submission of Matters to a Vote of Security Holders
Item 6. Exhibits and Reports on Form 8-K
Signatures
Index to Exhibits
<TABLE>
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Consolidated Condensed Statements of Operations
(unaudited)
<S> <C> <C> <C> <C>
Three Months Ended Six Months Ended
June 30, June 30,
(dollars in millions,except share data) 1999 1998 1999 1998
- --------------------------------------------------------------------------------
Revenue $ 106 $ 103 $ 208 $ 190
Costs and Expenses:
Cost of revenue 81 49 143 91
Depreciation and amortization 51 10 92 16
Selling, general and administrative expenses 157 55 282 103
Write-off of in-process research &
development - 30 - 30
----- ----- ---- -----
Total costs and expenses 289 144 517 240
----- ----- ---- -----
Loss from Operations (183) (41) (309) (50)
Other Income (Expense):
Interest income 57 45 107 71
Interest expense, net (45) (36) (98) (40)
Gain on equity investee stock transactions 111 21 111 21
Other, net (7) (25) (30) (47)
----- ----- ---- -----
Total other income 116 5 90 5
----- ----- ---- -----
Loss Before Income Taxes and
Discontinued Operations (67) (36) (219) (45)
Income Tax Benefit 23 2 70 5
----- ----- ---- -----
Loss from Continuing Operations (44) (34) (149) (40)
Discontinued Operations:
Gain on split-off of Construction Group - - - 608
Gain on disposition of energy business,
net of income tax expense of $175 - - - 324
----- ----- ---- -----
Earnings from discontinued operations - - - 932
----- ----- ---- -----
Net Earnings (Loss) $ (44) $ (34) $(149) $ 892
===== ===== ===== =====
Earnings(Loss)Per Share (Basic and Diluted):
Continuing operations $(.13) $(.11) $(.45) $(.14)
===== ===== ===== =====
Discontinued operations $ - $ - $ - $3.14
===== ===== ===== =====
Net earnings (loss) $(.13) $(.11) $(.45) $3.00
===== ===== ===== =====
Net earnings (loss), excluding gain on
split-off of Construction Group $(.13) $(.11) $(.45) $0.96
===== ===== ===== =====
- -------------------------------------------------------------------------------
See accompanying notes to consolidated condensed financial statements.
</TABLE>
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Consolidated Condensed Balance Sheets
(unaudited)
<TABLE>
<S> <C> <C>
June 30, December 31,
(dollars in millions, except share data) 1999 1998
- --------------------------------------------------------------------------------
Assets
Current Assets
Cash and cash equivalents $ 795 $ 842
Marketable securities 3,383 2,863
Restricted securities 34 32
Accounts receivable, net 111 57
Income taxes receivable 89 54
Other 42 29
------ ------
Total Current Assets 4,454 3,877
Property, Plant and Equipment, net 2,185 1,061
Investments 387 323
Other Assets, net 324 264
------ ------
$7,350 $5,525
====== ======
- ---------------------------------------------------------------------------
See accompanying notes to consolidated condensed financial statements.
</TABLE>
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Consolidated Condensed Balance Sheets
(unaudited)
<TABLE>
<S> <C> <C>
June 30, December 31,
(dollars in millions, except share data) 1999 1998
- --------------------------------------------------------------------------------
Liabilities and Stockholders' Equity
Current Liabilities:
Accounts payable $ 478 $ 276
Current portion of long-term debt 6 5
Accrued payroll and employee benefits 39 16
Accrued interest 33 33
Deferred revenue 56 1
Other 44 39
------ ------
Total Current Liabilities 656 370
Long-Term Debt, less current portion 2,667 2,641
Deferred Income Taxes 57 86
Accrued Reclamation Costs 95 96
Other Liabilities 266 167
Commitments and Contingencies
Stockholders' Equity:
Preferred stock, $.01 par value,
authorized 10,000,000 shares; no shares
outstanding in 1999 and 1998 - -
Common Stock:
Common Stock,$.01 par value, authorized 1,500,000,000
shares; 339,616,599 shares outstanding in 1999 and
307,874,706 outstanding in 1998 3 3
Class R, $.01 par value, authorized 8,500,000 shares,
no shares outstanding in 1999 and 1998 - -
Additional paid-in capital 2,372 765
Accumulated other comprehensive (loss) income (10) 4
Retained earnings 1,244 1,393
------ ------
Total Stockholders' Equity 3,609 2,165
------ ------
$7,350 $5,525
====== ======
- ----------------------------------------------------------------------------
See accompanying notes to consolidated condensed financial statements.
</TABLE>
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Consolidated Condensed Statements of Cash Flows
(unaudited)
<TABLE>
<S> <C> <C>
Six Months Ended
June 30,
(dollars in millions) 1999 1998
- --------------------------------------------------------------------------------
Cash flows from continuing operations:
Net cash provided by (used in)continuing operations $ 159 $ (62)
Cash flows from investing activities:
Proceeds from sales and maturities of
marketable securities 2,769 2,484
Purchases of marketable securities (3,275) (4,713)
Investments (3) (22)
Proceeds from sale of property, plant and
equipment and other investments 11 26
Capital expenditures (1,215) (144)
Other 1 -
------ ------
Net cash used in investing activities (1,712) (2,369)
Cash flows from financing activities:
Payments on long-term debt including current portion (4) (5)
Issuance of long-term debt 1 1,937
Issuances of common stock 1,496 21
Proceeds from exercise of stock options 13 7
Exchange of Class C Stock for Common Stock, net - 122
------ ------
Net cash provided by financing activities 1,506 2,082
Cash flows from discontinued operations:
Proceeds from sale of energy operations, net of income
tax payments of $96 million - 1,063
------ ------
Net cash provided by discontinued operations - 1,063
------ ------
Net change in cash and cash equivalents (47) 714
Cash and cash equivalents at beginning of year 842 87
------ ------
Cash and cash equivalents at end of period $ 795 $ 801
====== ======
</TABLE>
The activities of the Construction & Mining Group have been removed from the
consolidated condensed statements of cash flows in 1998. The Construction Group
had cash flows of ($62) million for the three months ended March 31, 1998.
- -------------------------------------------------------------------------------
See accompanying notes to consolidated condensed financial statements.
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Consolidated Statement of Changes in Stockholders' Equity
For the six months ended June 30, 1999
(unaudited)
<TABLE>
<S> <C> <C> <C> <C> <C>
Accumulated
Additional Other
Common Paid-in Comprehensive Retained
(dollars in millions) Stock Capital Income (Loss) Earnings Total
- --------------------------------------------------------------------------------
Balance at
December 31, 1998 $ 3 $ 765 $ 4 $ 1,393 $ 2,165
Common Stock:
Issuances, net - 1,503 - - 1,503
Stock options exercised - 13 - - 13
Stock option grants - 49 - - 49
Income tax benefit from
exercise of options - 42 - - 42
Net Loss - - - (149) (149)
Other Comprehensive Loss - - (14) - (14)
------ ------ ------ ------ ------
Balance at June 30, 1999 $ 3 $2,372 $ (10) $ 1,244 $ 3,609
====== ====== ====== ======= =======
- -------------------------------------------------------------------------------
See accompanying notes to consolidated condensed financial statements.
</TABLE>
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Consolidated Statements of Comprehensive Income (Loss)
(unaudited)
<TABLE>
<S> <C> <C> <C> <C>
Three Months Ended Six Months Ended
June 30, June 30,
(dollars in millions) 1999 1998 1999 1998
- --------------------------------------------------------------------------------
Net (Loss) Earnings $ (44) $ (34) $ (149) $ 892
Other Comprehensive (Loss) Income
Before Tax:
Foreign currency translation
adjustments (6) - (8) 1
Unrealized holding (loss) gain
arising during period 1 (5) (2) 3
Reclassification adjustment for
losses (gains) included in net
earnings (loss) (14) (3) (12) (8)
------ ------ ------ ------
Other Comprehensive (Loss) Before Tax (19) (8) (22) (4)
Income Tax Benefit Related to Items of
Other Comprehensive (Loss) 7 3 8 2
------ ------ ------ ------
Other Comprehensive (Loss)
Net of Taxes (12) (5) (14) (2)
------ ------ ------ ------
Comprehensive (Loss) Income $ (56) $ (39) $ (163) $ 890
====== ====== ====== ======
- -------------------------------------------------------------------------------
See accompanying notes to consolidated condensed financial statements.
</TABLE>
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Notes to Consolidated Condensed Financial Statements
1. Basis of Presentation
The consolidated condensed balance sheet of Level 3 Communications, Inc. and
subsidiaries ("Level 3" or the "Company"), at December 31, 1998 has been
condensed from the Company's audited balance sheet as of that date. All other
financial statements contained herein are unaudited and, in the opinion of
management, contain all adjustments (consisting only of normal recurring
accruals) necessary for a fair presentation of financial position, results of
operations and cash flows for the periods presented. The Company's accounting
policies and certain other disclosures are set forth in the notes to the
consolidated financial statements contained in the Company's Annual Report on
Form 10-K, for the year ended December 31, 1998. These financial statements
should be read in conjunction with the Company's audited consolidated financial
statements and notes thereto. The preparation of the consolidated condensed
financial statements in conformity with generally accepted accounting principles
requires management to make estimates and assumptions that affect the reported
amount of assets and liabilities, disclosure of contingent assets and
liabilities and the reported amount of revenue and expenses during the reported
period. Actual results could differ from these estimates.
The Company has embarked on a plan to become a facilities-based provider (that
is, a provider that owns or leases a substantial portion of the property, plant
and equipment necessary to provide its services) of a broad range of integrated
communications services in the United States, Europe and Asia. To reach this
goal, the Company is expanding substantially the business of its PKS Information
Services, Inc. subsidiary and creating, through a combination of construction,
purchase and leasing of facilities and other assets, an international,
end-to-end, facilities-based communications network (the "Business Plan"). The
Company is building the network based on Internet Protocol ("IP") technology in
order to leverage the efficiencies of this technology to provide lower cost
communications services.
In 1997, the Company agreed to sell its energy assets to MidAmerican Energy
Holding Company, Inc. (f/k/a CalEnergy Company, Inc.) ("MidAmerican") and to
separate the construction operations ("Construction Group") from the Company. On
January 2, 1998, the Company completed the sale of its energy assets to
MidAmerican. On March 31, 1998, the Company completed the split-off of the
Construction Group to stockholders that held Class C Stock. Therefore, the
results of operations of both businesses have been classified as discontinued
operations on the consolidated condensed statements of operations for 1998.
On May 1, 1998, the Company's Board of Directors changed Level 3's fiscal year
end from the last Saturday in December to a calendar year end. The additional
four days for the period ending June 30 1998, were not material to the overall
results of operations and cash flows.
The results of operations for the six months ended June 30, 1999, are not
necessarily indicative of the results expected for the full year.
Where appropriate, items within the consolidated condensed financial statements
have been reclassified from the previous periods to conform to current period
presentation.
2. Reorganization - Discontinued Construction Operations
Prior to March 31, 1998, the Company had a two-class capital structure. The
Company's Class C Stock reflected the performance of the Construction Group and
the Class D Stock reflected the performance of the other businesses, including
communications, information services and coal mining. In 1997 the Board of
Directors of Level 3 approved a proposal for the separation of the Construction
Group from the other operations of the Company through a split-off of the
Construction Group (the "Split-off"). In December 1997, the Company's
stockholders approved the Split-off and on March 5, 1998 the Company received a
ruling from the Internal Revenue Service that stated the Split-off would be
tax-free to U.S. stockholders. The Split-off was effected on March 31, 1998. As
a result of the Split-off, the Company no longer owns any interest in the
Construction Group. Accordingly, the separate financial statements and
management's discussion and analysis of financial condition and results of
operations of Peter Kiewit Sons', Inc. should be obtained to review the results
of operations of the Construction Group for the three months ended March 31,
1998.
On March 31, 1998, the Company reflected the fair value of the Construction
Group as a distribution to the Class C stockholders because the distribution was
considered non-pro rata as compared to the Company's previous two-class capital
stock structure. The Company recognized a gain of $608 million within
discontinued operations, equal to the difference between the carrying value of
the Construction Group and its fair value in accordance with Financial
Accounting Standards Board Emerging Issues Task Force Issue 96-4, "Accounting
for Reorganizations Involving a Non-Pro Rata Split-off of Certain Nonmonetary
Assets to Owners". No taxes were provided on this gain due to the tax-free
nature of the Split-off.
In connection with the Split-off, the Class D Stock became the common stock of
Level 3 Communications, Inc. ("Common Stock"), and shortly thereafter, began
trading on the Nasdaq National Market on April 1, 1998, under the symbol "LVLT".
3. Discontinued Energy Operations
On January 2, 1998, the Company completed the sale of its energy assets to
MidAmerican. These assets included approximately 20.2 million shares of
MidAmerican common stock (assuming the exercise of 1 million options held by
Level 3), Level 3's 30% interest in CE Electric and Level 3's investments in
international power projects in Indonesia and the Philippines. Level 3
recognized an after-tax gain on the disposition of $324 million and the
after-tax proceeds of approximately $967 million from the transaction are being
used in part to fund the Business Plan. Results of operations for the period
through January 2, 1998 were not considered significant and the gain on
disposition was calculated using the carrying amount of the energy assets as of
December 27, 1997.
4. Earnings (Loss) Per Share
Basic earnings (loss) per share have been computed using the weighted average
number of shares during each period. The Company had a loss from continuing
operations for the three and six month periods ended June 30, 1999 and 1998.
Therefore, the 21,868,537 options and warrants outstanding at June 30, 1999 and
19,718,014 options and warrants outstanding at June 30, 1998 have not been
included in the computation of diluted earnings (loss) per share because the
resulting computation would have been anti-dilutive.
Effective August 10, 1998, the Company issued a dividend of one share of Level 3
Common Stock for each share of Level 3 Common Stock outstanding. All share
information and per share data have been restated to reflect the stock dividend.
The following details the earnings (loss) per share calculations for Level 3
Common Stock:
<TABLE>
<S> <C> <C> <C> <C>
Three Months Ended Six Months Ended
June 30, June 30,
1999 1998 1999 1998
- --------------------------------------------------------------------------------
Loss From Continuing Operations
(in millions) $ (44) $ (34) $ (149) $ (40)
Discontinued Operations:
Gain on Split-off of Construction Group - - - 608
Earnings from Discontinued Energy
Operations - - - 324
----- ----- ----- -----
Net earnings (loss) $ (44) $ (34) $(149) $ 892
===== ===== ===== =====
Total Number of Weighted Average Shares
Outstanding Used to Compute Basic
and Diluted Earnings Per Share
(in thousands) 339,266 301,786 327,840 296,986
======= ======= ======= =======
Earnings (Loss) Per Share
(Basic and Diluted):
Continuing operations $ (.13) $ (.11) $ (.45) $ (.14)
======= ======= ======= =======
Discontinued operations $ - $ - $ - $ 3.14
======= ======= ======= =======
Net earnings (loss) $ (.13) $ (.11) $ (.45) $ 3.00
======= ======= ======= =======
Net earnings (loss), excluding
gain on Split-off of Construction
Group $ (.13) $ (.11) $ (.45) $ .96
======= ======= ======= =======
- -------------------------------------------------------------------------------
</TABLE>
5. Acquisitions
On January 5, 1999, Level 3 acquired BusinessNet Ltd. ("BusinessNet"), a leading
London-based internet service provider in a largely stock-for-stock transaction
valued at $12 million and accounted for as a purchase. After completion of
certain adjustments, the Company agreed to issue approximately 400,000 shares of
Common Stock and paid $1 million in cash in exchange for all of the issued and
outstanding shares of BusinessNet's capital stock. Of the approximately 400,000
shares Level 3 agreed to issue in connection with the acquisition, approximately
150,000 shares of Level 3 Common Stock have been pledged to Level 3 to secure
certain indemnification obligations of the former BusinessNet stockholders. The
pledge of these shares will terminate in approximately 18 months from the
acquisition date, unless otherwise extended pursuant to the terms of the
acquisition agreement. Liabilities exceeded assets acquired, and goodwill of $16
million was recognized from the transaction which is being amortized over five
years.
On April 23, 1998, the Company acquired XCOM Technologies, Inc. ("XCOM"), a
privately held company that has developed technology which the Company believes
will provide certain key components necessary for the Company to develop an
interface between its IP-based network and the existing public switched
telephone network. The Company issued approximately 5.3 million shares of Level
3 Common Stock and 0.7 million options and warrants to purchase Level 3 Common
Stock in exchange for all the stock, options and warrants of XCOM.
The Company accounted for this transaction, valued at $154 million, as a
purchase. Of the total purchase price, $115 million was originally allocated to
in-process research and development and was taken as a nondeductible charge to
earnings in the second quarter of 1998. The purchase price exceeded the fair
value of the net assets acquired by $30 million which was recognized as
goodwill.
In October 1998, the Securities and Exchange Commission ("SEC") issued new
guidelines for valuing acquired research and development which are applied
retroactively. The Company believes its accounting for the acquisition was made
in accordance with generally accepted accounting principles and established
appraisal practices at the time of the acquisition. However, due to the
significance of the charge relative to the total value of the acquisition, the
Company reviewed the facts with the SEC. Consequently, using the revised
guidelines and assumptions, the Company reduced the charge for in-process
research and development from $115 to $30 million, and increased the related
goodwill by $85 million. The goodwill associated with the XCOM transaction is
being amortized over a five year period. The results for the three and six
months ended June 30, 1998 have been restated to reflect the reduced charge for
in-process research and development and increased amortization expense.
The Company believes that its resulting charge for acquired research and
development conforms to the SEC's expressed guidelines and methodologies.
However, no assurances can be given that the SEC will not require additional
adjustments.
The cumulative operating results of BusinessNet, XCOM and other 1998
acquisitions were not significant relative to the Company's 1999 and 1998
results.
For the Company's acquisitions, the excess purchase price over the fair market
value of the underlying assets was allocated to goodwill and other intangible
assets and property based upon preliminary estimates of fair value. The final
purchase price allocation for XCOM did not vary significantly from preliminary
estimates. The Company does not believe that the final purchase price allocation
will vary significantly from the preliminary estimates for the entities acquired
after June 30, 1998.
6. Property, Plant and Equipment, net
Construction in Progress
The Company is currently constructing its communications network. Costs
associated directly with the uncompleted network and interest expense incurred
during construction are capitalized based on the weighted average accumulated
construction expenditures and the interest rates related to borrowings
associated with the construction. Certain gateway facilities, local networks and
operating equipment have been placed in service during 1999. These assets are
being depreciated over their useful lives, primarily ranging from 3-20 years. As
other segments of the network are placed in service, the assets will be
depreciated over their useful lives.
The Company is currently developing business support systems required for its
Business Plan. The external direct costs of software, materials and services,
payroll and payroll related expenses for employees directly associated with the
project and interest costs incurred when developing the business support systems
are capitalized. Upon completion of the projects, the total cost of the business
support systems are amortized over their useful lives of 3 years.
For the six months ended June 30, 1999, the Company invested $1,118 million in
its communications business, including $429 million on the U.S. intercity
network, $207 million on international networks, $85 million on transoceanic
networks and $284 million on gateway facilities and local networks.
Capitalized business support systems and network construction costs that have
not been placed in service have been classified as construction-in-progress
within Property, Plant and Equipment below.
<TABLE>
<S> <C> <C> <C>
Accumulated Book
(dollars in millions) Cost Depreciation Value
- --------------------------------------------------------------------------------
June 30, 1999
Land and Mineral Properties $ 35 $ (11) $ 24
Facility and Leasehold Improvements:
Communications 114 (2) 112
Information Services 26 (2) 24
Coal Mining 18 (15) 3
CPTC 91 (8) 83
Operating Equipment:
Communications 294 (43) 251
Information Services 58 (34) 24
Coal Mining 176 (155) 21
CPTC 17 (6) 11
Network Construction Equipment 79 (4) 75
Furniture and Office Equipment 90 (26) 64
Other 75 (15) 60
Construction-in-Progress 1,433 - 1,433
------ ------ ------
$2,506 $ (321) $2,185
====== ====== ======
December 31, 1998
Land and Mineral Properties $ 32 $ (11) $ 21
Facility and Leasehold Improvements:
Communications 80 (1) 79
Information Services 24 (2) 22
Coal Mining 18 (15) 3
CPTC 91 (5) 86
Operating Equipment:
Communications 245 (18) 227
Information Services 53 (30) 23
Coal Mining 180 (155) 25
CPTC 17 (4) 13
Network Construction Equipment 46 (1) 45
Furniture and Office Equipment 67 (10) 57
Other 72 (2) 70
Construction-in-Progress 390 - 390
------ ------ ------
$1,315 $ (254) $1,061
====== ====== ======
- -------------------------------------------------------------------------------
</TABLE>
7. Investments
The Company holds significant equity positions in two publicly traded companies;
RCN Corporation ("RCN") and Commonwealth Telephone Enterprises, Inc.
("Commonwealth Telephone"). RCN is a facilities-based provider of communications
services to the residential market primarily in the northeastern United States
and California. RCN provides local and long distance phone, cable television and
Internet services in several markets; including Boston, New York, Washington,
D.C., and California's San Francisco to San Diego corridor.
Commonwealth Telephone holds Commonwealth Telephone Company, an incumbent local
exchange carrier operating in various rural Pennsylvania markets, and CTSI,
Inc., a competitive local exchange carrier which commenced operations in 1997.
On June 30, 1999, Level 3 owned approximately 35% and 48% of the outstanding
shares of RCN and Commonwealth Telephone, respectively, and accounts for each
entity using the equity method. The market value of the Company's investment in
the two entities was $1,109 million and $431 million, respectively, on June 30,
1999.
The Company recognizes gains from the sale, issuance and repurchase of stock by
its subsidiaries and equity method investees in its statement of operations.
During 1999, RCN issued stock in a public offering and for certain transactions
which diluted the Company's ownership of RCN from 41% at December 31, 1998 to
35% at June 30, 1999. The increase in the Company's proportionate share of RCN's
net assets as a result of these transactions resulted in a pre-tax gain of $111
million for the Company in the second quarter of 1999. The Company also
recognized a gain of $21 million in the second quarter of 1998 related to stock
transactions of RCN.
The following is summarized financial information of RCN and Commonwealth
Telephone for the three and six months ended June 30, 1999 and 1998, and as of
June 30, 1999 and December 31, 1998 (in millions):
<TABLE>
<S> <C> <C> <C> <C>
Three Months Ended Six Months Ended
June 30, June 30,
Operations 1999 1998 1999 1998
- --------------------------------------------------------------------------------
RCN Corporation:
Revenue $ 67 $ 50 $ 134 $ 90
Net loss available to
common shareholders (68) (49) (136) (117)
Level 3's share:
Net loss (25) (22) (52) (53)
Goodwill amortization (1) - (1) -
------- ------ ------ -----
Equity in net loss $ (26) $ (22) $ (53) $ (53)
======= ====== ====== =====
Commonwealth Telephone Enterprises:
Revenue $ 63 $ 56 $ 124 $ 109
Net income available to
common shareholders 6 5 11 9
Level 3's share:
Net income 3 2 5 4
Goodwill amortization - - (1) (1)
------- ------ ----- -----
Equity in net income $ 3 $ 2 $ 4 $ 3
======= ====== ===== =====
</TABLE>
<TABLE>
<S> <C> <C> <C> <C>
Commonwealth
RCN Telephone
Corporation Enterprises
Financial Position 1999 1998 1999 1998
- --------------------------------------------------------------------------------
Current assets $ 1,837 $ 1,093 $ 78 $ 79
Other assets 1,023 815 387 354
------- ------- ----- -----
Total assets 2,860 1,908 465 433
Current liabilities 174 178 85 85
Other liabilities 1,741 1,282 245 223
Minority interest 103 77 - -
Preferred stock 244 - - -
------ ------ ----- -----
Total liabilities and preferred stock 2,262 1,537 330 308
------ ------ ----- -----
Common Equity $ 598 $ 371 $ 135 $ 125
====== ====== ===== =====
Level 3's share:
Equity in net assets $ 214 $ 150 $ 65 $ 60
Goodwill 28 34 55 56
------ ------ ----- -----
$ 242 $ 184 $ 120 $ 116
====== ====== ===== =====
- --------------------------------------------------------------------------------
Investments at June 30, 1999 and December 31, 1998 also include $23 million for
the Company's investment in the Pavilion Towers office buildings in Aurora,
Colorado.
</TABLE>
8. Other Assets, net
At June 30, 1999 and December 31, 1998 other assets consisted of the following:
<TABLE>
<S> <C> <C>
(in millions) 1999 1998
- --------------------------------------------------------------------------------
Goodwill:
XCOM, net of accumulated amortization of $26 and $15 $ 86 $ 100
GeoNet, net of accumulated amortization of $3 and $1 18 20
BusinessNet, net of accumulated amortization of $2 and $- 14 -
Other, net of accumulated amortization of $4 and $1 16 19
Prepaid Network Assets 77 -
Deferred Debt Issuance Costs 63 67
Deferred Development and Financing Costs 15 15
Unrecovered Mine Development Costs 15 15
Leases 7 9
Timberlands 6 6
Other 7 13
----- ------
Total other assets $ 324 $ 264
===== ======
- --------------------------------------------------------------------------------
</TABLE>
9. Long-Term Debt
9.125% Senior Notes
On April 28, 1998, the Company received $1.94 billion of net proceeds from an
offering of $2 billion aggregate principal amount 9.125% Senior Notes Due 2008
("Senior Notes"). Interest on the notes accrues at 9.125% per year and is
payable on May 1 and November 1 each year in cash.
Debt issuance costs of $65 million were capitalized and are being amortized as
interest expense over the term of the Senior Notes.
10.5% Senior Discount Notes
On December 2, 1998, the Company sold $834 million aggregate principal amount at
maturity of 10.5% Senior Discount Notes Due 2008 ("Senior Discount Notes"). The
sales proceeds of $500 million, excluding debt issuance costs, were recorded as
long term debt. Interest on Senior Discount Notes accretes at a rate of 10.5%
per annum, compounded semiannually, to an aggregate principal amount of $834
million by December 1, 2003. Cash interest will not accrue on the Senior
Discount Notes prior to December 1, 2003; however, the Company may elect to
commence the accrual of cash interest on all outstanding Senior Discount Notes
on or after December 1, 2001. Accrued interest expense for the six months ended
June 30, 1999 on the Senior Discount Notes of $27 million was added to long-term
debt.
Debt issuance costs of $14 million have been capitalized and are being amortized
as interest expense over the term of the Senior Discount Notes.
The Company capitalized $20 and $31 million of interest expense and amortized
debt issuance costs related to network construction and business systems
development projects for the three and six months ended June 30, 1999 and $1
million for the three and six months ended June 30, 1998.
10. Employee Benefit Plans
The Company adopted the recognition provisions of SFAS No. 123, "Accounting for
Stock Based Compensation" ("SFAS No. 123") in 1998. Under SFAS No. 123, the fair
value of an option (as computed in accordance with accepted option valuation
models) on the date of grant is amortized over the vesting periods of the
options. The recognition provisions of SFAS No. 123 are applied prospectively
upon adoption. As a result, the recognition provisions are applied to all stock
awards granted in the year of adoption and are not applied to awards granted in
previous years unless those awards are modified or settled in cash after
adoption of the recognition provisions. Although the recognition of the value of
the stock awards results in compensation or professional expenses in an entity's
financial statements, the expense differs from other compensation and
professional expenses in that these charges will not be settled in cash, but
rather, generally, through issuance of common stock.
The Company believes that the adoption of SFAS No. 123 will result in material
non-cash charges to operations in 1999 and thereafter. The amount of the
non-cash charges will be dependent upon a number of factors, including the
number of grants and the fair value of each grant estimated at the time of its
award.
Non-Qualified Stock Options and Warrants
The Company granted 55,100 nonqualified stock options with a fair value of $1
million ("NQSO") to employees during the six months ended June 30, 1999. The
expense recognized for the three and six months ended June 30, 1999 for NQSOs
and warrants outstanding at June 30, 1999 in accordance with SFAS No. 123 was $4
million and $2 million, respectively. In addition to the expense recognized,
the Company capitalized $- and $1 million of non-cash compensation costs for the
three and six months ended June 30, 1999, respectively related to NQSOs and
warrants for employees directly involved in the construction of the IP
network and the development of the business support systems. The
Company recognized $4 million and $6 million of expense for the three and six
months ended June 30, 1998 for NQSOs and warrants granted during the six months
ended June 30, 1998.
Outperform Stock Option Plan
In April 1998, the Company adopted an outperform stock option ("OSO") program
that was designed so that the Company's stockholders would receive a market
return on their investment before OSO holders receive any return on their
options. The Company believes that the OSO program aligns directly management's
and stockholders' interests by basing stock option value on the Company's
ability to outperform the market in general, as measured by the Standard &
Poor's ("S&P") 500 Index. Participants in the OSO program do not realize any
value from awards unless the Common Stock price outperforms the S&P 500 Index.
When the stock price gain is greater than the corresponding gain on the S&P 500
Index, the value received for awards under the OSO plan is based on a formula
involving a multiplier related to the level by which the Common Stock
outperforms the S&P 500 Index. To the extent that the Common Stock outperforms
the S&P 500, the value of OSOs to a holder may exceed the value of non-qualified
stock options.
OSO grants are made quarterly to participants employed on the date of the grant.
Each award vests in equal quarterly installments over two years and has a
four-year life. Each award typically has a two-year moratorium on exercising
from the date of grant. As a result, once a participant is 100% vested in the
grant, the two year moratorium expires. Therefore, each grant has an exercise
window of two years.
The fair value recognized under SFAS No. 123 for the 1,525,702 OSOs granted to
employees and consultants for services performed for the six months ended June
30, 1999 was $96 million. The Company recognized $25 million and $39 million of
compensation expense for the three and six months ended June 30, 1999 for OSOs
granted in 1999 and 1998. In addition to the expense recognized, $2 million and
$3 million of non-cash compensation was capitalized for the three and six months
ended June 30, 1999 for employees directly involved in the construction of the
IP network and development of business support systems. The Company recognized
$5 million of expense for the three and six months ended June 30, 1998 for OSOs
outstanding at June 30, 1998.
Shareworks and Restricted Stock
The Company recorded $2 million and $4 million of non-cash compensation expense
for the three and six months ended June 30, 1999 related to the shareworks and
restricted stock programs adopted in the third quarter of 1998.
11. Stockholders' Equity
On March 9, 1999 the Company closed the offering of 28,750,000 shares of its
Common Stock through an underwritten public offering. The net proceeds from the
offering of approximately $1.5 billion after underwriting discounts and offering
expenses will be used for working capital, capital expenditures, acquisitions
and other general corporate purposes in connection with the implementation of
the Company's Business Plan.
12. Industry Data
In 1998, the Company adopted SFAS No. 131 "Disclosures about Segments of an
Enterprise and Related Information". SFAS No. 131 establishes standards for
reporting information about operating segments in annual financial statements
and requires selected information about operating segments in interim financial
reports issued to stockholders. Operating segments are components of an
enterprise for which separate financial information is available and which is
evaluated regularly by the Company's chief operating decision maker, or decision
making group, in deciding how to allocate resources and assess performance.
Operating segments are managed separately and represent strategic business units
that offer different products and serve different markets.
The Company's reportable segments include: communications and information
services (including communications, computer outsourcing and systems integration
segments), and coal mining. Other primarily includes California Private
Transportation Company L.P. ("CPTC"), a privately owned tollroad in southern
California, equity investments and other corporate assets and overhead not
attributable to a specific segment.
Industry data for the Company's discontinued construction and energy operations
are not included.
EBITDA, as defined by the Company, consists of earnings (loss) before interest,
income taxes, depreciation, amortization, non-cash operating expenses (including
stock-based compensation and in- process research and development charges) and
other non-operating income or expense. The Company excludes noncash compensation
due to its adoption of the expense recognition provisions of SFAS No. 123.
EBITDA is commonly used in the communications industry to analyze companies on
the basis of operating performance. EBITDA is not intended to represent cash
flow for the periods.
The information presented in the table below includes information for the three
and six months periods ended June 30, 1999 and 1998 for all income statement and
cash flow information presented and as of June 30, 1999 and December 31, 1998
for all balance sheet information presented.
<TABLE>
<S> <C> <C> <C> <C> <C> <C>
Communications & Information Services
-------------------------------------
Computer Systems Coal
(dollars in millions) Communications Outsourcing Integration Mining Other Total
- ---------------------------------------------------------------------------------------------------
1999
- ----
Three Months Ended June 30, 1999
Revenue $ 18 $ 18 $ 17 $ 47 $ 6 $ 106
EBITDA (99) 3 - 19 (26) (103)
Capital Expenditures 744 2 1 - 61 808
Depreciation and
Amortization 35 2 2 1 11 51
Six Months Ended June 30, 1999
- ------------------------------
Revenue $ 33 $ 34 $ 32 $ 98 $ 11 $ 208
EBITDA (167) 7 (3) 39 (46) (170)
Capital Expenditures 1,118 5 1 - 91 1,215
Depreciation and
Amortization 60 4 3 2 23 92
1998
- ----
Three Months Ended June 30, 1998
- --------------------------------
Revenue $ 6 $ 15 $ 15 $ 62 $ 5 $ 103
EBITDA (29) 4 (3) 26 10 8
Capital Expenditures 97 4 1 1 23 126
Depreciation and
Amortization 5 2 - 2 1 10
Six Months Ended June 30, 1998
- ------------------------------
Revenue $ 6 $ 30 $ 29 $ 115 $ 10 $ 190
EBITDA (29) 8 (3) 46 (15) 7
Capital Expenditures 107 9 3 1 24 144
Depreciation and
Amortization 5 4 1 3 3 16
Identifiable Assets
- -------------------
June 30, 1999 $2,292 $ 57 $ 48 $ 348 $4,605 $ 7,350
December 31, 1998 1,072 59 42 362 3,990 5,525
- ------------------------------------------------------------------------------------------------------
</TABLE>
The following information provides a reconciliation of EBITDA to loss from
continuing operations for the three and six months ended June 30, 1999 and 1998:
<TABLE>
<S> <C> <C> <C> <C>
Three Months Ended Six Months Ended
June 30, June 30,
(in millions) 1999 1998 1999 1998
- --------------------------------------------------------------------------------
EBITDA $ (103) $ 8 $ (170) $ 7
Depreciation and Amortization Expense (51) (10) (92) (16)
Non-Cash Compensation Expense (29) (9) (47) (11)
Write-off of In-Process Research
and Development - (30) - (30)
------ ------ ----- -----
Loss from Operations (183) (41) (309) (50)
Other Income 116 5 90 5
Income Tax Benefit 23 2 70 5
------ ----- ----- -----
Loss from Continuing Operations $ (44) $ (34) $(149) $ (40)
====== ====== ===== =====
- --------------------------------------------------------------------------------
</TABLE>
13. Related Party Transactions
Peter Kiewit Sons', Inc. ("Kiewit") acted as the general contractor on several
significant projects for the Company in 1999 and 1998. These projects include
the intercity network, local loops and gateway sites, the Company's new
corporate headquarters in Colorado and a new data center in Tempe, Arizona.
Kiewit provided approximately $490 million and $8 million of construction
services related to these projects in the first half of 1999 and 1998,
respectively.
In 1999, the Company entered into an agreement with RCN whereby RCN will lease
cross country capacity on Level 3's nationwide network. Revenue attributable to
this agreement was less than $1 million for the six months ended June 30, 1999.
Also in 1999, the Company and RCN announced that it had reached joint
construction agreements in several RCN markets, through which the companies will
share the cost of constructing their respective fiber optic networks.
Level 3 also receives certain mine management services from Kiewit. The expense
for these services was $7 million and $14 million for the three and six months
ended June 30, 1999, respectively and $9 million and $17 million for the three
and six months ended June 30, 1998, respectively, and is recorded in selling,
general and administrative expenses.
14. Other Matters
Prior to the Split-off, as of January 1 of each year, holders of Class C Stock
had the right to convert Class C Stock into Class D Stock, subject to certain
conditions. In January 1998, holders of Class C Stock converted 2.3 million
shares, with a redemption value of $122 million, into 21 million shares of Class
D Stock (now known as Common Stock).
The Company is involved in various lawsuits, claims and regulatory proceedings
incidental to its business. Management believes that any resulting liability for
legal proceedings beyond that provided should not materially affect the
Company's financial position, future results of operations or future cash flows.
Level 3 filed with the Securities and Exchange Commission a "universal" shelf
registration statement covering up to $3.5 billion of common stock, preferred
stock, debt securities and depositary shares that became effective February 17,
1999. On March 9, 1999 the Company sold 28.75 million shares, or $1.5 billion of
the $3.5 billion available under the "universal" shelf registration statement,
through a public offering.
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Management's Discussion and Analysis of Financial Condition
and Results of Operations
The following discussion should be read in conjunction with the Company's
consolidated condensed financial statements (including the notes thereto),
included elsewhere herein.
This document contains forward looking statements and information that are based
on the beliefs of management as well as assumptions made by and information
currently available to the Company. When used in this document, the words
"anticipate", "believe", "estimate" and "expect" and similar expressions, as
they relate to the Company or its management, are intended to identify
forward-looking statements. Such statements reflect the current views of the
Company with respect to future events and are subject to certain risks,
uncertainties and assumptions. Should one or more of these risks or
uncertainties materialize, or should underlying assumptions prove incorrect,
actual results may vary materially from those described in this document. For a
more detailed description for these risks and factors, please see the Company's
additional filings with the Securities and Exchange Commission.
Recent Developments
BusinessNet Ltd. Acquisition
On January 5, 1999, Level 3 acquired BusinessNet Ltd., a leading London-based
internet service provider in a largely stock-for-stock transaction valued at $12
million and accounted for as a purchase. After completion of certain
adjustments, the Company agreed to issue approximately 400,000 shares of Common
Stock and paid $1 million in cash in exchange for all of the issued and
outstanding shares of BusinessNet's capital stock. Of the approximately 400,000
shares Level 3 agreed to issue in connection with the acquisition, approximately
150,000 shares of Level 3 Common Stock have been pledged to Level 3 to secure
certain indemnification obligations of the former BusinessNet stockholders. The
pledge of these shares will terminate in approximately 18 months. Liabilities
exceeded assets acquired, and goodwill of $16 million was recognized from the
transaction which is being amortized over five years.
Common Stock Offering
Level 3 filed a "universal" shelf registration statement covering up to $3.5
billion of common stock, preferred stock, debt securities and depository shares
that became effective February 17, 1999. On March 9, 1999 the Company closed the
offering of 28,750,000 shares of its Common Stock through a public offering. The
net proceeds from the offering of approximately $1.5 billion, after underwriting
discounts and offering expenses, will be used for working capital, capital
expenditures, acquisitions and other general corporate purposes in connection
with the implementation of the Company's Business Plan.
Increase in Authorized Shares Outstanding
On February 25, 1999, the Board of Directors approved an increase in the number
of authorized shares of Common Stock from 500 million to 1 billion. On April 12,
1999, the Board of Directors approved a further increase in the number of
authorized shares of Common Stock by 500 million to 1.5 billion. The Company's
stockholders approved the increase in authorized shares at the Company's 1999
Annual Meeting held on May 27, 1999.
Transatlantic Cable
On April 23, 1999, Level 3 announced that it had contracted with Tyco Submarine
Systems Ltd. to design and build a transatlantic terabit cable system from Long
Island, New York to North Cornwall, UK. The cable system is expected to be in
service by September 2000 and is expected to cost between $600 to $800 million.
The total cost will depend on how the cable is upgraded over time. Level 3 has
prefunded the purchase of significant amounts of undersea capacity as part of
the Business Plan, but may require additional funding depending on the cable's
ultimate structure, pre-construction sales and ownership.
European Network
Level 3 announced on April 29, 1999 that it had finalized contracts relating to
construction of Ring 1 of its European Network in France, Belgium, the
Netherlands, Germany and the United Kingdom. Ring 1, which is approximately
2,000 miles, will connect Paris, Frankfurt, Amsterdam, Brussels and London. The
network is expected to be ready for service by September 2000. Ring 1 is part of
the approximate 3,500 mile intercity network that will ultimately connect a
minimum of 13 local city networks in Europe. This European network will be
linked to the Level 3 U.S. network by the Level 3 transatlantic terabit cable
system currently under development, also expected to be ready for service by
September 2000.
On July 26, 1999, the Company announced two important developments of its
European network build with an agreement with Eurotunnel and Alcatel. Eurotunnel
will provide Level 3 with multiple cross-Channel cables between the United
Kingdom and continental Europe. Eurotunnel will install and supply Level 3 with
multiple cross-Channel cables between the United Kingdom and France through the
high-security service tunnel. The first of these cables will be completed by
the first quarter of 2000. Subsequent cables will be installed to upgrade and
expand the network as and when required or when new fiber technology becomes
available. Alcatel will provide Level 3 with a cross-Channel undersea cable link
between the United Kingdom and Belgium. In the agreement Alcatel will design,
develop, and install an undersea cable to link the Level 3 network between the
United Kingdom and Belgium. The cable system is already under development and
will be complete by the end of this year.
Colt Cost Sharing Agreement
On May 4, 1999, Level 3 and Colt Telecom Group plc ("Colt") announced an
agreement to share costs for the construction of European networks. The
agreement calls for Level 3 to share construction costs of Colt's planned 1,600
mile intercity German network linking Berlin, Cologne, Dusseldorf, Frankfurt,
Hamburg, Munich and Stuttgart. In return, Colt will share construction costs of
Level 3's planned European network.
Lucent Agreement
On June 23, 1999 Level 3 announced a minimum four year, $250 million strategic
agreement with Lucent Technologies to purchase Lucent systems, including
breakthrough software switches or "softswitches." The minimum purchase
commitment is subject to certain conditions and has the potential to grow to $1
billion over five years.
Under the agreement, Lucent will provide Level 3 its Lucent Technologies
Softswitch, a software switch for IP networks that combines the reliability and
features that customers expect from the public telephone network with the cost
effectiveness and flexibility of IP technology. With the Lucent Softswitch,
Level 3 expects to provide a full range of IP-based communications services
indistinguishable in quality and ease of use from services on traditional
circuit voice networks. In addition, the companies also agreed to collaborate on
future enhancements of softswitches and gateway products to support
next-generation broadband services for business and consumers that will combine
high-quality voice and video communications with Internet-style Web data
services.
Results of Operations
In late 1997, the Company announced a plan to increase substantially its
information services business and to expand the range of services it offers by
building an advanced, international, facilities-based communications network
based on Internet Protocol ("IP") technology. Since the Business Plan represents
a significant expansion of the Company's communications and information services
business, the Company does not believe that the Company's financial condition
and results of operations for prior periods will serve as a meaningful
indication of the Company's future financial condition or results of operations.
The Company expects to incur substantial net operating losses for the
foreseeable future, and there can be no assurance that the Company will be able
to achieve or sustain operating profitability in the future.
Second Quarter 1999 vs. Second Quarter 1998
Revenue for the quarters ended June 30, is summarized as follows (in millions):
<TABLE>
<S> <C> <C>
1999 1998
Communications and Information Services $ 53 $ 36
Coal Mining 47 62
Other 6 5
------ -------
$ 106 $ 103
====== =======
</TABLE>
Communications and information services revenue for the three months ended June
30, 1999 increased 47% compared to the same period in 1998. New IP-related
products which the Company began offering in late 1998 and early 1999, including
private line, colocation and managed modem services, provided $18 million of
revenue for the communications segment in 1999. The Company's purchase of XCOM
Technologies, Inc. in April, 1998 provided $6 million of communications revenue
in the second quarter of 1998 subsequent to the acquisition. A significant
portion of XCOM's revenue is attributable to reciprocal compensation agreements
with Bell Atlantic ("Bell Atlantic"). These agreements require the company
originating a call to compensate the company terminating the call. The Federal
Communication Commission ("FCC") has been considering whether local carriers are
obligated to pay compensation to each other for the transport and termination of
calls to Internet service providers when a local call is placed from an end user
of one carrier to an Internet service provider served by the competing local
exchange carrier. Recently, the FCC determined that it had no rule addressing
inter-carrier compensation for these calls. The FCC also released for comment
alternative federal rules to govern compensation for these calls in the future.
If state commissions, the FCC or the courts determine that inter-carrier
compensation does not apply, carriers may be unable to recover their costs or
will be compensated at a significantly lower rate. In May, 1999 the
Massachusetts Department of Public Utilities ruled that Bell Atlantic was no
longer required to pay the established reciprocal compensation rates for certain
services. As a result Level 3 has elected, effective at the beginning of the
second quarter, not to recognize this revenue source until these uncertainties
are resolved. Bell Atlantic has also notified the Company that it will be
escrowing all amounts due the Company under the reciprocal compensation
agreements until the issue is resolved. An unfavorable resolution to this matter
may have a material adverse effect to the Company.
Revenues for the computer outsourcing and systems integration businesses
increased 12% and 21% to $18 million and $17 million, respectively. Revenue
attributable to new customers is primarily responsible for the increase for both
the computer outsourcing and systems integration businesses.
Coal mining revenue decreased $15 million, or 24% in the second quarter of 1999
compared to the same period in 1998. The decrease was partially due to timing of
shipments taken by Commonwealth Edison Company ("Commonwealth"). Commonwealth is
obligated to purchase annually, minimum amounts of coal; however, it is
Commonwealth's option as to when the coal will be purchased. Due to expiration
of certain long-term coal contracts in 1998, 1999 coal revenue is expected to
decline approximately 10% from 1998 levels.
If current market conditions continue, the Company will experience a significant
decline in coal revenue and earnings beginning in 2001 as delivery requirements
under long-term contracts decline as additional long-term contracts begin to
expire.
Other revenue was consistent with 1998, and is primarily attributable to CPTC, a
privately owned tollroad in southern California.
Cost of Revenue increased 65% in 1999 to $81 million from $49 million in 1998
primarily as a result of the increase in network expenses of $36 million in 1999
related to the communications business as compared to the same period in 1998.
Cost of revenue for the communications business is expected to increase
substantially in the future as the Company continues to increase the number of
markets in which it offers services and the products available in each of those
markets. The cost of revenue for the information services business was
consistent with the corresponding increase in revenue. The cost of revenue for
the coal business, as a percentage of revenue, increased approximately 7% due to
the expiration of the high margin long-term contract in 1998.
Depreciation and Amortization expense increased to $51 million in 1999 from $10
million in 1998. The commencement of operations in 21 U.S. and 4 European
markets and the completion of the initial installation of 11 local networks in
the second half of 1998 and the first half of 1999 resulted in the higher
depreciation expense in 1999. In addition, the amortization of goodwill
attributable to the acquisitions of XCOM, BusinessNet and others contributed to
the higher depreciation and amortization expense in 1999.
Selling, General and Administrative expenses increased significantly in 1999 to
$157 million from $55 million in 1998 primarily due to the cost of activities
associated with the expanding communications business. The Company incurred
incremental compensation and travel costs for the substantial number of new
employees that have been hired to implement the Business Plan. The total number
of employees of the Company increased to over 3,200 at June 30, 1999.
Professional fees, including legal costs associated with obtaining licenses,
agreements and technical facilities and other development costs associated with
the Company's plans to expand services offered in U.S. and European cities, and
consulting fees to develop and implement the Company's business support systems,
also increased selling general and administrative expenses. In addition to the
costs to expand the communications and information services businesses, the
Company recorded $29 million of non-cash compensation expense in the second
quarter of 1999 under SFAS No. 123 related to grants of stock options and
warrants. General and administrative costs are expected to increase
significantly in future periods as the Company continues to implement the
Business Plan.
Write-off of In-Process Research and Development was $30 million in 1998. The
in-process research and development costs were the portion of the purchase price
allocated to the telephone network-to-IP network bridge technology acquired by
the Company in the XCOM transaction and were estimated through formal valuation,
at $30 million. In accordance with generally accepted accounting principles, the
$30 million was taken as a nondeductible charge against earnings in the second
quarter of 1998.
EBITDA, as defined by the Company, consists of earnings (losses) before
interest, income taxes, depreciation, amortization, non-cash operating expenses
(including stock-based compensation and in- process research and development
charges) and other non-operating income or expenses. EBITDA was $8 million in
1998 and $(103) million in 1999. The primary reason for the decrease between
periods is the significant increase in general and administrative expenses,
described above, incurred in connection with the implementation of the Company's
Business Plan. EBITDA is commonly used in the communications industry to analyze
companies on the basis of operating performance. EBITDA, however, should not be
considered an alternative to operating or net income as an indicator of the
performance of the Company's businesses, or as an alternative to cash flows from
operating activities as a measure of liquidity, in each case determined in
accordance with generally accepted accounting principles. See Consolidated
Condensed Statements of Cash Flows.
Interest Income increased 27% in 1999 to $57 million from $45 million in 1998 as
the Company's average cash, cash equivalents and marketable securities balance
increased from approximately $3.2 billion during the second quarter of 1998 to
approximately $4.6 billion during the second quarter of 1999. Pending
utilization of the cash equivalents and marketable securities in implementing
the Business Plan, the Company intends to invest the funds primarily in
government and governmental agency securities. This investment strategy will
provide lower yields on the funds, but is expected to reduce the risk to
principal in the short term prior to using the funds in implementing the
Business Plan.
Interest Expense, net increased significantly from $36 million in 1998 to $45
million in 1999. Interest expense increased substantially due to the completion
of the offering of $2 billion aggregate principal amount of 9.125% Senior Notes
Due 2008 issued in April 1998 and $834 million aggregate principal amount at
maturity of 10.5% Senior Discount Notes Due 2008 issued in December 1998. The
amortization of debt issuance costs associated with the Senior Notes and Senior
Discount Notes also increased interest expense in 1999. The Company capitalized
$20 million and $1 million of interest expense on network construction and
business support systems in the second quarter of 1999 and 1998, respectively.
Gain on Equity Investee Stock Transactions increased to $111 million in 1999
from $21 million in 1998. In the second quarter of 1999 RCN issued stock in a
public offering and for certain transactions which diluted the Company's
ownership of RCN from 40% at March 31, 1999 to 35% at June 30, 1999 but
increased its proportionate share of RCN's net assets. The increase in the
Company's proportionate share of RCN's net assets resulted in a pre-tax gain of
$111 million for the Company in the second quarter of 1999. In 1998, the Company
recognized a $21 million gain related to RCN stock activity.
Other Expense, net decreased in 1999 to $(7) million from $(25) million. Other
expense consists primarily of the Company's share of losses incurred by the
Company's equity method investees, principally RCN. RCN is incurring significant
costs in developing its business plan including the acquisitions of several
internet service providers. The Company recorded $26 million of equity losses
attributable to RCN in the second quarter of 1999, as compared to $22 million in
the second quarter of 1998. During the second quarter of 1999, the Company sold
its equity position in Burlington Resources, which resulted in a pre-tax gain of
$17 million. Also included in other expense are equity earnings in Commonwealth
Telephone Enterprises, Inc., and realized gains and losses on the sale of other
assets each not individually significant to the Company's results of operations.
Income Tax Benefit in 1999 differs from the statutory rate of 35% primarily due
to losses incurred by the Company's international subsidiaries which cannot be
included in the consolidated U.S. federal return, nondeductible goodwill
amortization expense and state income taxes. The income tax benefit differs from
the statutory rate in 1998 primarily due to the $30 million nondeductible
write-off of the research and development costs acquired in the XCOM
acquisition.
Six Months 1999 vs. Six Months 1998
Revenue for the six months ended June 30, is summarized as follows (in millions)
<TABLE>
<S> <C> <C>
1999 1998
Communications and Information Services $ 99 $ 65
Coal Mining 98 115
Other 11 10
------ ------
$ 208 $ 190
====== ======
</TABLE>
Communications and information services revenue increased from $65 million for
the six months ended June 30, 1998 to $99 million for the six months ended June
30, 1999. In May, 1999 the Massachusetts Department of Public Utilities ruled
that Bell Atlantic was no longer required to pay the established reciprocal
compensation rates for certain services. As a result, Level 3 has elected not to
recognize additional revenue, beginning in the second quarter, from these
agreements until the uncertainties are resolved. An unfavorable resolution to
this matter may have a material adverse effect to the Company. Systems
integration revenue increased 10% to $32 million in 1999. Revenue for the
computer outsourcing business increased from $30 million in 1998 to $34 million
in 1999. Revenue attributable to new customers led to the increase in computer
outsourcing and systems integration revenue.
Mining revenue in 1999 decreased to $98 million from $115 million in 1998 due to
timing of shipments taken by Commonwealth Edison Company ("Commonwealth"). The
purchase agreement with Commonwealth requires that minimum amounts of coal must
be purchased, however, does not stipulate when the coal must be purchased. In
addition, the expiration of a long-term contract in late 1998 will result in an
approximate 10% decline in 1999 coal sales from 1998 levels.
Other revenue, was consistent with 1998, and is primarily attributable to CPTC,
a privately owned tollroad in southern California.
Cost of Revenue increased $52 million or 57% to $143 million in 1999 as a result
of the expanding communications business. In 1999 network expenses were $54
million as compared to $1 million in the prior year. The increase in costs is
primarily attributable to the XCOM and GeoNet acquisitions, the costs associated
with the Frontier and IXC Communications leases and costs attributable to the
products the Company began offering in late 1998 and 1999. The cost of revenue,
as a percentage of revenue, for the information services business increased
slightly for the six months ended June 30, 1999 compared to the same period in
1998. The increase is primarily due to the costs incurred by the systems
integration segment to transition from Year 2000 services to systems and
software reengineering for IP related applications. The cost of revenue for the
coal business as a percentage of revenue, increased due to the expiration of the
high margin long-term contract in 1998.
Depreciation Expense increased from $12 million in 1998 to $76 million in 1999.
The significant increase in the amount of assets placed in service during the
last half of 1998 and first half of 1999 for the communications business
resulted in the increase in depreciation expense. The acquisitions of XCOM,
Geonet and BusinessNet in 1998 and 1999 resulted in goodwill amortization
increasing from $4 million in 1998 to $16 million in 1999.
Selling, General and Administrative expenses increased significantly to $282
million in 1999 from $103 million in 1998 primarily due to the cost of
activities associated with the expanding communications business. Compensation,
travel and facilities costs increased substantially due to the additional
employees that have been hired to implement the Business Plan. The total number
of employees of the Company increased to over 3,200 at June 30, 1999.
Professional fees, including legal costs associated with obtaining licenses,
agreements and technical facilities and other development costs associated with
the Company's plans to expand services offered in U.S. and European cities and
consulting fees incurred to develop and implement the Company's business support
systems contributed to higher selling general and administrative expenses. In
addition, the Company recorded $47 million of non-cash compensation in the first
half of 1999 for expenses recognized under SFAS No. 123 related to grants of
stock options and warrants, up from $11 million in 1998. As the Company
continues to implement the Business Plan, general and administrative costs are
expected to continue to increase significantly.
Write-off of In-Process Research and Development of $30 million in 1998 was the
portion of the purchase price allocated to the telephone network-to-IP network
bridge technology acquired by the Company in the XCOM transaction and was
estimated through formal valuation. In accordance with generally accepted
accounting principles, the $30 million was taken as a nondeductible charge
against earnings in the second quarter of 1998.
EBITDA decreased from $7 million in 1998 to $(170) million in 1999. The primary
reason for the decrease between periods is the significant increase in general
and administrative expenses, described above, incurred in connection with the
implementation of the Company's Business Plan.
Interest Income increased substantially from $71 million in 1998 to $107 million
in 1999 primarily as a function of the Company's increasing average cash, cash
equivalents and marketable securities balances. The average cash balance
increased from approximately $2.6 billion during the first half of 1998 to
approximately $4.2 billion during the first half of 1999. Pending utilization of
the cash equivalents and marketable securities in implementing the Business
Plan, the Company intends to invest the funds primarily in government and
governmental agency securities. This investment strategy will provide lower
yields on the funds, but is expected to reduce the risk to principal in the
short term prior to using the funds in implementing the Business Plan.
Interest Expense, net increased $58 million to $98 million in 1999 due to the
completion of the offering of $2 billion aggregate principal amount of 9.125%
Senior Notes Due 2008 in April, 1998 and $834 million aggregate principal amount
at maturity of 10.5% Senior Discount Notes Due 2008 in the fourth quarter of
1998. The amortization of the related debt issuance costs also contributed to
the increased interest expense in 1999. The Company capitalized $31 million and
$1 million of interest expense on network construction and business support
systems in the first half of 1999 and 1998, respectively.
Gain on Equity Investee Stock Transactions increased to $111 million during the
first half of 1999. RCN issued stock in a public offering and for certain
transactions which diluted the Company's ownership of RCN from 41% at December
31, 1998 to 35% at June 30, 1999. The increase in the Company's proportionate
share of RCN's net assets as a result of these transactions resulted in a
pre-tax gain of $111 million from subsidiary stock sales for the Company in the
first half of 1999. The Company recognized $21 million of gains for similar
stock transactions of RCN in 1998.
Other Expense, net decreased to $(30) million in 1999 from $(47) million in
1998. Other expense consists of the Company's share of losses incurred by the
Company's equity method investees, primarily RCN. RCN is incurring significant
costs in developing its business plan including the acquisitions of several
internet service providers. The Company recorded $53 million of equity losses
attributable to RCN in the first half of 1999, as compared to $53 million in the
first half of 1998. The Company also sold 1.2 million shares of Burlington
Resources common stock, resulting in a pre-tax gain of $17 million for the
Company in 1999. Equity earnings of Commonwealth Telephone Enterprises, Inc. and
gains on the disposition of other assets were not individually significant in
the first half of 1999 or 1998.
Income Tax Benefit in 1999 differs from the statutory rate of 35% primarily due
to losses incurred by the Company's international subsidiaries which cannot be
included in the consolidated U.S. federal return, nondeductible goodwill
amortization expense and state income taxes. The income tax benefit in 1999
differs from the statutory rate in 1998 primarily due to the $30 million
nondeductible write-off of the research and development costs acquired in the
XCOM acquisition.
Discontinued Operations includes the one-time gain of $608 million recognized
upon the distribution of the Construction Group to former Class C stockholder on
March 31, 1998. Also included in discontinued operations is the gain, net of
tax, of $324 million from the Company's sale of its energy assets to MidAmerican
on January 2, 1998.
Financial Condition-June 30, 1999
The Company's working capital increased $291 million during 1999 from $3.5
billion at December 31, 1998 to $3.8 billion at June 30, 1999 primarily due to
the $1.5 billion equity offering completed in March 1999, offset by capital
expenditures for the communications network.
Cash (used in) provided by continuing operations increased from $(62) million in
1998 to $159 million in 1999 primarily due to the changes in components of
working capital and an increase in interest income. Interest income increased in
1999 as a result of the proceeds received from the Senior Notes, Senior Discount
Notes and the March 9, 1999 equity offering. The increase in cash provided by
interest income was partially offset by the decrease in cash provided by
operations for the semi-annual payment of interest on the Senior Notes. Interest
payments on the Senior Discount Notes are deferred until 2004. An increase in
the costs paid to implement the Business Plan also reduced cash provided by
continuing operations.
Investing activities include the purchase of $3,275 million of marketable
securities offset by the sales and maturities of securities of $2,769 million.
The Company also incurred costs of $1,215 million for capital expenditures,
primarily for the expanding communications business. In addition, the Company
realized $11 million of proceeds from the sale of property, plant and equipment.
Financing sources in the first six months of 1999 consisted primarily of the net
proceeds of $1.5 billion from the issuance of 28,750,000 shares of Common Stock,
and the exercise of the Company's stock options for $13 million. The Company
also repaid long-term debt of $4 million during the first half of 1999.
Liquidity and Capital Resources
Since late 1997, the Company has substantially increased the emphasis it places
on and the resources devoted to its communications and information services
business. The Company has commenced the implementation of a plan to become a
facilities-based provider (that is, a provider that owns or leases a substantial
portion of the property, plant and equipment necessary to provide its services)
of a broad range of integrated communications services. To reach this goal, the
Company is expanding substantially the business of its subsidiary, PKS
Information Services, Inc., ("PKSIS") to create, through a combination of
construction, purchase and leasing of facilities and other assets, an
international, end-to-end, facilities- based communications network. The Company
is designing its network based on IP technology in order to leverage the
efficiencies of this technology to provide lower cost communications services.
The development of the Business Plan will require significant capital
expenditures, a substantial portion of which will be incurred before any
significant related revenues from the Business Plan are expected to be realized.
These expenditures, together with the associated early operating expenses, will
result in substantial negative operating cash flow and substantial net operating
losses for the Company for the foreseeable future. Although the Company believes
that its cost estimates and build-out schedule are reasonable, there can be no
assurance that the actual construction costs or the timing of the expenditures
will not deviate from current estimates. The Company estimates that its capital
expenditures in connection with the Business Plan will approximate $2.5 billion
in 1999. The Company's current liquidity and the cost sharing agreement with
INTERNEXT should be sufficient to fund the currently committed portions of the
Business Plan.
The Company currently estimates that the implementation of the Business Plan, as
currently contemplated, will require between $9 and $11 billion over the next 10
years. The Company's ability to implement the Business Plan and meet its
projected growth is dependent upon its ability to secure substantial additional
financing in the future. The Company expects to meet its additional capital
needs with the proceeds from credit facilities and other borrowings, sales or
issuance of additional equity securities, or additional debt securities. The
Senior Notes and Senior Discount Notes were issued under an indenture which
permits the Company and its subsidiaries to incur substantial amounts of debt.
The Company also has approximately $2 billion of unissued securities available
under the "universal" shelf registration statement that was declared effective
by the Securities and Exchange Commission in February, 1999. In addition, the
Company may sell or dispose of existing businesses or investments to fund
portions of the Business Plan. The Company may also sell or lease fiber optic
capacity, or access to its conduits. There can be no assurance that the Company
will be successful in producing sufficient cash flow, raising sufficient debt or
equity capital on terms that it will consider acceptable, or selling or leasing
fiber optic capacity or access to its conduits, or that proceeds from
dispositions of the Company's assets will reflect the assets' intrinsic value.
Further, there can be no assurance that expenses will not exceed the Company's
estimates or that the financing needed will not likewise be higher than
estimated. Failure to generate sufficient funds may require the Company
to delay or abandon some of its future expansion or expenditures, which
could have a material adverse effect on the implementation of the Business Plan.
There can be no assurance that the Company will be able to obtain such financing
if and when it is needed or that, if available, such financing will be on terms
acceptable to the Company. If the Company is unable to obtain additional
financing when needed, it may be required to scale back significantly its
Business Plan and, depending upon cash flow from its existing businesses, reduce
the scope of its plans and operations.
In connection with implementing the Business Plan, management will continue
reviewing the existing businesses of the Company to determine how those
businesses will complement the Company's focus on communications and information
services. If it is decided that an existing business is not compatible with the
communications and information services business and if a suitable buyer can be
found, the Company may dispose of that business.
Year 2000
General
The Company's wholly owned subsidiary, Level 3 Communications, LLC is a new
Company that is implementing new technologies to provide Internet Protocol (IP)
technology-based communications services to its customers. The Company has
adopted a strategy to select technology vendors and suppliers that provide
products that are represented by such vendors and suppliers to be Year 2000
compliant. In negotiating its vendor and supplier contracts, the Company secures
Year 2000 warranties that address the Year 2000 compliance of the applicable
product(s). As part of the Company's Year 2000 compliance program, plans will be
put into place to test these products to confirm they are Year 2000 ready.
PKS Systems Integration LLC ("PKS Systems"), a subsidiary of PKSIS, provides a
wide variety of information technology services to its customers. In fiscal
year 1998, approximately 57% of the revenue generated by PKS Systems
related to projects involving Year 2000 assessment and renovation services
performed by PKS Systems for its customers. These contracts generally
require PKS Systems to identify date affected fields in certain application
software of its customers and, in many cases, PKS Systems undertakes efforts
to remediate those date-affected fields so that Year 2000 data may be
processed. Thus, Year 2000 issues affect many of the services PKS Systems
provides to its customers. This exposes PKS Systems to potential risks that
may include problems with services provided by PKS Systems to its customers
and the potential for claims arising under PKS Systems' customer contracts.
PKS Systems attempts to contractually limit its exposure to liability for Year
2000 compliance issues. However, there can be no assurance as to the
effectiveness of these contractual limitations.
Outlined below is additional information with respect to the Year 2000
compliance programs that are being pursued by Level 3 Communications, LLC and
PKSIS.
Level 3 Communications, LLC ("Level 3")
Level 3 Communications, LLC, uses software and related technologies throughout
its business that may be affected by the date change in the Year 2000. The
inability of systems to appropriately recognize the Year 2000 could result in a
disruption of Level 3's operations. Level 3 has one main line of business:
delivery of communications services to commercial clients over fiber optic
cable. The delivery of service will be over Level 3 owned cable when the network
construction is complete. In the interim, services will be delivered over both
owned and leased lines.
Level 3 faces two primary Year 2000 issues with respect to its business. First,
Level 3 must assess the readiness of its systems that are required to provide
its customer's communications services ("Service Delivery Systems"). Second,
Level 3 must evaluate the Year 2000 readiness of its internal business support
systems ("Internal Business Support Systems"). Level 3 must also verify the
readiness of the providers of the leased lines currently in use.
Level 3 has designated a full-time Year 2000 director in addition to
establishing a program office staffed in part by experienced Year 2000
consultants. Level 3 is progressing through a comprehensive program to evaluate
and address the effect of the Year 2000 on its Internal Business Support
Systems, and the Service Delivery Systems. The plans' focus upon Year 2000
issues consists of the following phases:
Phase
(I) Assessment - Awareness, commitment, and evaluation which includes a
detailed inventory of systems and services that the Year 2000 may impact.
(II) Detailed Plan - Establishment of priorities, development of specific
action steps and allocation of resources to address the issues as outlined
in Phase I.
(III)Implementation - Completion of the necessary changes as delineated in Phase
II.
(IV) Verification - Determining whether the conversions implemented in Phase
III have resolved the Year 2000 problem so that date related
calculations will function properly, both as individual units and on
an integrated basis. This will culminate in an end-to-end system
test to ensure that the customer services being delivered by Level 3 will
function properly and that all support services necessary to business
operations will be Year 2000 compliant.
(V) Contingency Plans - Establishment of alternative plans should any of the
services or suppliers that Level 3 requires to do business fail to be Year
2000 ready.
With respect to its Year 2000 plans, Level 3 currently has activities underway
in each of the five phases above. The current stage of activities varies based
upon the type of component, system, and/or customer service at issue.
<TABLE>
<S> <C> <C>
Business Functions Operational Effect Current Status
- --------------------------------------------------------------------------------
Customer Delivery Systems Inability to deliver Phases I to Phase V*
Customer Services
Internal Business Support Systems Failures of Internal Phases I to Phase V*
Support Services and
Customer Billing
</TABLE>
* Level 3 anticipates this range of activity to continue through 1999 as it
adds new equipment and services while building its infrastructure. Additionally,
the upgrading of service delivery through its proprietary systems will require
that the delivery systems go through verification with each new innovation.
The expenses associated with this project by Level 3, as well as the related
potential effect on Level 3's earnings, are not expected to have a material
effect on the future operating results or financial condition of Level 3. There
can be no assurance, however, that the Year 2000 problem, and any loss incurred
by any customers of Level 3 as a result of the Year 2000 problem, will not have
a material adverse effect on Level 3's financial condition and results of
operations.
Level 3 has significant relationships and dependencies with regard
to systems and technology provided and supported by third party vendors and
service providers. In particular, the customer delivery systems for the
communications business of Level 3 are dependent upon third parties who provide
telecommunication services while the infrastructure continues to be built. As
part of its Year 2000 program, Level 3 has sought to obtain formal Year 2000
compliance representation from vendors who provide products and services to
Level 3. The vendor compliance process is being performed concurrently with the
Company's ongoing Year 2000 validation activities. This compliance process
consists of obtaining information from disclosures made publicly available on
company websites, reviewing test plans and results made available from
suppliers, and following up with letters and phone calls to any vendors who have
not made such information available to Level 3 as yet.
Because of the aforementioned reliance placed on third party vendors, Level
3's estimate of costs to be incurred could change substantially should
one or more of the vendors be unable to timely deliver Year 2000 compliant
products. Level 3 does not own the proprietary hardware technology or third
party software source code utilized in its business and therefore, Level 3
cannot actually renovate the hardware or third party software identified as
having Year 2000 support issues. The standard components supplied by vendors
for the customer delivery systems have been tested in laboratory settings and
certified as to their compliance.
With respect to the contingency plans for Level 3, such plans generally fall
into two categories. Concerning the customer delivery systems of Level 3, Level
3 has certain redundant and backup facilities, such as on-site generators. With
respect to systems obtained from third party vendors, contingency plans are
developed by Level 3 on a case by case basis where deemed appropriate.
PKSIS
PKSIS and its subsidiaries use software and related technologies throughout its
business that may be affected by the date change in the Year 2000. The inability
of systems to appropriately recognize the Year 2000 could result in a disruption
of PKSIS operations. PKSIS has two main lines of business: computer outsourcing
and systems integration. The computer outsourcing business is managed by PKS
Computer Services LLC ("PKSCS"). The systems integration is managed by PKS
Systems Integration LLC ("PKSSI").
PKSCS generally faces two primary Year 2000 issues with respect to its business.
First, PKSCS must evaluate the Year 2000 readiness of its internal support
systems. Second, PKSCS must assess and, if necessary, upgrade the operating
systems which PKSCS provides for its outsourcing customers. PKSCS outsourcing
customers are responsible for their own application code remediation.
PKSCS established a corporate-wide Year 2000 program in 1997, which in
relation to other business projects and objectives has been assigned a high
priority, including the designation of a full-time year 2000 director.
PKSCS is progressing through a comprehensive program to evaluate and address the
effect of the Year 2000 on its internal operations and support systems, and the
operating systems which PKSCS is responsible for providing to its outsourcing
customers. Due to the nature of its business, PKSCS has developed and is
administering approximately twenty separate Year 2000 project plans.
Approximately eighteen of these plans are devoted to the specific
operating systems software upgrades to be undertaken by PKSCS for its
outsourcing customers according to software vendor specifications. The remaining
plans focus upon Year 2000 issues relating to PKSCS internal support systems.
PKSCS is utilizing both internal and external resources in implementing these
plans. These PKSCS plans generally consist of the following phases:
Phase
(I) Assessment - Awareness, commitment, and evaluation, which includes a
detailed inventory of systems and services that the Year 2000 may impact.
(II) Detailed Plan - Establishment of priorities, development of specific
action steps and allocation of resources to address the issues as outlined
in Phase I.
(III)Implementation - Completion of the necessary changes per vendor
specifications,(that is, replacement or retirement) as outlined in
Phase II.
(IV) Verification - With respect to PKSCS' internal support systems, determining
whether the conversions implemented in Phase III have resolved the Year
2000 problem so that date related calculations will function properly,
both as individual units and on an integrated basis.
(V) Completion - The final rollout of components into an operational unit.
With respect to its Year 2000 plans, PKSCS currently has activities underway
in each of phases III through V. The current stage of activities varies
based upon the type of component, system, and/or customer service at issue.
Some PKSCS customers have delayed or postponed operating system upgrades to
be performed by PKSCS as a result of the customer's delay in its application
code remediation schedule.
PKSSI generally faces two primary Year 2000 issues with respect to its business.
First, PKSSI provides a wide variety of information technology services to its
customers which could potentially expose PKSIS to contractual liability for Year
2000 related risks if services are not performed in a timely or satisfactory
manner. Second, PKSSI must evaluate and, if necessary, upgrade or replace its
internal business support systems which may have date dependencies. PKSSI
believes the primary internal systems affected by the Year 2000 issue which
could have an impact on its business are desktop and network hardware and
software. PKSSI previously completed its Year 2000 assessment of desktop
hardware and software, and, based on vendor representations, determined that
material upgrades or replacements were not required. PKSIS is continuing to
validate these findings and currently plans to do so throughout the remainder of
1999. PKSSI is also in the process of communicating with its vendors to assess
its servers and communications hardware for Year 2000 readiness.
In fiscal year 1998, approximately 57% of the revenue generated by PKSSI related
to projects involving Year 2000 assessment and renovation services performed by
PKSSI for its customers. This is a reduction from 80% in 1997. Some of these
contracts require PKSSI to identify date affected fields in certain application
software of its customers and, in many cases, PKSSI undertakes efforts to
remediate those date-affected fields so that Year 2000 data may be processed.
Thus, Year 2000 issues affect certain services PKSSI provides to its customers.
This exposes PKSSI to potential risks that may include problems with services
provided by PKSSI to its customers and the potential for claims arising under
PKSSI's customer contracts. In some cases PKSSI has contractual warranties
which could require PKSSI to perform Year 2000 related services after the year
2000. PKSSI attempts to contractually limit its exposure to liability
for Year 2000 compliance issues. However, there can be no assurance as to the
effectiveness of such contractual limitations.
The following chart describes the status of PKSIS' Year 2000 program with
respect to Computer Outsourcing Services and Systems Integration Services.
<TABLE>
<S> <C> <C> <C>
Business Current Areas of
Functions Focus Operational Impact Current Status
- ------------------------------------------------------------------------------------------------
Computer Large & Mid-Range Inability to continue Mid Phase III to Phase V
Outsourcing Service CPU critical processing of
OEM Software customer's systemss
OS Systems
Network Equipment
Support Facilities
Internal Support Failures of critical Mid Phase III to Phase V
Systems & Business Internal Support
Processes Services
Systems Integration Internal Support Failures of critical Assessment of desktop
Services Systems & Business Internal Support hardware and software has
Processes Services been completed and is
validated
Assessment of services
and communications hardware
is expected to be completed
by the end of the third quarter
of 1999.
</TABLE>
PKSIS has significant relationships and dependencies with regard to systems and
technology provided and supported by third party vendors and service providers.
In particular, the computer outsourcing business of PKSCS is dependent upon
third parties who provide telecommunication service, electrical utilities and
mainframe and midrange hardware and software providers. As part of its Year 2000
program, PKSIS has sought to obtain formal Year 2000 compliance representation
from vendors who provide products and services to PKSIS. The vendor compliance
process is being performed concurrently with the Company's ongoing Year 2000
remediation activities. PKSCS is also working with its outsourcing customers to
inform them of certain dependencies which exist which may affect PKSIS' Year
2000 efforts and certain critical actions which PKSIS believes must be
undertaken by the customer in order to allow PKSIS to implement its Year 2000
efforts concerning the operating software system provided by PKSCS for its
customers.
To date, PKSCS has received written responses from approximately 40%
of the vendors from whom it has sought Year 2000 compliance statements. With
respect to those key third party vendors and suppliers who have failed to
respond in writing, PKSIS is following up directly with such vendors and
suppliers and obtaining information from other sources, such as disclosures made
publicly available on company websites.
Because of this reliance on third party vendors, PKSIS' estimate of costs to be
incurred could change substantially should one or more of the vendors be unable
to timely deliver Year 2000 compliant products. PKSCS does not own the
proprietary hardware technology or third party software source code utilized in
its business and therefore, PKSCS cannot actually renovate the hardware or
software identified as having Year 2000 support issues.
The expenses associated with PKSIS' Year 2000 efforts, as well as the related
potential effect on PKSIS' earnings, are not expected to have a material
effect on the future operating results or financial condition of Level 3.
There can be no assurance,however,that the Year 2000 problem, and any loss
incurred by any customers of PKS as a result of the Year 2000 problem, will not
have a material adverse effect on Level 3's financial condition and results of
operations.
With respect to the contingency plans for PKSCS, such plans generally fall into
two categories. Concerning the internal support systems of PKSCS, PKSCS has
certain redundant and backup facilities, such as on-site generators, water
supply and pumps. PKSCS has undertaken contingency plans with respect to
these internal systems by performing due diligence with the vendors of these
systems in order to investigate the Year 2000 compliance status of these
systems, and such systems are tested on a monthly basis. With respect to the
operating systems obtained from third party vendors and maintained by PKSCS
for its outsourcing customers,contingency plans are developed by PKSCS and its
customers on a case by case basis as requested, contracted and paid for by
PKSCS' customers. However, there is no contingency plan for the failure of
operating system software to properly handle Year 2000 date processing. If the
operating system software provided to PKSIS by third party vendors fails at the
PKSCS Data Center, such vendor supplied software is expected to fail everywhere
and no immediate work around could be supplied by PKSCS. In the event computer
hardware supplied by PKSCS for its outsourcing customer fails, some customers
have contracted for contingency plans through disaster recovery arrangements
with a third party which supplies disaster recovery services.
Costs of Year 2000 Issues
Level 3 currently expects to incur approximately $12.5 million of costs in
aggregate, through the end of 1999. These costs primarily arise from direct
costs of Level 3 employees verifying equipment and software as Year 2000 ready.
However, Level 3 does not separately track the internal employee costs incurred
for its Year 2000 projects. Level 3 does track all material costs incurred for
its Year 2000 projects as well as all costs incurred by the Year 2000 program
office. Level 3 has estimated the time and effort expended by its employees on
Year 2000 projects based on an analysis of Year 2000 project plans.
PKSIS incurred approximately $4.2 million of costs to implement its Year 2000
program through 1998, and currently expects to incur an additional approximately
$3.6 million of costs in aggregate, through the end of 1999. These costs
primarily arise from direct costs of PKSCS employees working on upgrades per
vendor specifications of operating system software for PKSCS outsourcing
customers and the cost of vendor supplied operating systems software upgrades
and the cost of additional hardware. However, PKSIS does not separately track
the internal costs incurred for its Year 2000 projects and does not track the
cost and time its employees spend on Year 2000 projects. PKSCS has estimated the
time and effort expended by its employees on Year 2000 projects based on an
analysis of Year 2000 project plans. Labor costs for PKSCS' Year 2000 projects
were estimated to be $2.1 million for 1998 and are estimated to be approximately
one million dollars for 1999 through September 1999, when such projects are
currently scheduled for completion. These labor costs will necessarily increase
if such projects take longer to complete. Costs for software upgrades,
additional equipment costs and a test system for PKSCS' Year 2000 projects were
estimated to be $2.1 million for 1998 and are estimated to be $2.5 million for
1999. Such costs are not available for PKSSI but are not believed to be
material. Year 2000 costs for PKSSI are believed to be substantially
less than PKSCS and focus primarily on the cost of evaluating and, if necessary,
upgrading network and desktop hardware and software. The costs incurred by
PKSSI for performing Year 2000 services for its customers are included within
PKSSI's pricing for such services.
Risks Associated with Year 2000 Issues
Due to the complexity of the issues presented by the Year 2000 date change and
the proposed solutions, and the interdependence of external vendor support
services, it is difficult to assess with any degree of accuracy the future
effect of a failure in any one aspect or combination of aspects of the Company's
Year 2000 activities. The Company cannot provide assurance that actual results
will not differ from management's estimates due to the complexity of upgrading
the systems and related technologies surrounding the Year 2000 issue.
Failure by the Company to complete its Year 2000 activities in a timely or
complete manner, within its estimate of projected costs, or failure by third
parties, such as financial institutions and related networks, software
providers, local telephone companies, long distance providers and electricity
providers among others, to correct their systems, with which the Company's
systems interconnect, could have a material effect on the Company's future
results of operations and financial position. Other factors which might cause
a material difference from management's estimate would include, but not be
limited to, the availability and cost of personnel with appropriate skills
and abilities to locate and upgrade relevant computer systems and similar
uncertainties, as well as the related effects on the Company of the Year 2000
problem on the economy in general, or on the Company's business partners and
customers in particular.
Market Risk
Level 3 is subject to market risks arising from changes in interest rates,
equity prices and foreign exchange rates. The Company's exposure to and policies
regarding interest rate risk has not changed significantly from December 31,
1998.
Level 3 continues to hold positions in certain publicly traded entities,
primarily Commonwealth Telephone and RCN. The Company accounts for these two
investments using the equity method. The market value of these investments is
$1,540 million as of June 30, 1999, which is significantly higher than their
carrying value of $362 million. The Company does not currently have plans to
dispose of these investments, however, if any such transaction occurred, the
value received for the investments would be affected by the market value of the
underlying stock at the time of any such transaction. A 20% decrease in the
price of Commonwealth Telephone and RCN stock would result in approximately a
$308 million decrease in fair value of these investments. The Company does not
currently utilize financial instruments to minimize its exposure to price
fluctuations in equity securities.
The Company's Business Plan includes developing and constructing networks in
Europe and Asia. As of June 30, 1999, the Company has invested significant
amounts of capital in Europe and will continue to expand its presence in Europe
and Asia in the second half of 1999. To date, the Company has not utilized
financial instruments to minimize its exposure to foreign currency fluctuations.
The Company will continue to analyze risk management strategies to reduce
foreign currency exchange risk in the future.
The change in equity security prices is based on hypothetical movements and are
not necessarily indicative of the actual results that may occur. Future earnings
and losses will be affected by actual fluctuations in interest rates, equity
prices and foreign currency rates.
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
PART II - OTHER INFORMATION
Item 4. Submission of Matters to a Vote of Security Holders
At the annual meeting of stockholders held on May 27, 1999, the following
matters were submitted to a vote:
1. To reelect the four Class II Directors to the Board of Directors of Level 3
for a three-year term until the 2002 Annual Meeting of Stockholders:
<TABLE>
<S> <C> <C>
In Favor Withheld
William L. Grewcock 248,198,886 463,213
Richard R. Jaros 248,172,548 489,551
Robert E. Julian 248,157,374 504,725
David C. McCourt 247,883,555 778,544
</TABLE>
2. To adopt an amendment to Level 3's Restated Certificate of Incorporation to
increase the number of authorized shares of common stock from 500 million to
1.5 billion.
<TABLE>
<S> <C>
Affirmative votes: 239,480,594
Negative votes: 8,756,054
Abstentions: 425,451
</TABLE>
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits filed as part of this report are listed below.
Exhibit
Number
27 Financial Data Schedule.
(b) The Company filed a Form 8-K on May 17, 1999, disclosing an open letter to
stockholders from James Q. Crowe, Level 3's President and Chief Executive
Officer. In the letter Mr. Crowe detailed a plan to sell 4,000 shares of Level 3
Common Stock each day for 250 consecutive days, for an aggregate total of
1,000,000 shares.
The Company also filed a Form 8-K on June 3, 1999, reporting that on May 27,
1999, the Board of Directors had approved an amendment and restatement of the
Company's By-laws and to reflect the approval by the Company's stockholders to
increase the number of authorized shares of common stock, par value $.01 per
share, from 500 million to 1.5 billion.
SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
LEVEL 3 COMMUNICATIONS, INC.
Dated: August 10, 1999 \s\ Eric J. Mortensen
Eric J. Mortensen
Controller and Principal
Accounting Officer
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
INDEX TO EXHIBITS
Exhibit
No.
27 Financial Data Schedule.
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
This schedule contains summary financial information extracted from the
Form 10-Q for the period ending June 30, 1999 and is qualified in its entirety
by reference to such financial statements.
</LEGEND>
<MULTIPLIER> 1,000,000
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0
0
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</TABLE>
