<PAGE>
- --------------------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(MARK ONE)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED MARCH 31, 1997
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 0-20763
MCLEOD, INC.
------------------------------------------------------
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 58-421407240
- ------------------------ ---------------------------------
(STATE OF INCORPORATION) (IRS EMPLOYER IDENTIFICATION NO.)
MCLEODUSA TECHNOLOGY PARK
6400 C STREET SW
P.O. BOX 3177
CEDAR RAPIDS IOWA 52406-3177
- --------------------------------------- ----------
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICE) (ZIP CODE)
319-364-0000
---------------------------------------------------
(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), 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 May 9,1997:
Common Stock Class A: ($.01 par value).......37,004,269 shares
Common Stock Class B: ($.01 par value).......15,625,929 shares
- -------------------------------------------------------------------------------
<PAGE>
INDEX
<TABLE>
<CAPTION>
Page
----
PART I. FINANCIAL INFORMATION
- ------------------------------
<S> <C>
Item 1. Financial Statements................................................................... 2
Consolidated Balance Sheets, March 31, 1997 (unaudited) and December 31, 1996............... 3
Unaudited Consolidated Statements of Operations for the three months ended
March 31, 1997 and 1996.................................................................... 4
Unaudited Consolidated Statements of Cash Flows for the three months ended
March 31, 1997 and 1996.................................................................... 5
Notes to Consolidated Financial Statements (unaudited)...................................... 6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations... 7
PART II. OTHER INFORMATION
- ---------------------------
Item 1. Legal Proceedings...................................................................... 16
Item 6. Exhibits and Reports on Form 8-K....................................................... 17
Signatures...................................................................................... 19
</TABLE>
2
<PAGE>
PART I
FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
MCLEOD, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARES)
<TABLE>
<CAPTION>
MARCH 31, DECEMBER 31,
1997 1996 *
----------- -------------
(UNAUDITED)
<S> <C> <C>
ASSETS
Current Assets
Cash and cash equivalents $366,999 $ 96,480
Investment in available-for-sale
securities 67,842 80,518
Trade receivables, net (Note 2) 26,200 27,560
Inventory (Note 2) 2,409 1,600
Deferred expenses 11,073 12,156
Prepaid expenses and other 7,417 6,087
-------- --------
TOTAL CURRENT ASSETS 481,940 224,401
-------- --------
Property and Equipment
Land 2,246 2,246
Telecommunications networks 42,511 32,041
Furniture, fixtures and equipment 24,610 22,302
Networks in progress 43,957 35,481
Building in progress 10,293 6,103
-------- --------
123,617 98,173
Less accumulated depreciation 8,105 6,050
-------- --------
115,512 92,123
-------- --------
Investments, Intangible and Other Assets
Investment in available-for-sale
securities 39,348 47,474
Goodwill, net 58,567 57,012
Customer lists, net 23,261 17,095
Noncompete agreements, net 14,156 6,737
Deferred line installation costs, net 3,914 2,083
PCS licenses (Note 5) 31,968 4,800
Other 10,988 1,269
-------- --------
182,202 136,470
-------- --------
$779,654 $452,994
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities
Current maturities of long-term debt $ 1,190 $ 793
Contracts payable 6,360 ---
Accounts payable 18,994 15,807
Accrued payroll and payroll related 6,154 7,259
expenses
Other accrued liabilities 2,275 3,095
Due on PCS licenses (Note 5) 25,413 ---
Deferred revenue, current portion 1,960 1,793
Customer deposits 9,720 9,686
-------- --------
TOTAL CURRENT LIABILITIES 72,066 38,433
-------- --------
Long-term Debt, less current maturities (Note 3) 304,304 2,573
-------- --------
Deferred Revenue, less current portion 9,057 8,559
-------- --------
Commitments (Note 5)
Stockholders' Equity
Capital Stock:
Preferred, Class A, $5.50 par value; authorized 1,150,000 shares;
none issued --- ---
Preferred, $.01 par value; authorized 2,000,000 shares,
none issued; terms determined upon issuance --- ---
Common, Class A, $.01 par value; authorized 75,000,000 shares;
issued and outstanding 1997 36,919,930 shares;
1996 36,172,817 shares 369 362
Common, Class B, convertible, $.01 par value; authorized
22,000,000 shares; issued and outstanding 1997 and
1996 15,625,929 shares 156 156
Additional paid-in capital 454,882 450,736
Accumulated deficit (61,180) (47,825)
-------- --------
394,227 403,429
-------- --------
$779,654 $452,994
======== ========
*Condensed from audited financial statements.
</TABLE>
See Notes to Consolidated Financial Statements
3
<PAGE>
MCLEOD, INC. AND SUBSIDIARIES
UNAUDITED CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31,
---------------------
1997 1996
---------- ---------
<S> <C> <C>
Revenue $ 35,747 $12,488
Operating expenses:
Cost of service 21,200 9,250
Selling, general and administrative 23,985 6,345
Depreciation and amortization 4,122 969
Other 1,608 ---
-------- -------
TOTAL OPERATING EXPENSES 50,915 16,564
-------- -------
OPERATING LOSS (15,168) (4,076)
Nonoperating income (expense):
Interest income 4,253 1
Interest (expense) (2,447) (265)
Other income 7 ---
-------- -------
TOTAL NONOPERATING INCOME (EXPENSE) 1,813 (264)
-------- -------
LOSS BEFORE INCOME TAXES (13,355) (4,340)
Income taxes --- ---
-------- -------
NET LOSS $(13,355) $(4,340)
======== =======
Loss per common and common equivalent share $ (0.26) $ (0.12)
======== =======
Weighted average common and common equivalent shares outstanding 52,327 37,055
======== =======
</TABLE>
See Notes to Consolidated Financial Statements
4
<PAGE>
MCLEOD, INC. AND SUBSIDIARIES
UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31,
---------------------
1997 1996
---------- ---------
<S> <C> <C>
Cash Flows from Operating Activities
Net Loss $(13,355) $ (4,340)
Adjustments to reconcile net loss to net cash (used in) operating activities:
Depreciation 1,930 512
Amortization 2,192 644
Accretion of interest on senior discount notes 2,621 ---
Changes in assets and liabilities, net of effects of acquisitions (Note 5):
(Increase) decrease in trade receivables 1,739 (4,932)
(Increase) in inventory (26) (204)
Decrease in deferred expenses 1,083 ---
(Increase) in deferred line installation costs (2,120) (230)
Increase in accounts payable and accrued expenses 950 2,715
Increase in deferred revenue 291 2,118
Increase in customer deposits 34 ---
Other, net (1,263) (187)
-------- --------
NET CASH (USED IN) OPERATING ACTIVITIES (5,924) (3,904)
-------- --------
Cash Flows from Investing Activities
Purchase of property and equipment (24,511) (3,942)
Available-for-sale securities:
Purchases (32,721) ---
Sales 30,730 ---
Maturities 22,793 ---
Acquisitions (Note 5) (7,529) ---
Deposits on PCS licenses (Note 5) (1,755) ---
Other (143) ---
-------- --------
NET CASH (USED IN) INVESTING ACTIVITIES (13,136) (3,942)
-------- --------
Cash Flows from Financing Activities
Proceeds from line of credit agreements --- 25,100
Payments on line of credit agreements --- (17,400)
Net Proceeds from long-term debt 289,796 ---
Payments on long-term debt (533) ---
Net proceeds from issuance of common stock 316 23
Other --- 123
-------- --------
NET CASH PROVIDED BY FINANCING ACTIVITIES 289,579 7,846
-------- --------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 270,519 ---
Cash and cash equivalents:
Beginning 96,480 ---
-------- --------
Ending $366,999 $ ---
======== ========
</TABLE>
See Notes to Consolidated Financial Statements
5
<PAGE>
MCLEOD, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(INFORMATION AS OF AND FOR THE THREE MONTHS ENDED
MARCH 31, 1997 AND 1996 IS UNAUDITED)
NOTE 1: BASIS OF PRESENTATION
Interim Financial Information (unaudited): The financial statements and notes
related thereto as of March 31, 1997, and for the three month periods ended
March 31, 1997 and 1996, are unaudited, but in the opinion of management include
all adjustments, consisting only of normal recurring adjustments, necessary for
a fair presentation of the Company's financial position and results of
operations. The operating results for the interim periods are not indicative of
the operating results to be expected for a full year or for other interim
periods. Not all disclosures required by generally accepted accounting
principles necessary for a complete presentation have been included. It is
recommended that these consolidated condensed financial statements be read in
conjunction with the Company's Annual Report on Form 10-K filed with the
Securities and Exchange Commission on March 31, 1997.
NOTE 2: SUPPLEMENTAL ASSET DATA
Trade Receivables: The composition of trade receivables, net is as follows:
<TABLE>
<CAPTION>
MARCH 31, DECEMBER 31,
1997 1996
---------- -------------
(IN THOUSANDS)
Trade Receivables:
<S> <C> <C>
Billed $21,256 $22,846
Unbilled 8,833 8,613
------- -------
30,089 31,459
Allowance for doubtful accounts and discounts (3,889) (3,899)
------- -------
$26,200 $27,560
======= =======
</TABLE>
Inventory: Inventory is carried principally at the lower of average cost or
market and consists primarily of new and reusable parts required to maintain
fiber optic networks. As of March 31, 1997, inventories of approximately $1.5
million used to support a maintenance agreement are being amortized on a
straight-line basis over the 10-year life of the agreement.
Goodwill and customer lists: Goodwill and customer lists resulting from the
Company's acquisitions are being amortized over a range of 5 to 25 years using
the straight-line method and are periodically reviewed for impairment based upon
an assessment of future operations to ensure that they are appropriately valued.
Accumulated amortization on goodwill totaled $1,618,000 and $1,049,000 and
accumulated amortization on customer lists totaled $813,000 and $432,000 at
March 31, 1997 and December 31, 1996, respectively.
Noncompete agreements: Noncompete agreements primarily relate to directories
previously acquired by Telecom*USA Publishing Group, Inc. (now known as
McLeodUSA Media Group, Inc. ("McLeodUSA Publishing")) and are being amortized by
the straight-line method over various periods. Accumulated amortization on
noncompete agreements totaled $493,000 and $250,000 at March 31, 1997 and
December 31, 1996, respectively.
Deferred line installation costs: Deferred line installation costs include
costs incurred in the establishment of local access lines for customers and are
being amortized on the straight-line method over the life of the average
customer contract. The contracts' terms do not exceed 60 months. Accumulated
amortization on deferred line installation costs totaled $1,437,000 and
$1,148,000 at March 31, 1997 and December 31, 1996, respectively.
6
<PAGE>
NOTE 3: DEBT OFFERING
On March 4, 1997, the Company completed a private offering of 10 1/2% Senior
Discount Notes due March 1, 2007 (the "Notes"). The Notes were issued at an
original issue discount in which the Company received approximately $289.8
million in net proceeds, which were invested in highly-liquid short-term
investment grade securities classified as cash equivalents at March 31, 1997.
The Notes accrete from March 4, 1997 at a rate of 10 1/2% per year, compounded
semi-annually, to an aggregate principal amount of $500 million by March 1,
2002. At March 31, 1997, the accreted balance of the Notes was $302.6 million.
Interest will not accrue on the Notes prior to March 1, 2002. Thereafter,
interest on the Notes will accrue at a rate of 10 1/2% per annum, payable semi-
annually. The indenture relating to the Notes contains certain covenants which,
among other things, restrict the ability of the Company to incur additional
indebtedness, pay dividends or make distributions in respect of the Company's or
its subsidiaries' capital stock, make other restricted payments, enter into sale
and leaseback transactions, create liens, enter into transactions with
affiliates or related persons, sell assets, or consolidate, merge or sell all or
substantially all of its assets. The Notes have not been registered under the
Securities Act of 1933 (the "Securities Act"), and therefore may not be offered
for resale, resold or otherwise transferred unless so registered or unless an
applicable exemption from the registration requirements of the Securities Act is
available. The Company has agreed to file a registration statement with the
Securities and Exchange Commission for the registration of 10 1/2% Senior
Discount Notes due March 1, 2007 to be offered in exchange for the Notes.
7
<PAGE>
NOTE 4: SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31,
-----------------------
1997 1996
---------- ----------
(IN THOUSANDS)
(UNAUDITED)
<S> <C> <C>
Supplemental Disclosure of Cash Flow Information
Cash payment for interest, net of interest capitalized 1997 $290,000;
1996 $204,000 $ --- $ 99
========== =========
Supplemental Schedule of Noncash Investing and Financing Activities
Release of 37,107 shares of Class A Common Stock from escrow to certain
of the shareholders of Ruffalo, Cody & Associates, Inc. ("Ruffalo Cody")
as additional consideration for the Company's acquisition of Ruffalo,
Cody in July 1996 $ 1,020
==========
Acquisition of Digital Communications of Iowa, Inc. (Note 5)
Cash acquisition costs $ 29
Stock issued $ 2,250
----------
$ 2,279
==========
Working capital acquired, net $ 543
Fair value of other assets acquired, principally furniture,
fixtures and equipment 658
Goodwill 1,118
Long-term debt assumed (40)
----------
$ 2,279
==========
Acquisition of Fronteer Financial Holdings, Ltd. directories (Note 5):
Cash purchase price $ 1,500
==========
Customer list $ 1,350
Noncompete agreement 2,350
Contract payable (1,700)
Option agreement (500)
----------
$ 1,500
==========
Acquisition of Indiana Directories, Inc. directories (Note 5)
Cash purchase price $ 6,000
==========
Furniture, fixtures and equipment $ 150
Customer list 5,195
Noncompete agreement 5,315
Contract payable (4,660)
----------
$ 6,000
==========
</TABLE>
NOTE 5: ACQUISITIONS AND COMMITMENTS
Digital Communications of Iowa, Inc. ("Digital Communications"): On January
30, 1997, the Company issued 84,430 shares of Class A common stock in exchange
for all the outstanding shares of Digital Communications, in a transaction
accounted for as a purchase. The total purchase price was approximately $2.3
million based on the average closing market price of the Company's Class A
common stock at the time of the acquisition.
Directories: On January 27, 1997, McLeodUSA Publishing acquired six
directories from Fronteer Financial Holdings, Ltd., ("Fronteer") for a total
estimated purchase price of approximately $3.7 million.
8
<PAGE>
On March 31, 1997, McLeodUSA Publishing acquired 26 telephone directories
published by Indiana Directories, Inc. ("Indiana Directories") at a price to be
determined based on the sum of the revenues derived from the last Indiana
Directories editions of the directories. The purchase price is currently
estimated to be approximately $10.7 million.
Personal Communications Services (PCS) licenses: In April 1997, the Federal
Communications Commission (FCC) awarded the Company 25 "D" and "E" block
frequency PCS licenses in 23 market areas of Iowa, Illinois, Minnesota, Nebraska
and South Dakota. The PCS licenses will allow the Company to provide wireless
telecommunications services to its customers in the markets covered by the
licenses. The Company paid the FCC an aggregate of approximately $32 million
for these PCS licenses. The Company made a $4.8 million deposit with the FCC at
the beginning of the bidding process in 1996, made an additional $1.8 million
deposit in January 1997 and paid the balance of $25.4 million for these PCS
licenses on May 12, 1997.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Unless otherwise indicated, all dollar amounts in the following Management's
Discussion and Analysis of Financial Condition and Results of Operations that
exceed $1 million have been rounded to one decimal place and all dollar amounts
less than $1 million have been rounded to the nearest thousand.
OVERVIEW
The Company has historically derived its telecommunications revenue from (i)
the sale of local and long distance telecommunications services to end users,
(ii) telecommunications network maintenance services and (iii) special access
and private line services. The Company also derives revenue from the sale of
advertising space in telephone directories as a result of its acquisition of
McLeodUSA Publishing in September 1996, and from ancillary services as a result
of its acquisitions of Ruffalo, Cody and Digital Communications in July 1996 and
January 1997, respectively. The Company began deriving revenue from direct
marketing and telemarketing services on July 15, 1996, the date the Company
acquired Ruffalo, Cody. The Company began deriving revenue from the sale of
advertising space in telephone directories published by McLeodUSA Publishing on
September 20, 1996, the date the Company acquired McLeodUSA Publishing. The
Company began deriving revenue from the sale, installation and service of
business telephone systems on January 30, 1997, the date the Company acquired
Digital Communications. The table set forth below summarizes the Company's
percentage of revenues from these sources:
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31,
------------------
1997 1996
-------- --------
<S> <C> <C>
Local and long distance
telecommunications services 42% 67%
Telecommunications network maintenance
services 4% 11%
Special access and private line services 7% 22%
Telephone directory advertising 40% ---
Ancillary services 7% ---
---- ----
100% 100%
==== ====
</TABLE>
The Company began offering "bundled" local and long distance services to
business customers in January 1994. At the end of 1995, the Company began
providing, on a test basis, long distance services to residential customers. In
June 1996, the Company began marketing and providing to residential customers in
Cedar Rapids, Iowa and Iowa City, Iowa an integrated package of
telecommunications services, marketed under the name PrimeLine(R), which
includes local and long distance service, voice mail, paging, Internet access
and travel card services. The Company expanded its PrimeLine(R) service to
Cedar Falls and Waterloo, Iowa in January 1997, Des Moines, Iowa in February
1997, Ames, Davenport, and Bettendorf, Iowa in March 1997, Clinton, Sioux City,
and Muscatine, Iowa in April 1997 and Rock
9
<PAGE>
Island, Moline, Springfield, and Decatur, Illinois in May 1997. The Company
plans to continue its efforts to market and provide local, long distance and
other telecommunications services to business customers and plans to accelerate
its efforts to market its PrimeLine(R) service to residential customers. The
Company believes its efforts to market its integrated telecommunications
services will be enhanced by its July 1996 acquisition of Ruffalo, Cody, which
specializes in direct marketing and telemarketing services, including
telecommunications sales, and its September 1996 acquisition of McLeodUSA
Publishing, which publishes and distributes "white page" and "yellow page"
telephone directories in nineteen states in the midwestern and Rocky Mountain
regions of the United States, including most of the Company's target markets.
Because its revenue from network maintenance is derived almost exclusively
from the Iowa Communications Network Maintenance Contract and such revenue is
expected to increase more slowly than the Company's other types of revenue, the
Company expects that revenue derived from network maintenance services will
continue to constitute a decreasing percentage of the Company's revenue in the
future. Special access and private line services as a percentage of the
Company's total revenue increased in 1995 due to the revenue generated by MWR
Telecom, Inc., which was acquired in April 1995.
The Company's principal operating expenses consist of cost of service;
selling, general and administrative expenses ("SG&A"); and depreciation and
amortization. Cost of service primarily includes local services purchased from
two Regional Bell Operating Companies, costs to terminate the long distance
calls of the Company's customers through an interexchange carrier, costs of
printing and distributing the telephone directories published by McLeodUSA
Publishing, costs associated with maintaining the Iowa Communications Network
and costs associated with operating the Company's network. The Iowa
Communications Network is a fiber optic network that links certain of the State
of Iowa's schools, libraries and other public buildings. SG&A consists of
selling and marketing, customer service and administrative expenses.
Depreciation and amortization include depreciation of the Company's
telecommunications network and equipment; amortization of goodwill, customer
lists and noncompete agreements related to the Company's acquisitions;
amortization expense related to the excess of estimated fair market value in
aggregate of certain options over the aggregate exercise price of such options
granted to certain officers, other employees and directors; and amortization of
one-time installation costs associated with transferring customers' local line
service from the Regional Bell Operating Companies to the Company's
telemanagement service.
As the Company expands into new markets, both cost of service and SG&A will
increase. The Company expects to incur SG&A expenses prior to achieving
significant revenues in new markets. Significant levels of marketing activity
may be necessary in new markets in order for the Company to build a customer
base large enough to generate sufficient revenue to offset such marketing
expenses. In addition, SG&A may increase as a percentage of total revenue in
the short term after the Company enters a new market, because many of the fixed
costs of providing service in new markets are incurred before significant
revenue can be expected from those markets.
In January and February 1996, the Company granted options to purchase an
aggregate of 965,166 and 688,502 shares of its Class A Common Stock,
respectively, at an exercise price of $2.67 per share, to certain directors,
officers and other employees. The estimated fair market value of these options,
in the aggregate, at the date of grant was later determined to exceed the
aggregate exercise price by approximately $9.2 million. This amount is being
amortized on a monthly basis over the four-year vesting period of the options.
The Company has experienced operating losses since its inception as a result
of efforts to build its customer base, develop and construct its network
infrastructure, build its internal staffing, develop its systems and expand into
new markets. The Company expects to continue to focus on increasing its
customer base and geographic coverage. Accordingly, the Company expects that
its cost of service, SG&A and capital expenditures will continue to increase
significantly, all of which may have a negative impact on operating results.
The Company expects to incur significant operating losses and to generate
negative cash flows from operating and construction activities during the next
several years while it develops its business, installs and expands its fiber
optic network and develops and constructs its
10
<PAGE>
proposed PCS system. In addition, the Company may be forced to change its
pricing policies to respond to a changing competitive environment, and there can
be no assurance that the Company will be able to maintain its operating margin.
There can be no assurance that growth in the Company's revenue or customer base
will continue or that the Company will be able to achieve or sustain
profitability or positive cash flows.
The Company has generated net operating losses since its inception and,
accordingly, has incurred no income tax expense. The Company has reduced the
net deferred tax assets generated by these losses by a valuation allowance which
offsets the net deferred tax asset due to the uncertainty of realizing the
benefit of the tax loss carryforwards. The Company will reduce the valuation
allowance when, based on the weight of available evidence, it is more likely
than not that some portion or all of the deferred tax assets will be realized.
THREE MONTHS ENDED MARCH 31, 1997 COMPARED WITH THREE MONTHS ENDED MARCH 31,
1996
Revenue increased from $12.5 million for the three months ended March 31,
1996 to $35.7 million for the three months ended March 31, 1997, representing an
increase of $23.2 million or 186%. Revenue from the sale of local and long
distance telecommunications services accounted for $6.5 million of this
increase. In addition, revenues from Ruffalo, Cody, which was acquired in July
1996, McLeodUSA Publishing, which was acquired in September 1996, and Digital
Communications, which was acquired in January 1997, contributed $2.3 million,
$14.2 million and $521,000, respectively, to the increase.
Cost of service increased from $9.3 million for the three months ended March
31, 1996, to $21.2 million for the three months ended March 31, 1997,
representing an increase of $11.9 million or 129%. This increase in cost of
service was due primarily to the growth in the Company's local and long distance
telecommunications services and to the acquisitions of Ruffalo, Cody and
McLeodUSA Publishing, which contributed $1 million and $5.4 million,
respectively, to the increase. Cost of service as a percentage of revenue
decreased from 74% for the three months ended March 31, 1996 to 59% for the
three months ended March 31, 1997, primarily as a result of these acquisitions.
The cost of providing local and long distance services as a percentage of local
and long distance telecommunications revenue increased from 70% for the three
months ended March 31, 1996 to 76% for the three months ended March 31, 1997,
primarily as a result of increased line costs associated with the Company's
accelerated expansion into new markets.
SG&A increased from $6.3 million for the three months ended March 31, 1996
to $24 million for the three months ended March 31, 1997, an increase of $17.7
million or 277%. The acquisitions of Ruffalo, Cody and McLeodUSA Publishing
contributed $963,000 and $6.6 million, respectively, to this increase.
Increased costs of $10 million related to expansion of selling, customer support
and administration activities to support the Company's growth also contributed
to this increase.
Depreciation and amortization expenses increased from $969,000 for the three
months ended March 31, 1996 to $4.1 million for the three months ended March 31,
1997, representing an increase of $3.1 million or 325%. This increase consisted
of $1.7 million related to the acquisitions of Ruffalo, Cody and McLeodUSA
Publishing; an increase in amortization expense of $252,000 related to the
excess of estimated aggregate fair market value of certain options over the
aggregate exercise price of such options granted to certain officers, other
employees, and directors; and $1.1 million due primarily to the growth of the
Company's network.
Other operating expense during the three-month period ended March 31, 1997
represented the realization of a purchase accounting adjustment related to the
capitalization of costs associated with directories in progress at the time the
Company acquired McLeodUSA Publishing.
Interest income increased from $1,000 for the three-month period ended March
31, 1996 to $4.3 million for the same period in 1997. This increase resulted
from earnings on investments made with a portion of the proceeds from the
Company's public offerings of Class A Common Stock in June and November 1996 and
from its private offering of the Notes in March 1997.
11
<PAGE>
Gross interest expense increased from $265,000 for the three months ended
March 31, 1996 to $2.7 million for the three months ended March 31, 1997. This
increase was primarily a result of $2.6 million of accretion of the Notes.
Interest expense of approximately $290,000 during the three month period ended
March 31, 1997 was capitalized as part of the Company's construction of fiber
optic network.
Net loss increased from $4.3 million for the three months ended March 31,
1996 to $13.4 million for the three months ended March 31, 1997, an increase of
$9.1 million. This increase resulted primarily from the expansion of the
Company's central office operations, the opening of new sales offices and costs
related to the acquisition of Ruffalo, Cody, McLeodUSA Publishing and Digital
Communications. The development of the Company's business and the construction
and expansion of its network require significant expenditures, a substantial
portion of which is incurred before the realization of revenues.
LIQUIDITY AND CAPITAL RESOURCES
The Company's total assets increased from $453 million at December 31, 1996
to $754.2 million at March 31, 1997, primarily due to the net proceeds of
approximately $289.8 million from the Company's private offering of the Notes in
March 1997. At March 31, 1997, $115.5 million of the total assets consisted of
property and equipment, net of depreciation. At March 31, 1997, the Company's
current assets of $481.9 million exceeded its current liabilities of $46.7
million, providing working capital of $435.2 million, which represents an
increase of $249.2 million compared to December 31, 1996, primarily attributable
to the net proceeds from the private offering of the Notes. At December 31,
1996, the Company's current assets of $224.4 million exceeded current
liabilities of $38.4 million, providing working capital of $186 million.
The net cash used in operating activities totaled $5.9 million for the three
months ended March 31, 1997 and $3.9 million for the three months ended March
31, 1996. During the three months ended March 31, 1997, cash for operating
activities was used primarily to fund the Company's net loss of $13.4 million
for such period. The Company also required cash to fund the growth in line
installation costs of $2.1 million as a result of the expansion of the Company's
local and long distance telecommunications services. During the three months
ended March 31, 1996, cash for operating activities was used primarily to fund
the Company's net loss of $4.3 million for such period. The Company also
required cash to fund the growth in trade receivables of $4.9 million. The use
of cash during the three months ended March 31, 1996 was partially offset by an
increase in accounts payable and accrued expenses of $2.7 million.
The Company's investing activities used cash of $13.1 million during the
three months ended March 31, 1997 and $3.9 million during the three months ended
March 31, 1996. The equipment required for the expansion of the Company's local
and long distance telecommunications services, the Company's continued
development and construction of its fiber optic telecommunications network and
other capital expenditures resulted in purchases of equipment and fiber optic
cable and other property and equipment totaling $24.5 million and $3.9 million
during the three months ended March 31, 1997 and 1996, respectively. The uses
of cash for investing activities during the three months ended March 31, 1997
were partially offset by net proceeds of $20.8 million from the sales and
maturities of available-for-sale securities.
On July 15, 1996, the Company acquired Ruffalo, Cody in a cash and stock
transaction valued at up to a maximum of approximately $19.9 million, based on
the average closing sales price of the Class A Common Stock on The Nasdaq
National Market at the time of the transaction. On July 15, 1996, the Company
paid approximately $4.8 million in cash and issued 361,420 shares of Class A
Common Stock to the shareholders of Ruffalo, Cody, and granted options to
purchase 158,009 shares of Class A Common Stock to the holders of options to
purchase shares of Ruffalo, Cody common stock. An additional $50,782 in cash and
56,177 shares of Class A Common Stock were delivered to certain of the
shareholders of Ruffalo, Cody upon the fulfillment of certain conditions
relating to Ruffalo, Cody's ongoing revenues from a material agreement with a
major long distance carrier to provide telemarketing services. The major long
distance carrier terminated this agreement, effective December 31, 1996. The
Company recorded the Ruffalo, Cody acquisition as a purchase for accounting
purposes.
12
<PAGE>
On January 30, 1997, the Company acquired Digital Communications in a stock
transaction valued at approximately $2.3 million, based on the average closing
sales price of the Class A Common Stock on The Nasdaq National Market at the
time of the transaction. The Company issued 84,430 shares of Class A Common
Stock to the shareholders of Digital Communications and recorded the acquisition
as a purchase for accounting purposes.
On February 25, 1997, McLeodUSA Publishing acquired six telephone
directories from Fronteer. As of the date hereof, McLeodUSA Publishing has paid
approximately $1.5 million for these directories. The balance of the cash
purchase price is to be determined based on the sum of the revenues derived from
the last Fronteer editions of the directories and is estimated as of the date
hereof to be approximately $1.7 million.
On March 31, 1997, McLeodUSA Publishing acquired 26 telephone directories
published by Indiana Directories. As of the date hereof, McLeodUSA Publishing
has paid approximately $6 million for these directories. The balance of the
purchase price is to be determined based on the sum of the revenues derived from
the last Indiana Directories editions of the directories and is estimated as of
the date hereof to be approximately $4.7 million.
The balance of the purchase price is to be determined based on the sum of
the revenues derived form the last Indiana Directories, editions of the
directories and is estimated as of the date hereof to be approximately $4.7
million.
On April 28, 1997, the FCC awarded the Company 25 "D" and "E" block
frequency PCS licenses in 23 markets covering areas of Iowa, Illinois,
Minnesota, Nebraska and South Dakota. The Company paid the FCC an aggregate of
approximately $32 million for these PCS licenses. The Company made a deposit of
$4.8 million with the FCC in 1996, made an additional deposit of $1.8 million in
January 1997 and paid the balance of $25.4 million for these PCS licenses on May
12, 1997. The Company will be required to make significant additional
expenditures to develop, construct and operate a PCS system.
Cash received from net financing activities was $289.6 million during the
three months ended March 31, 1997, primarily as a result of the Company's
private offering of the Notes in March 1997. Cash received from financing
activities for the three months ended March 31, 1996 was $7.8 million and was
primarily obtained from drawings under a bank credit facility maintained by the
Company, which was canceled in June 1996.
On March 4, 1997, the Company received net proceeds of approximately $289.8
million from a private offering of the Notes. The Notes will accrete to an
aggregate principal amount of $500 million by March 1, 2002. Interest will not
accrue on the Notes prior to March 1, 2002. Thereafter, interest will accrue at
a rate of 10 1/2% per annum and will be payable semi-annually on March 1 and
September 1 of each year, commencing September 1, 2002. The Notes will be
redeemable, at the option of the Company, in whole or in part, at any time on or
after March 1, 2002, at 105.25% of their principal amount at maturity, plus
accrued and unpaid interest, declining to 100% of their principal amount at
maturity, plus accrued and unpaid interest, on or after March 1, 2005. In the
event of certain equity investments in the Company by certain strategic
investors on or before March 1, 2000, the Company may, at its option, use all or
a portion of the net proceeds therefrom to redeem up to a maximum of 33 1/3% of
the original principal amount of the Notes at a redemption price of 110.5% of
the accreted value thereof. In addition, in the event of a change of control
of the Company, each holder of Notes will have the right to require the Company
to repurchase all or any part of such holder's Notes at a repurchase price equal
to 101% of the accreted value thereof prior to March 1, 2002, or 101% of the
principal amount thereof plus accrued and unpaid interest, if any, on or after
March 1, 2002.
The Notes are senior unsecured obligations of the Company ranking pari passu
in right of payment with all other existing and future senior unsecured
obligations of the Company and rank senior to
13
<PAGE>
all other existing and future subordinated debt of the Company. The Notes are
effectively subordinated to all existing and future secured indebtedness of the
Company and its subsidiaries to the extent of the value of the assets securing
such indebtedness. The Notes also are effectively subordinated to all existing
and future third-party indebtedness and other liabilities of the Company's
subsidiaries.
The indenture relating to the Notes imposes operating and financial
restrictions on the Company and its subsidiaries. These restrictions affect,
and in certain cases significantly limit or prohibit, among other things, the
ability of the Company and its subsidiaries to incur additional indebtedness,
pay dividends or make distributions in respect of the Company's or such
subsidiaries' capital stock, make other restricted payments, enter into sale and
leaseback transactions, create liens upon assets, enter into transactions with
affiliates or related persons, sell assets, or consolidate, merge or sell all or
substantially all of their assets. There can be no assurance that such
covenants will not adversely affect the Company's ability to finance its future
operations or capital needs or to engage in other business activities that may
be in the interest of the Company.
As of March 31, 1997, the Company had no actual contractual commitments for
costs associated with the construction of fiber optic networks.
As of March 31, 1997, the Company estimates that its aggregate capital
requirements for the remainder of 1997, 1998 and 1999 will be approximately $413
million. The Company's estimated capital requirements include the estimated
cost of (i) developing and constructing its fiber optic network, (ii) market
expansion activities, (iii) acquiring the PCS licenses awarded to the Company in
the FCC's recent "D" and "E" block frequency PCS license auction, (iv)
developing, constructing and operating a PCS system, and (v) constructing its
new corporate headquarters and associated buildings. These capital
requirements are expected to be funded, in large part, out of the net proceeds
from the Company's March 1997 private offering of the Notes, approximately
$289.8 million, the net proceeds remaining from the Company's public offerings
of Class A Common Stock in June and November 1996 (approximately $184.3 million
as of March 31, 1997), and lease payments to the Company for portions of the
Company's networks.
The Company may require additional capital in the future for business
activities related to those specified above and also for acquisitions, joint
ventures and strategic alliances, as well as to fund operating deficits and net
losses. These activities could require significant additional capital not
included in the foregoing estimated aggregate capital requirements of $413
million.
The Company's estimate of its future capital requirements contained in this
report is a "forward looking statement" within the meaning of the safe harbor
provisions of the Private Securities Litigation Reform Act of 1995. The
Company's actual capital requirements may differ materially as a result of
regulatory, technological and competitive developments (including new
opportunities) in the Company's industry.
The Company expects to meet its additional capital needs with the proceeds
from credit facilities and other borrowings, and additional debt and equity
issuances. The Company plans to obtain one or more lines of credit, although as
of the date hereof, no such lines of credit have yet been negotiated. There can
be no assurance, however, that the Company will be successful in producing
sufficient cash flows or raising sufficient debt or equity capital to meet its
strategic objectives or that such funds, if available at all, will be available
on a timely basis or on terms that are acceptable to the Company.
EFFECTS OF NEW ACCOUNTING STANDARDS
In February 1997, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards No. 128, "Earnings per Share" (SFAS
128), and SFAS No. 129, "Disclosure of Information about Capital Structure",
(SFAS 129). SFAS 128 specifies the computation, presentation and disclosure
requirements for earnings per share for entities with publicly held common
stock. Its objective is to simplify the computation of earnings per share and
to make the U.S. standard for computing earnings per share more compatible with
the standards of other countries and with that of the International Accounting
Standards Committee. SFAS 129 incorporates related disclosure requirements from
APB Opinion No. 10, "Disclosure of Long-Term Obligations," and SFAS No. 47,
"Disclosure of Long-Term Obligations," for entities that were subject to the
requirements for those standards. Both statements
14
<PAGE>
are effective for fiscal years beginning after December 15, 1997. The Company
will adopt the statements effective January 1, 1998 and does not expect adoption
of the statements to have a significant impact on its current earnings per share
calculation and disclosures.
INFLATION
The Company does not believe that inflation has had a significant impact on
the Company's consolidated operations.
15
<PAGE>
PART II
OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Company is not aware of any material litigation against the Company. The
Company is involved in numerous regulatory proceedings before various public
utilities commissions, particularly the Iowa Utilities Board, as well as before
the FCC.
The Company is dependent on the Regional Bell Operating Companies for
provision of its local and certain of its long distance services. As of the date
hereof, U S WEST Communications, Inc. ("U S WEST") and Ameritech Corporation
("Ameritech") are the Company's sole suppliers of access to local central office
switches. The Company uses such access to partition the local switch and provide
local service to its customers.
The Company purchases access in the form of a product generally known as
"Centrex." Without such access, the Company could not, as of the date hereof,
provide bundled local and long distance services, although it could provide
stand-alone long distance service. Since the Company believes its ability to
offer bundled local and long distance services is critical to its current sales
efforts, any successful effort by U S WEST or Ameritech to deny or substantially
limit the Company's access to partitioned switches would have a material adverse
effect on the Company.
On February 5, 1996, U S WEST filed tariffs and other notices announcing its
intention to limit future Centrex access to its switches by Centrex customers
(including the Company) throughout U S WEST's fourteen-state service region,
effective February 5, 1996 (the "U S WEST Centrex Action"). Although U S WEST
stated that it would "grandfather" existing Centrex agreements with the Company
and permit the Company to continue to use U S WEST's central office switches
through April 29, 2005, it also indicated that it would not permit the Company
to expand to new cities and would severely limit the number of new lines it
would permit the Company to partition onto U S WEST's portion of the switches in
cities served by the Company.
The Company has challenged, or is challenging, the U S WEST Centrex Action
before the public utilities commissions in certain of the states served by U S
WEST where the Company is doing business or plans to do business. The Company
based such challenges on various state and federal laws, regulations and
regulatory policies, including Sections 251(b)(1) and 251(c)(4)(B) of the
Telecommunications Act of 1996 (the "Telecommunications Act"), which the Company
believes impose upon the Regional Bell Operating Companies the duty not to
prohibit, and not to impose unreasonable or discriminatory conditions or
limitations on, the resale of their telecommunications services, and Section
251(c)(4)(A) of the Telecommunications Act, which the Company believes obligates
the Regional Bell Operating Companies to offer for resale at wholesale rates any
telephone communications services that are provided at retail to subscribers who
are not telecommunications carriers. Additional statutes cited in the Company's
challenges include provisions of the laws of Iowa, Minnesota, Nebraska, South
Dakota, North Dakota, Idaho and Colorado, which the Company believes prohibit
restrictions on the resale of local exchange services, functions or
capabilities; prohibit local exchange carriers from refusing access by other
carriers to essential facilities on the same terms and conditions as the local
exchange carrier provides to itself; and prohibit the provision of carrier
services pursuant to rates, terms and conditions that are unreasonably
discriminatory.
In Iowa, the Company filed a complaint with the Iowa Utilities Board against
U S WEST's actions and was granted interim relief on an ex parte basis that
allowed the Company to continue to expand to new cities and expand the number of
new lines partitioned onto U S WEST's switches. Subsequent to the grant of
interim relief, the Company on March 18, 1996 entered into a settlement
agreement with U S WEST that permits the Company to continue to expand, without
restrictions, the number of new lines it serves in Iowa through March 18, 2001.
In addition, the settlement agreement provides that the Company may expand to
seven new markets (central offices) in Iowa per year through March 18, 2001. As
a result of the settlement agreement, the Company withdrew its complaint before
the Iowa Utilities
16
<PAGE>
Board. Because MCI, AT&T and others also challenged U S WEST's action, the Iowa
Utilities Board continued to review the U S WEST Centrex Action and on June 14,
1996 issued an order rejecting U S WEST's filing. The order of the Iowa
Utilities Board was appealed by U S WEST and affirmed by the Iowa District Court
for Polk County on February 21, 1997.
In Minnesota, U S WEST's initial filing was rejected on procedural grounds
by the Public Utilities Commission. On April 30, 1996, U S WEST refiled its
proposed limitations on Centrex service in Minnesota, proposing to "grandfather"
the service to existing customers as of July 9, 1996. The Company opposed this
filing in a letter to the Minnesota Public Utilities Commission on May 20, 1996.
On May 31, 1996, the Minnesota Public Utilities Commission issued an order
suspending the new U S WEST filing and scheduling a contested-case proceeding to
consider it. On December 23, 1996, an administrative law judge ruled that U S
WEST must continue to offer Centrex service in Minnesota. U S WEST filed
exceptions to this ruling. The Minnesota Public Utilities Commission denied U S
WEST's exceptions on February 20, 1997. U S WEST has filed a petition for
rehearing with the Minnesota Public Utilities Commission. As of the date hereof,
the Minnesota Public Utilities Commission had not yet ruled on the petition for
a rehearing.
In South Dakota, the Public Utilities Commission rejected the U S WEST
Centrex Action on August 22, 1996. U S WEST appealed the unfavorable decision of
the Public Utilities Commission in South Dakota state court. On December 2,
1996, the South Dakota state court hearing the appeal affirmed the decision of
the Public Utilities Commission.
In North Dakota, on November 6, 1996, the Public Service Commission
concluded that the U S WEST Centrex Action is unlawful and ordered U S WEST to
reinstate Centrex service in North Dakota. U S WEST appealed the unfavorable
decision by the Public Service Commission in North Dakota state court. On
January 24, 1997, the North Dakota state court hearing the appeal affirmed the
decision of the Public Service Commission.
In Nebraska, on November 25, 1996, the Public Service Commission rejected
complaints objecting to the U S WEST Centrex Action. On February 3, 1997, the
Company and other parties appealed the order of the Public Service Commission to
the Nebraska Court of Appeals. The appeal remains pending.
In Idaho, on November 14, 1996, the Public Utilities Commission rejected
complaints by AT&T and MCI objecting to the U S WEST Centrex Action. On January
31, 1997, the Company filed its own complaint with the Idaho Public Utilities
Commission. As of the date hereof, the Idaho Public Utilities Commission has
not yet ruled on the Company's complaint.
In Utah, the Public Service Commission rejected the U S WEST Centrex Action
and ordered U S WEST to continue the availability of Centrex service for resale
on September 26, 1996. Upon rehearing, however, the Utah Public Service
Commission issued an order on April 29, 1997 including restrictions on Centrex
resale. The Company is preparing to appeal such order.
Other telecommunication firms also have challenged the U S WEST Centrex
Action in each of the other states where U S WEST engages in local telephone
service and public utilities commissions in several of those states have
rejected the U S WEST Centrex Action. In Oregon, U S WEST's filing was rejected
by the Public Utilities Commission on March 7, 1996. In Colorado, on September
3, 1996, an administrative law judge issued a recommendation that the U S WEST
Centrex Action be rejected. On December 20, 1996, the Colorado Public Utilities
Commission rejected U S WEST's exceptions to the recommendation. In Wyoming, U S
WEST's filing was rejected by the Public Service Commission on September 6,
1996. On March 21, 1997, the Wyoming Public Service Commission rejected U S
WEST's petition for a rehearing of the matter. U S WEST appealed the decision
of the Public Service Commission to Wyoming state court on April 2, 1997. The
appeal remains pending. On October 29, 1996, the Arizona Corporation Commission
rejected the U S WEST Centrex Action. In New Mexico, the Public Service
Commission has not allowed U S WEST's filing to become effective. In Montana, on
March 6, 1997, the Public Service Commission approved the U S WEST Centrex
Action. On April 4, 1997, AT&T filed an
17
<PAGE>
application for a rehearing with the Montana Public Service Commission. As of
the date hereof, the Montana Public Service Commission had not yet ruled on the
application for rehearing.
The Company anticipates that U S WEST will continue to appeal unfavorable
decisions by public utilities commissions with respect to the U S WEST Centrex
Action.
In addition to the U S WEST Centrex Action, U S WEST has taken other
measures that may impede the Company's ability to use Centrex service to provide
its competitive local exchange services. In Colorado, U S WEST filed new tariffs
in July 1996 that, as interpreted by U S WEST, would prohibit the Company from
consolidating telephone lines of separate customers into leased common blocks in
U S WEST's central office switches, thereby significantly increasing the cost of
serving customers in Colorado through resale of Centrex services. The Company
filed a complaint with the Colorado Public Utilities Commission on February 12,
1997 alleging that U S WEST's tariffs, as interpreted by U S WEST, unlawfully
create a barrier to the Company's ability to compete in Colorado. The Company's
complaint was suspended to allow the Colorado Public Utilities Commission to
rule on the same issues in a U S WEST tariff proceeding, which ruling is
expected in June 1997.
In January 1997, U S WEST proposed to implement certain interconnection
surcharges in each of the states in its service region. On February 20, 1997,
the Company and several other parties filed a petition with the FCC objecting to
U S WEST's proposal. The petition was based on Section 252(d) of the
Telecommunications Act, which governs the pricing of interconnection and network
elements. The Company believes that U S WEST's proposal is an unlawful attempt
to recover costs associated with the upgrading of U S WEST's network, in
violation of Section 252 of the Telecommunications Act. U S WEST filed an
opposition to the Company's petition with the FCC on March 3, 1997. The matter
remains pending before the FCC.
There can be no assurance that the Company will ultimately succeed in its
legal challenges to the U S WEST Centrex Action or other actions by U S WEST
that have the effect of preventing or deterring the Company from using Centrex
service, or that these actions by U S WEST, or similar actions by other Regional
Bell Operating Companies, will not have a material adverse effect on the
Company. In any jurisdiction where U S WEST prevails, the Company's ability to
offer integrated telecommunications services would be impaired, which could have
a material adverse effect on the Company.
If the U S WEST Centrex Action or other actions by U S WEST have the effect
of preventing or deterring the Company from using Centrex service in any
jurisdiction and the Company is consequently not able to obtain Centrex access
on acceptable economic terms or at all in a state where the Company is doing
business or plans to do business, the Company intends to evaluate other U S WEST
services that could potentially be purchased and resold in such jurisdiction to
allow the Company to provide some form of integrated local and long distance
services until the Company can obtain access to unbundled elements pursuant to
interconnection agreements. There can be no assurance that the Company would be
able to identify, purchase and resell any such U S WEST service or ultimately
obtain access to such unbundled elements.
The Company also anticipates that U S WEST will seek various legislative
initiatives in states within the Company's target market area in an effort to
reduce state regulatory oversight over its rates and operations. There can be no
assurance that U S WEST will not succeed in such efforts or that any such state
legislative initiatives, if adopted, will not have a material adverse effect on
the Company.
As a result of its use of the Centrex product, the Company depends upon U S
WEST to process service orders placed by the Company to transfer new customers
to the Company's local service. U S WEST had imposed a limit of processing one
new local service order of the Company per hour for each U S WEST central
office, creating a significant backlog of local service orders of the Company.
Furthermore, according to the Company's records, U S WEST commits an error on
one of every three lines ordered by the Company, thereby further delaying the
transition of new customers to the Company's local service. The Company
repeatedly requested that U S WEST increase its local service order processing
rate and improve the accuracy of such processing, which U S WEST refused to do.
18
<PAGE>
On July 12, 1996, the Company filed a complaint with the Iowa Utilities
Board against U S WEST in connection with such actions. At a hearing held to
consider the complaint, U S WEST acknowledged that it had not dedicated
resources to improve its processing of the Company's service orders to switch
new customers to the Company's local service because of its desire to limit
Centrex service. In an order issued on October 10, 1996, the Iowa Utilities
Board determined that U S WEST's limitation on the processing of the Company's
service orders constituted an unlawful discriminatory practice under Iowa law.
On October 21, 1996, in accordance with the Iowa Utilities Board's order, the
Company and U S WEST jointly filed supplemental evidence regarding a potential
modification of order processing practices that would increase U S WEST's rate
of processing service orders. However, since implementing the new process, U S
WEST has not significantly increased its overall order processing rate. On
December 23, 1996, the Company filed a report with the Iowa Utilities Board
requesting further direction. On February 14, 1997, the Iowa Utilities Board
clarified that U S WEST must eliminate numerical limitations on the Company's
residential and business orders. On April 15, 1997, U S WEST agreed to eliminate
the backlog of the Company's local service orders by May 19, 1997 and to process
the Company's service orders within a standard five-day period. U S WEST also
agreed to waive the installation fee for those service orders not processed
within five days until the backlog is eliminated. There can be no assurance,
however, that the decision of or any further action by the Iowa Utilities Board
will adequately resolve the service order problems or that such problems will
not impair the Company's ability to expand or to attract new customers, which
could have a material adverse effect on the Company.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
EXHIBIT NUMBER EXHIBIT DESCRIPTION
- ---------------- -------------------
10.1 Letter Agreement dated April 15, 1997 between
U S WEST Communications and McLeodUSA Network Services, Inc.
11.1 Statement regarding computation of loss per common share.
27.1 Financial Data Schedule.
99.1 Press release dated April 30, 1997.
(b) Report on Form 8-K
On February 24, 1997, the Company filed a Current Report on Form 8-K
which reported that the Company proposed to make a private offering of the Notes
and that the Company acquired Digital Communications pursuant to an Agreement
and Plan of Reorganization dated as of January 27, 1997. The Company issued
shares of the Company's Class A Common Stock having an aggregate value of
approximately $2.3 million to the shareholders of Digital Communications in
exchange for their shares of Digital Communications Common Stock. The Company
did not provide with this report financial statements of Digital Communications
or pro forma financial information relating to this transaction.
19
<PAGE>
SIGNATURES
PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934,
THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY THE
UNDERSIGNED THEREUNTO DULY AUTHORIZED.
MCLEOD, INC.
(registrant)
Date: May 14, 1997 By: /s/ Stephen C. Gray
----------------------------------------
Stephen C. Gray
President and Chief Operating Officer
Date: May 14, 1997 By: /s/ Blake O. Fisher, Jr.
----------------------------------------
Blake O. Fisher, Jr.
Chief Financial Officer, Executive
Vice President, Corporate Administration
and Treasurer
20
<PAGE>
INDEX TO EXHIBITS
<TABLE>
<CAPTION>
SEQUENTIALLY
EXHIBIT NUMBERED
NUMBER EXHIBIT DESCRIPTION PAGE
- --------------------------- ------------------------------------- ------------
<S> <C> <C>
10.1 Letter Agreement dated April 15, 1997
between U S WEST Communications
and McLeodUSA Network Services, Inc.
11.1 Statement regarding computation of
loss per common share.
27.1 Financial Data Schedule.
99.1 Press release dated April 30, 1997.
</TABLE>
<PAGE>
Exhibit 10.1
U S WEST Communications
1801 California Street Room 2420
Denver, CO 60202
Phone 303 965-8057
FAX 303 965-9301
William J. Stewart
Vice President [LOGO OF US WEST]
Wholesale Local Markets
April 15, 1997
Via Fax 319-298-7127
Mr. Kirk E. Kaalberg, President
McLeod USA Network Services
221 3rd Avenue S.E. Suite 500
Cedar Rapids, Iowa 52401-1522
Dear Kirk:
As we discussed at our April 10 meeting in Cedar Rapids and confirmed on
our April 15 conference call, U S WEST Communications is committed to
eliminating the current order backlog and providing McLeod with timely ongoing
delivery of Centrex station lines. Additional resources are being added in our
centers and we continue to work toward greater mechanization of the Centrex
ordering process. In the immediate future, our plans call for two separate
teams to focus on the problem, one team working on the reduction of our backlog,
the other to process new order requests. We believe our efforts will result in
the elimination of our current backlog by May 19, 1997.
The purpose of this proposal is to provide McLeod with a schedule for the
reduction of current backlog and waiver of installation charges for overdue
orders in exchange for McLeod's holding in abeyance both pending and filing of
any further complaints directed at U S WEST Communications with the Iowa Utility
Board. Details are as follows:
1. Effective the week of April 14, U S WEST Communications will change
the way McLeod orders are processed from a FIFO (first-in, first-out)
approach to a LIFO (last-in, first-out) approach. In this way, new
orders (excluding BOH and new facilities orders) will be assigned due
dates within a 5-business-day interval.
2. Concurrent with the process change described above, U S WEST
Communications will reduce and eliminate the current backlog based on
the following schedule:
Week of Backlog Volume
---------- --------------
April 14 3088
April 21 2443
April 28 1738
May 5 1039
May 12 303
May 19 0
This schedule is based upon McLeod's currently forecasted volumes over
the period.
<PAGE>
Mr. Kirk E. Kaalberg
April 15, 1997
Page 2
3. In consideration of McLeod's acceptance of this proposal, installation
charges will be waived on the following orders:
-- all orders considered in backlog effective April 15 delivered
beyond the standard 5 business days (excluding BOH and new
facilities orders)
-- all new orders entered from April 15 through May 19, 1997 not
delivered within the standard 5 business day interval
(excluding BOH and new facilities orders)
An order is considered delivered when conversion is complete and dial
tone is provided. Delivery can be confirmed through the Centrex
Management System on the day following conversion.
4. McLeodUSA and U S WEST Communications personnel will work closely to
reconcile order backlog records. Management level personnel from both
companies will conduct weekly meetings or conference calls to review
prior week performance and resolve outstanding issues.
5. Reserving all future rights and remedies, McLeod will hold in abeyance
all current or new petitions filed with the Iowa State Utilities Board
relating to U S WEST Communications' provisioning of Centrex services.
This hold will remain in effect for the period from April 15 through
May 19, 1997.
In addition to the actions described above, McLeod and U S WEST
Communications will continue working together toward the resolution of other
outstanding issues between our firms including Business Office Hold (BOH) and
SMDR.
We believe this proposal represents a significant step toward improving the
business relationship between our firms and look forward to working with you to
continue this improvement.
If you concur that this letter accurately states our agreement, please
execute and return one copy of this letter. I will then attach this plan to our
filing with the Commission asking that they hold their proceeding in abeyance.
Sincerely,
/s/ WILLIAM J. STEWART
William J. Stewart
WJS:dle
mcleod/kaalberg
Concurrence:
/s/ KIRK E. KAALBERG Date: 4/22/97
- --------------------------- -----------------
Kirk E. Kaalberg, President
McLeod USA Network Services
<PAGE>
EXHIBIT 11.1
MCLEOD, INC.
COMPUTATION OF LOSS PER COMMON AND COMMON EQUIVALENT SHARE
(AMOUNTS IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31,
--------------------
1997 1996
--------- ---------
<S> <C> <C>
Computation of weighted average number of
common shares outstanding and common
equivalent shares: (A)
Common shares, Class A, outstanding at the
beginning of the period 36,173 16,387
Common shares, Class B, outstanding at the
beginning of the period 15,626 15,626
Weighted average number of shares issued during
the period (C) 528 ----
Common equivalent shares attributable to stock
options granted (B) ---- 5,019
Common stock issued (C) ---- ----
-------- -------
Weighted average number of common shares and
common equivalent shares 52,327 37,055
======== =======
Net loss $(13,355) $(4,340)
======== =======
Loss per common and common equivalent share $ (0.26) $ (0.12)
======== =======
</TABLE>
(A) All shares have been adjusted to give effect to the 3.75 for 1 stock split
effected in the form of a stock dividend effective March 28, 1996.
(B) All stock options are anti-dilutive; however, pursuant to Securities and
Exchange Commission Staff Accounting Bulletin No. 83 (SAB 83), stock options
granted with exercise prices below the assumed initial offering price during
the twelve-month period preceding the date of the initial filing of the
Registration Statement filed in connection with the Company's initial public
offering have been included in the calculation of common stock equivalent
shares as if they were outstanding for all periods through June 30, 1996,
the quarter in which the initial public offering was completed.
(C) All stock issued during the three months ended March 31, 1996 was within the
twelve-month period discussed in (B) above. As a result, the shares issued
at prices below the assumed initial public offering price during this period
have been included in the calculation as if they were outstanding for all
periods presented.
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS OF MCLEOD, INC. AND SUBSIDIARIES FOR
THE THREE MONTHS ENDED MARCH 31, 1997 AND IS QUALIFIED IN ITS ENTIRETY BY
REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> DEC-31-1997
<PERIOD-START> JAN-01-1997
<PERIOD-END> MAR-31-1997
<CASH> 366,999,000
<SECURITIES> 107,190,000
<RECEIVABLES> 30,089,000
<ALLOWANCES> 3,889,000
<INVENTORY> 2,409,000
<CURRENT-ASSETS> 481,940,000
<PP&E> 123,617,000
<DEPRECIATION> 8,105,000
<TOTAL-ASSETS> 779,654,000
<CURRENT-LIABILITIES> 72,066,000
<BONDS> 304,304,000
0
0
<COMMON> 525,000
<OTHER-SE> 393,702,000
<TOTAL-LIABILITY-AND-EQUITY> 779,654,000
<SALES> 35,747,000
<TOTAL-REVENUES> 35,747,000
<CGS> 21,200,000
<TOTAL-COSTS> 21,200,000
<OTHER-EXPENSES> 27,605,000
<LOSS-PROVISION> 502,000
<INTEREST-EXPENSE> 2,447,000
<INCOME-PRETAX> (13,355,000)
<INCOME-TAX> 0
<INCOME-CONTINUING> (13,355,000)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (13,355,000)
<EPS-PRIMARY> (0.26)
<EPS-DILUTED> (0.26)
</TABLE>
<PAGE>
Exhibit 99.1
[MCLEODUSA LOGO]
PRESS RELEASE
McLeod, Inc.
221 Third Avenue, SE, Suite 500
Cedar Rapids, IA 52401
Press and Investor Contact: Bryce E. Nemitz
Phone: (319) 364-0000
FAX: (319) 298-7767
FOR IMMEDIATE RELEASE
MCLEODUSA REPORTS FIRST QUARTER RESULTS
STRONG LINE SALES--UP OVER 300 PERCENT
Cedar Rapids, IA, April 30, 1997--McLeod, Inc. (NASDAQ/NMS:MCLD), doing
business as McLeodUSA, a provider of integrated telecommunications services,
today reported first quarter results for 1997. Revenues were $35.7 million for
the first quarter ended March 31, 1997, an increase of 186 percent compared to
revenues of $12.5 million for the first quarter of 1996. Net loss for the
quarter was $13.4 million or $(0.26) per share compared to a net loss of $4.3
million or $(0.12) per share for the first quarter of 1996. EBITDA loss for the
quarter was $9.4 million compared with EBITDA loss of $3.1 million a year ago.
"We are pleased with our 1997 first quarter growth compared to first
quarter of 1996. However, we are even more pleased with our sales growth within
the quarter," said Steve Gray, president and chief operating officer. He
continued, "Our local line sales results have doubled. Sales for the quarter
exceeded 22,000 lines, and because of this increase in sales, our backlog of
lines to be installed in the U S West market grew from approximately 3,000 to
13,500. After McLeodUSA filed a report with the Iowa Utilities Board in March,
U S West immediately committed to increase their order volume. Further, U S
West agreed to process orders within the normal five-day interval, and if they
fail to do so, they will make certain financial considerations. Since that
agreement, U S West has steadily decreased the McLeodUSA backlog and is
currently meeting our sales pace."
Gray adds, "Contributing significantly to our sales figures for the quarter
was our telemarketing initiative for PrimeLine(R) service, our residential
product. We have now fully assimilated last summer's acquisition of Ruffalo,
Cody, and refocused the efforts of a good portion of that sales force to sell
our product. Although we have reduced revenues by $2 million from third party
contracts, this sales force is now creating a recurring revenue stream. We were
able to add 8 new PrimeLine markets and sold more than 11,000 residential lines
in the first quarter of 1997."
<PAGE>
McLeodUSA now provides services from 227 U S West and Ameritech central
offices serving 138 cities. Gray adds, "Our expansion into 90 additional
central offices and the strengthening of our sales force in existing markets is
key to market share growth. We added 6 new sales offices in 4 states during
first quarter, including Illinois, Minnesota, North Dakota and Wisconsin. We
now have nearly 400 people devoted to direct and telephone sales activities, and
operate sales offices in 45 cities."
"Our white and yellow page publishing subsidiary made significant progress
in the quarter, growing its revenue total by 16% over the same quarter last
year. Because of the cyclical nature of the publishing business, first quarter
revenues were down by $700,000 from the previous quarter. McLeodUSA Publishing,
now with a 350-person sales force, acquired 32 telephone directories in North
Dakota and Indiana; distributed 1.2 million directories, of which nearly 700,000
carry the McLeodUSA name; and began publishing directories carrying an 8-page
service guide highlighting the Company's products," reported Gray.
Commenting on the quarterly revenue total of $35.7 million, Gray explains,
"Our revenues nearly tripled over the same quarter a year ago. Our
telecommunications business contributed $19.2 million, $14.2 million came from
advertising sales in telephone directories, and $2.3 million from telemarketing
sales."
The $9.1 million increase in net loss can be primarily attributed to the
Company's aggressive expansion plan. Included in this plan is the expansion of
Bell central office operations, the opening of new sales offices, and costs
related to the acquisitions completed in 1996. The development of the Company's
business and the construction and expansion of its network require significant
expenditures, a substantial portion of which is incurred before the realization
of revenues.
"First quarter also marked a financing milestone for the Company," stated
Clark McLeod, chairman and chief executive officer. "We completed a private
debt offering of $500 million, raising our financing total to nearly $1 billion
in less than one year. The debt offering of 10 1/2% senior discounted notes due
March 1, 2007, resulted in gross proceeds to the Company of $300 million. The
significant achievement is not the dollar total, but the fact that we now have
the funds in place to execute our current plan."
"We accomplished a number of regulatory successes this quarter as well,"
adds Gray. "We received approval to provide local service in Colorado, and
facilities-based service in Wisconsin. In North Dakota, the district court
upheld the Public Service Commission's decision to prohibit Centrex withdrawal
by U S West."
Gray summarized the quarterly results saying, "Our market share growth by
every measure is strong. The addition of central offices nearly tripled. Our
expansion into additional sales cities is progressing well. And, we completed
an additional 224 route miles of fiber optic network bringing our total to 2,576
route miles. Perhaps the most encouraging observation is the synergistic
merging of our 1996 acquisitions. As mentioned, the telemarketing efforts in
support
<PAGE>
of our PrimeLine sales are going very well, and the benefits of having
our name, logo, color scheme and product information merchandised by our
telephone directories is going better than we expected when we accomplished
these acquisitions last summer."
McLeod, Inc., founded in June of 1991, is a provider of integrated
telecommunications services to businesses and residential customers. The
Company's telecommunications customers are located primarily in Iowa, Illinois,
Minnesota and Wisconsin. In 1997, we will print and distribute over 8 million
telephone directories in 18 midwestern and Rocky Mountain states.
The statements contained in this release are forward-looking statements
that involve risks and uncertainties, including, but not limited to revision of
expansion plans, availability of financing and regulatory approvals, the number
of potential customers in a target market, the existence of strategic alliances
or relationships, technological, regulatory or other developments in the
Company's business, changes in the competitive climate in which the Company
operates and the emergence of future opportunities, all of which could cause
McLeod, Inc.'s actual results and experiences to differ materially from
anticipated results and expectations expressed in the forward-looking statements
contained herein. These and other applicable risks are summarized under the
caption "Business--Risk Factors" and elsewhere in the Company's Annual Report on
Form 10-K for its fiscal year ended December 31, 1996, which is filed with the
Securities and Exchange Commission.
PrimeLine(R) is a registered trademark of McLeod, Inc.
# # #
<PAGE>
MCLEOD, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF OPERATIONS
(In thousands except for per share data)
(UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31,
------------------
1997 1996
-------- -------
<S> <C> <C>
Revenue $ 35,747 $12,488
Operating expenses:
Cost of service 21,200 9,250
Selling, general and administrative 23,985 6,345
Depreciation and amortization 4,122 969
Other 1,608 --
-------- -------
TOTAL OPERATING EXPENSES 50,915 16,564
-------- -------
OPERATING LOSS (15,168) (4,076)
Non-operating income (expense):
Interest income 4,253 1
Interest (expense) (2,447) (265)
Other 7 --
-------- -------
TOTAL NON-OPERATING INCOME (EXPENSE) 1,813 (264)
-------- -------
LOSS BEFORE INCOME TAXES (13,355) (4,340)
Income Taxes -- --
-------- -------
NET LOSS $(13,355) $(4,340)
======== =======
Loss per common and common equivalent share $ (0.26) $ (0.12)
======== =======
Weighted average common and
common equivalent shares outstanding 52,327 37,055
======== =======
EBITDA $ (9,438) $(3,107)
======== =======
</TABLE>
<PAGE>
MCLEOD, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF OPERATIONS
(In thousands except for per share data)
(UNAUDITED)
<TABLE>
<CAPTION>
Three Months Ended
------------------------------------------
6/30/96 9/30/96 12/31/96 3/31/97
-------- -------- --------- --------
<S> <C> <C> <C> <C>
Revenue $ 13,918 $ 19,091 $ 35,826 $ 35,747
Operating expenses:
Cost of service 9,474 12,969 20,931 21,200
Selling, general and administrative 7,631 11,650 20,418 23,985
Depreciation and amortization 1,604 2,161 3,751 4,122
Other -- -- 2,380 1,608
-------- -------- --------- --------
TOTAL OPERATING EXPENSES 18,709 26,780 47,480 50,915
-------- -------- --------- --------
OPERATING LOSS (4,791) (7,689) (11,654) (15,168)
Non-operating income (expense):
Interest income 503 2,899 2,630 4,253
Interest (expense) (255) (23) (122) (2,447)
Other -- 278 218 7
-------- -------- --------- --------
TOTAL NON-OPERATING INCOME (EXPENSE) 248 3,154 2,726 1,813
-------- -------- --------- --------
LOSS BEFORE INCOME TAXES (4,543) (4,535) (8,928) (13,355)
Income Taxes -- -- -- --
-------- -------- --------- --------
NET LOSS $ (4,543) $ (4,535) $ (8,928) $(13,355)
======== ======== ========= ========
Loss per common and common equivalent share $ (0.11) $ (0.10) $ (0.18) $ (0.26)
======== ======== ========= ========
Weighted average common and
common equivalent shares outstanding 39,968 46,233 48,707 52,327
======== ======== ========= ========
EBITDA $ (3,187) $ (5,528) $ (5,523) $ (9,438)
======== ======== ========= ========
</TABLE>
<PAGE>
SELECTED STATISTICAL DATA:
<TABLE>
<CAPTION>
1Q97 vs. 1Q97 vs.
1Q96 4Q96
3/31/97 3/31/96 % Change 12/31/96 % Change
------- ------- -------- -------- --------
<S> <C> <C> <C> <C> <C>
Sales cities 45 30 50% 39 15%
Central Offices in operation 227 72 215% 137 66%
Cities served 138 46 200% 102 35%
Route miles 2,576 434 494% 2,352 10%
Local lines 77,228 41,268 87% 65,367 18%
Business 67,388 41,268 63% 61,505 10%
Residential 9,840 -- -- 3,862 155%
Local line customers 22,610 9,156 147% 16,562 37%
Business 13,155 9,156 44% 12,064 9%
Residential 9,455 -- -- 4,498 110%
Lines per business customer 5.1 4.5 13% 5.1 --
Lines sold 22,642 5,440 316% 10,283 120%
Business 10,666 5,440 120% 6,863 75%
Residential 11,976 -- -- 3,420 212%
Employees 2,362 462 411% 2,077 14%
</TABLE>
