<PAGE>
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from _________________ to _________________
Commission file number 0-23683
USN COMMUNICATIONS, INC.
------------------------
(Exact name of registrant as specified in its charter)
Delaware 36-3947804
-------- ----------
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
10 South Riverside Plaza, Suite 401, Chicago, Illinois 60606
----------------------------------------------------------------------
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code (312) 906-3600
--------------
N/A
- --------------------------------------------------------------------------------
(Former name, former address and former fiscal year, if changed since last
report)
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 [ ]
As of July 31, 1998, there were 23,483,519 shares outstanding of the
registrant's Common Stock, par value $.01 per share.
Exhibit Index is on page 21.
<PAGE>
[CAPTION]
<TABLE>
PART I. FINANCIAL INFORMATION
Item 1. FINANCIAL STATEMENTS
USN COMMUNICATIONS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)
June 30, December 31,
1998 1997
-------- ------------
<S> <C> <C>
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 56,372,059 $ 87,454,418
Marketable equity securities - 8,180,824
Accounts receivable, net of allowance for doubtful accounts of
$8,409,000 at 1998 and $4,537,000 at 1997 58,463,801 23,917,093
Inventory 1,249,205 -
Other current assets 6,136,085 1,443,575
------------- -------------
Total current assets 122,221,150 120,995,910
Property and equipment-net 31,990,041 16,802,065
Goodwill, net of accumulated amortization of $1,202,000 at 1998 48,778,948 -
Other assets 53,998,288 33,402,271
------------- -------------
Total assets $ 256,988,427 $ 171,200,246
------------- -------------
LIABILITIES, REDEEMABLE PREFERRED STOCK AND
COMMON STOCKHOLDERS' EQUITY (DEFICIT)
CURRENT LIABILITIES:
Accounts payable $ 34,336,208 $ 20,485,168
Accrued expenses and other liabilities 16,533,312 7,178,373
Capital lease obligations and notes payable 585,926 559,223
------------ ------------
Total current liabilities 51,455,446 28,222,764
14 5/8% Senior Discount Notes, net of Original Issue Discount 138,119,210 105,486,381
14% Senior Discount Notes, net of Original Issue Discount 13,423,146 35,790,140
9% Convertible Subordinated Discount Notes, net of
Original Issue Discount 32,256,657 30,867,615
9% Consent Convertible Notes, net of Original Issue Discount 10,412,500 -
Capital lease obligations and notes payable 534,632 555,960
------------ -----------
Total liabilities 246,201,591 200,922,860
REDEEMABLE PREFERRED STOCK:
9% Cumulative Convertible Pay-In-Kind Preferred Stock: par
value $1; 30,000 shares authorized at 1997; 10,920 shares
outstanding at December 31,1997 - 10,920
9% Cumulative Convertible Pay-In-Kind Preferred Stock,
Series A: par value $1; 150,000 shares authorized at 1997;
45,209 shares outstanding at December 31, 1997 - 45,209
Accumulated unpaid dividends - 1,516,355
Additional paid-in-capital - 55,704,861
------------ ------------
Total redeemable preferred stock - 57,277,345
COMMON STOCKHOLDERS' EQUITY (DEFICIT):
Common stock, $.01 par value, 100,000,000 shares authorized
at June 30, 1998 and 30,000,000 shares authorized at December 31,
1997; 23,376,791 and 7,282,511 shares issued at
June 30, 1998 and December 31, 1997, respectively 233,768 72,826
Additional paid-in capital 259,999,781 74,642,145
Treasury stock, 10,000 shares (1,077) (1,077)
Accumulated other comprehensive income:
Unrealized gain on available-for-sale securities - 8,180,824
Accumulated deficit (249,445,636) (169,894,677)
------------- -------------
Total common stockholders' equity (deficit) 10,786,836 (86,999,959)
------------- -------------
TOTAL LIABILITIES, REDEEMABLE PREFERRED STOCK, AND
COMMON STOCKHOLDERS' EQUITY (DEFICIT) $ 256,988,427 $ 171,200,246
------------- -------------
</TABLE>
See Notes to Condensed Consolidated Financial Statements.
2
<PAGE>
<TABLE>
<CAPTION>
USN COMMUNICATIONS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
Three Months Ended June 30,
------------------------------------
1998 1997
------------ -----------
<S> <C> <C>
NET SERVICE REVENUE $ 49,632,595 $ 7,804,451
COST OF SERVICES 38,600,944 7,084,813
------------ -----------
Gross profit 11,031,651 719,638
EXPENSES:
Sales and marketing 26,964,355 17,144,604
General and administrative 24,318,354 8,550,800
------------ ------------
OPERATING LOSS (40,251,058) (24,975,766)
OTHER INCOME (EXPENSE):
Interest income 1,224,887 366,161
Interest expense (7,443,380) (2,092,874)
Realized gain on sale of marketable securities 11,714,411 -
Other income 3,273 643
-------------- --------------
Other income (expense) - net 5,499,191 (1,726,070)
-------------- --------------
NET LOSS $ (34,751,867) $ (26,701,836)
============== ==============
ACCUMULATED PREFERRED DIVIDENDS - $ 235,126
============== ==============
NET LOSS TO COMMON SHAREHOLDERS $ (34,751,867) $ (26,936,962)
-------------- --------------
NET LOSS PER COMMON SHARE - BASIC AND DILUTED $ (1.50) $ (3.74)
============== ==============
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING - BASIC AND DILUTED 23,131,582 7,206,033
============== ==============
</TABLE>
See Notes to Condensed Consolidated Financial Statements.
3
<PAGE>
<TABLE>
<CAPTION>
USN COMMUNICATIONS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
Six Months Ended June 30,
-------------------------------------
1998 1997
------------- -------------
<S> <C> <C>
NET SERVICE REVENUE $ 82,053,133 $ 11,721,290
COST OF SERVICES 65,237,455 10,519,835
------------ ------------
Gross profit 16,815,678 1,201,455
EXPENSES:
Sales and marketing 51,389,532 27,335,250
General and administrative 44,406,195 15,013,143
------------ ------------
OPERATING LOSS (78,980,049) (41,146,938)
OTHER INCOME (EXPENSE):
Interest income 2,793,304 1,009,451
Interest expense (14,505,913) (4,129,201)
Realized gain on sale of marketable securities 11,714,411 -
Other income 6,022 3,948
------------ ------------
Other income (expense) - net 7,824 (3,115,802)
------------ ------------
NET LOSS $ (78,972,225) $ (44,262,740)
============== ==============
ACCUMULATED PREFERRED DIVIDENDS $ 578,734 $ 460,126
============== ==============
NET LOSS TO COMMON SHAREHOLDERS $ (79,550,959) $ (44,722,866)
-------------- --------------
NET LOSS PER COMMON SHARE - BASIC AND DILUTED $ (4.22) $ (6.22)
============== ==============
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING - BASIC AND DILUTED 18,851,767 7,190,902
============== ==============
</TABLE>
See Notes to Condensed Consolidated Financial Statements.
4
<PAGE>
<TABLE>
<CAPTION>
USN COMMUNICATIONS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF REDEEMABLE PREFERRED STOCK (UNAUDITED)
SIX MONTHS ENDED JUNE 30, 1998 AND YEAR ENDED DECEMBER 31, 1997
____________________________________________________________________________________________________________________________
Series A
9 % PIK 9% PIK Accumulated Additional
Preferred Preferred Unpaid Paid-in
Stock Stock Dividends Capital Total
--------- --------- ----------- ---------- -----
<S> <C> <C> <C> <C> <C>
BALANCE, DECEMBER 31, 1996 $10,000 $225,000 $9,810,185 $10,045,185
Issuance of 920 shares of 9% PIK Preferred
Stock as payment of dividends 920 (920,251) 919,331 -
Issuance of 45,209 shares of Series A 9%
PIK Preferred Stock $45,209 45,163,863 45,209,072
Costs incurred related to issuance of
Series A 9% PIK Preferred Stock (188,518) (188,518)
Accumulated dividends on 9% PIK Preferred Stock 940,957 940,957
Accumulated dividends on Series A 9% PIK
Preferred Stock 1,270,649 1,270,649
------ ------- --------- ---------- -----------
BALANCE, DECEMBER 31, 1997 10,920 45,209 1,516,355 55,704,861 57,277,345
------ ------- --------- ---------- -----------
Accumulated dividends on 9% PIK
Preferred Stock 113,847 113,847
Accumulated dividends on Series A 9%
PIK Preferred Stock 464,887 464,887
Conversion of 9% PIK and Series A 9%
PIK Preferred Stock to common stock (10,920) (45,209) (2,095,089) (55,704,861) (57,856,079)
-------- -------- ----------- ------------ ------------
BALANCE, JUNE 30, 1998 $ - $ - $ - $ - $ -
======== ======== =========== =========== ============
</TABLE>
See Notes to Condensed Consolidated Financial Statements.
5
<PAGE>
<TABLE>
<CAPTION>
USN COMMUNICATIONS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMMON STOCKHOLDERS' EQUITY (DEFICIT) (UNAUDITED)
SIX MONTHS ENDED JUNE 30, 1998 AND YEAR ENDED DECEMBER 31, 1997
- ------------------------------------------------------------------------------------------------------------------------------
ACCUMULATED
ADDITIONAL COMMON OTHER ACCUMU-
COMMON PAID-IN STOCK HELD COMPREHENSIVE LATED
STOCK CAPITAL IN TREASURY INCOME DEFICIT TOTAL
--------- ---------- ----------- -------------- ------------- ------------
<S> <C> <C> <C> <C> <C> <C>
BALANCE, DECEMBER 31, 1996 $71,853 $ 54,114,755 $ (1,077) $ (57,791,382) $ (3,605,851)
Issuance of 97,251 shares of 973 531,125 532,098
common stock
Compensation expense on stock 644,538 644,538
options
Issuance of stock warrants 19,351,727 19,351,727
Accumulated dividends on 9% PIK
Preferred Stock (940,957) (940,957)
Accumulated dividends on Series
A 9% PIK Preferred Stock (1,270,649) (1,270,649)
Comprehensive income (loss):
Net loss (109,891,689) (109,891,689)
Other comprehensive income
(loss), net of tax:
Unrealized gain of
available-for-sale
securities $8,180,824 8,180,824
------------
Comprehensive loss (101,710,865)
-------- ------------ -------- ----------- ------------- ------------
BALANCE, DECEMBER 31, 1997 72,826 74,642,145 (1,077) 8,180,824 (169,894,677) (86,999,959)
-------- ------------ -------- ----------- ------------- ------------
Issuance of 8,628,861 shares of
common stock 86,288 137,975,487 138,061,775
Costs incurred related to issuance
of stock (10,764,324) (10,764,324)
Accumulated dividends on 9% PIK
Preferred Stock (113,847) (113,847)
Accumulated dividends on Series A
9% PIK Preferred Stock (464,887) (464,887)
Conversion of 9% PIK and Series A
9% PIK Preferred Stock to common
stock 61,301 57,794,778 57,856,079
Issuance of 1,335,233 shares of
common stock upon exercise of
warrants and options 13,353 5,801 19,154
Compensation expense on stock
options 345,894 345,894
Comprehensive income (loss):
Net loss (78,972,225) (78,972,225)
Other comprehensive income
(loss), net of tax:
Unrealized gain on
available-for-sale
securities 3,533,587 3,533,587
Realized gain on sale of
marketable securities (11,714,411) (11,714,411)
------------
Comprehensive loss (87,153,049)
-------- ------------ -------- ----------- ------------- ------------
BALANCE, JUNE 30, 1998 $233,768 $259,999,781 $ (1,077) $ - $(249,445,636) $ 10,786,836
-------- ------------ -------- ----------- ------------- ------------
</TABLE>
See Notes to Condensed Consolidated Financial Statements.
6
<PAGE>
<PAGE>
<TABLE>
<CAPTION>
USN COMMUNICATIONS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
Three Months Ended June 30,
--------------------------------------
1998 1997
-------------- --------------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss $ (34,751,867) $ (26,701,836)
Adjustments to reconcile net loss to net cash flows from
operating activities:
Depreciation and amortization 4,440,148 927,959
Non-cash interest on debt obligations 7,393,866 2,067,172
Stock compensation award expense 172,947 172,947
Gain on sale of marketable securities (11,714,411) -
Changes in:
Accounts receivable (11,667,200) (3,896,224)
Allowance for doubtful accounts 724,493 213,096
Other assets (3,400,870) (351,444)
Accounts payable 5,879,201 3,107,807
Accrued expenses (3,115,039) 3,997,178
-------------- --------------
Net cash flows from operating activities (46,038,732) (20,463,345)
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property and equipment (11,601,771) (4,253,860)
Proceeds from sale of marketable securities 11,714,411 -
-------------- -------------
Net cash flows from investing activities 112,640 (4,253,860)
CASH FLOWS FROM FINANCING ACTIVITIES:
Issuance of common stock 13,038 4,098
Deposits (5,726,676) (15,532)
Repayment of capital lease obligations and notes payable (150,836) (288,940)
-------------- -------------
Net cash flows from financing activities (5,864,474) (300,374)
-------------- -------------
NET DECREASE IN CASH (51,790,566) (25,017,579)
CASH AND CASH EQUIVALENTS - Beginning of period 108,162,625 40,737,827
-------------- -------------
CASH AND CASH EQUIVALENTS - End of period $ 56,372,059 $ 15,720,248
============== =============
SUPPLEMENTAL CASH FLOW INFORMATION:
Declared dividends - $ 235,126
============== =============
Capital lease obligations incurred - $ 444,903
============== =============
Cash paid for interest $ 45,478 $ 23,398
============== =============
Cash paid for income taxes - -
============== =============
</TABLE>
See Notes to Condensed Consolidated Financial Statements.
7
<PAGE>
USN COMMUNICATIONS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
<TABLE>
<CAPTION>
SIX MONTHS ENDED JUNE 30,
-------------------------------------
1998 1997
-------------- -------------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss $(78,972,225) $(44,262,740)
Adjustments to reconcile net loss to net cash flows from
operating activities:
Depreciation and amortization 6,675,471 1,653,848
Non-cash interest on debt obligations 14,411,113 4,083,363
Stock compensation award expense 345,894 298,644
Gain on sale of marketable securities (11,714,411) -
Changes in:
Accounts receivable (30,029,104) (5,342,353)
Allowance for doubtful accounts 1,969,154 317,148
Other assets (3,690,390) (845,727)
Accounts payable 8,747,685 1,816,148
Accrued expenses 5,974,449 4,776,561
------------- ------------
Net cash flows from operating activities (86,282,364) (37,505,108)
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property and equipment (17,365,207) (7,171,245)
Proceeds from sale of marketable securities 11,714,411 -
Purchase of subsidiary, net of cash acquired (69,053,616) -
------------- ------------
Net cash flows from investing activities (74,704,412) (7,171,245)
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from Consent Convertible Notes 10,000,000 -
Issuance of common stock 138,080,929 4,098
Costs incurred related to issuance of stock (10,764,324) -
Deposits (7,116,900) 17,018
Repayment of capital lease obligations and notes payable (295,288) (442,993)
------------- -----------
Net cash flows from financing activities 129,904,417 (421,877)
------------- -----------
NET DECREASE IN CASH (31,082,359) (45,098,230)
CASH AND CASH EQUIVALENTS - Beginning of period 87,454,418 60,818,478
------------- -----------
CASH AND CASH EQUIVALENTS - End of period $ 56,372,059 $ 15,720,248
============= ============
SUPPLEMENTAL CASH FLOW INFORMATION:
Conversion of preferred stock to common stock $ 57,856,079 -
============= ============
Declared dividends $ 578,734 $ 460,126
============= ============
Capital lease obligations incurred $ 287,617 $ 444,903
============= ============
Dividends paid in kind - $ 450,000
============= ============
Cash paid for interest $ 90,764 $ 49,862
============= ============
Cash paid for income taxes - -
============= ============
</TABLE>
See Notes to Condensed Consolidated Financial Statements.
8
<PAGE>
USN COMMUNICATIONS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 1998
1 CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
The unaudited, condensed consolidated financial statements of USN
Communications, Inc. (the "Company") included herein have been prepared in
accordance with the rules and regulations of the Securities and Exchange
Commission. The interim financial statements reflect all adjustments, consisting
only of normal recurring adjustments, which are, in the opinion of management,
necessary for a fair presentation of the results for the interim periods
presented. The condensed consolidated financial statements should be read in
conjunction with the consolidated financial statements and notes thereto
included in the Company's latest annual report on Form 10-K. The results of
operations for the interim periods should not be considered indicative of
results to be expected for the full year.
2 NEW ACCOUNTING PRONOUNCEMENTS
On January 1, 1998, the Company adopted Statement of Financial Accounting
Standards No. 130 "Reporting Comprehensive Income", which establishes standards
for reporting and display of comprehensive income and its components. Other
comprehensive income consists solely of unrealized gains on available-for-sale
securities.
In June 1998, the Financial Accounting Standards Board issued SFAS No. 133,
"Accounting for Derivative Instruments and Hedging Activities," ("SFAS 133"),
effective for all fiscal quarters of fiscal years beginning after June 15, 1999.
It establishes accounting and reporting standards for derivative instruments and
for hedging activities. It requires that an entity recognize all derivatives as
either assets or liabilities in the statement of financial position and measure
those instruments at fair value. The Company is evaluating SFAS 133 to determine
its impact on the consolidated financial statements.
3 ACCOUNTS RECEIVABLE
Accounts receivable consists of the following (in thousands):
<TABLE>
<CAPTION>
June 30, December 31,
1998 1997
---------- -----------
<S> <C> <C>
Billed $44,288 $10,790
Unbilled 22,585 17,664
------- -------
Gross accounts receivable 66,873 28,454
Allowance for doubtful accounts (8,409) (4,537)
------- -------
Net accounts receivable $58,464 $23,917
======= =======
</TABLE>
9
<PAGE>
Unbilled accounts receivable comprises access charges, features and usage
for revenue earned but not yet billed to customers. A majority of the unbilled
accounts receivable were billed within 30 days after the quarter.
4 PRIVATE PLACEMENT OFFERINGS
In August 1997, in connection with the 1997 private placement offering, the
Company issued an option to the holders of the 14% Senior Discount Notes due
2003 (the "14% Senior Notes") to purchase $13.0 million aggregate principal
amount at maturity of the Company's 9% Convertible Subordinated Discount Notes
due 2006 ("Consent Notes") for an aggregate purchase price of $10 million and
convertible into common stock at a conversion price of $10.121 per share based
on accreted value at the time of conversion. Pursuant to the option, which was
exercised by the holders in October 1997, the Consent Notes were sold in January
1998 at a price of $767.90 per $1,000 face amount. These notes will accrete
interest at an annual rate of 9%, compounded semiannually, until January 13,
2001. Thereafter interest will be paid semiannually in arrears in cash.
In March 1998, the holders of the 14% Senior Notes exchanged $31.5 million
aggregate principal amount at maturity of the Company's 14% Senior Notes for
$33.6 million aggregate principal amount at maturity of the Company's 14 5/8%
Senior Discount Notes due 2004 (the "14 5/8% Senior Notes").
5 CHANGES IN EQUITY
In February 1998, the Company issued and sold 8,600,000 shares of Common
Stock (of which 600,000 shares were sold pursuant to the underwriters'
over-allotment options) in its initial public offering for net proceeds of
approximately $127.0 million. In March 1998, the Company issued and sold 28,861
additional shares pursuant to the exercise of the underwriters' over-allotment
option for net proceeds of $0.4 million. In conjunction with the initial public
offering, all of the Company's outstanding 9% Cumulative Convertible Pay-In-Kind
Preferred Stock ("9% Preferred Stock") and 9% Cumulative Convertible Pay-In-Kind
Preferred Stock, Series A ("Series A Preferred Stock"), including dividends
accrued through the conversion date, were converted to 6,130,175 shares of Class
A Common Stock. At the time of the initial public offering, all of the shares of
the Company's Class A Common Stock were converted to an equal number of the
Company's newly created common stock.
In the first half of 1998, the Company issued 1,335,233 shares of Common
Stock in conjunction with the exercise of Warrants and stock options.
10
<PAGE>
6 ACQUISITION
On February 20, 1998, the Company used a portion of the net proceeds from
its initial public offering to acquire all of the outstanding capital stock of
Hatten Communications Holding Company, Inc., a Connecticut corporation ("Hatten
Communications"), pursuant to a Stock Purchase Agreement dated January 7, 1998,
for approximately $69.1 million, net of cash acquired, including the repayment
of approximately $14.0 million of existing indebtedness and the payment of
certain fees and expenses.
The acquisition was recorded under the purchase method of accounting, and
accordingly, the results of operations of Hatten Communications have been
included in the consolidated financial statements since the date of acquisition.
The purchase price has been allocated to assets acquired and liabilities assumed
based on their fair market value at the date of the acquisition as summarized
below (in thousands):
<TABLE>
<CAPTION>
<S> <C>
Current assets $ 8,317
Long-term assets 1,291
Intangible assets 17,961
Goodwill 49,981
Current liabilities (8,496)
-------
Purchase price $69,054
=======
</TABLE>
Goodwill of approximately $50.0 million is being amortized on a
straight-line basis over 15 years. Additionally, the fair market value ascribed
to the acquired customer list of $15.0 million, included in intangible assets,
is being amortized on a straight-line basis over 5 years. Management is in the
process of reviewing the final allocation of the purchase price.
The following table reflects unaudited pro forma combined results of
operations of the Company and Hatten Communications on the basis that the
acquisition had taken place on January 1, 1997 (in thousands, except per
share data):
<TABLE>
<CAPTION>
Pro Forma Six Months Ended
June 30,
--------------------------
1998 1997
---------- ---------
<S> <C> <C>
Net service revenue $ 88,151 $ 30,182
Net loss to common shareholders $(81,294) $(50,352)
Net loss per common share - basic and diluted $ (4.31) $ (7.00)
Weighted average common shares outstanding 18,852 7,191
</TABLE>
11
<PAGE>
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Overview
Since the passage of the Telecommunications Act, the Company has focused
its operations on the acquisition of a large number of customers and on
maintaining strong customer relationships through a direct sales approach and
with scaleable, high-volume provisioning and other systems and responsive
customer care. The Company has executed this strategy through the bundled
offering of telecommunications services. This enables the Company to maintain
strategic flexibility in its service offerings, including the development of
facilities-based services, as the Company determines is appropriate.
The Company entered into the first total service resale agreement with
Ameritech Corporation for local services in November 1995, and entered into a
comprehensive local resale agreement in July 1996 with NYNEX Corporation (now
Bell Atlantic Corporation). The Company also consummated various other
agreements in 1996 with certain carriers for the resale of long distance and
enhanced and other value-added services. The Company commenced the marketing and
provisioning of services under those agreements during the latter half of 1996.
The Company has continued to develop additional services to meet the needs of
its target market through the acquisition of Hatten Communications in February
1998. Hatten Communications resells wireless communications services, including
cellular and paging.
The Company intends to leverage its significant customer base, attract new
customers and expand its profit margins by pursuing the staged development of a
facilities-based platform. The first step in its development program is the
introduction of high speed data transmission through DSL technology followed by
switched long distance service and switched local service. The Company expects
to provide DSL services to certain customers on a trial basis in the fourth
quarter of 1998 and on a commercial basis in the first half of 1999; switched
long distance service in the second half of 1999 and switched local service in
the first half of 2001. Although management believes that, through an increase
in its customer base and service offerings, its current strategy will have a
positive effect on the Company's results of operations over the long-term, the
Company anticipates losses and negative cash flow for the foreseeable future,
attributable in part to significant investments in operating, sales, marketing,
management information systems and general and administrative expenses. To date,
the Company's growth, including capital expenditures, has been funded primarily
by capital contributions, sales of preferred stock and by the proceeds from the
private placement or public offering of debt and equity securities.
The Company's net service revenue consists primarily of sales revenue from
telecommunications resale services net of certain adjustments, including credits
and allowances. The Company bills its subscribers for local, long distance and
other service usage based on the type of service utilized, the number, time and
duration of calls, the geographic location of the terminating phone numbers and
the applicable rate plan in effect at the time of the call.
Cost of service includes the cost of local, long distance and other
services charged by carriers for recurring charges, per minute usage charges and
feature charges, as well as the cost of fixed facilities for dedicated services
and special regional calling plans.
12
<PAGE>
Sales and marketing expense consists of the costs of providing sales and
other support services for customers including salaries of salesforce personnel.
General and administrative expense consists of the costs of the billing and
information systems and personnel required to support the Company's operations
and growth as well as bad debts and the amortization of organization costs and
intangible assets, other than deferred financing costs, the amortization of
which is included in interest expense. Depreciation is allocated throughout
sales and marketing expense and general and administrative expense based on
asset usage.
The Company has experienced significant growth in the past and, depending
on the extent of its future growth, may experience significant strain on its
management, personnel and information systems. While adding additional employees
during the last year, the Company has undertaken a number of initiatives to
enhance the accuracy and efficiency of its recordation of new customer orders
and the efficiency and consistency of its provisioning process. The Company is
now in the process of realigning and resizing various departments which will
reduce overall employee levels.
Results of Operations
Three Months Ended June 30, 1998 Compared to Three Months Ended June 30, 1997
Net service revenue increased to $49.6 million for the three months ended
June 30, 1998 from $7.8 million for the three months ended June 30, 1997. The
number of local access lines in service at June 30, 1998 was 276,319 compared to
65,142 as of June 30, 1997. The net increase in access lines was 50,235 lines
for the second quarter of 1998 compared to 46,585 lines for the second quarter
of 1997. The increase in net service revenue was due primarily to the
substantial increase in the Company's installed base and the corresponding
increase in the customer base in the Company's geographic markets as well as the
acquisition of Hatten Communications in the first quarter, which added $12.1
million to net service revenue.
Gross profit increased to $11.0 million for the three months ended June 30,
1998 from $0.7 million for the three months ended June 30, 1997. The gross
margin percentage was 22.2% for the second quarter of 1998, up from 9.2% for the
second quarter of 1997 and 17.8% for the first quarter of 1998. The increase in
gross profit is attributable to the above mentioned increase in customer base,
improvements in the Company's billing systems and revenue assurance processes
and the acquisition of Hatten Communications.
Sales and marketing expenses increased $9.9 million, or 57%, from $17.1
million for the three months ended June 30, 1997 to $27.0 million for the three
months ended June 30, 1998. The increase was due primarily to an increase in the
number of sales and marketing employees from approximately 520 at June 30, 1997
to approximately 935 at June 30, 1998 to support the growth in the customer
base. This increase in headcount resulted in increases to salaries and benefits
of approximately $5.9 million, facility and office related expenses of
approximately $2.2 million, travel and training costs of approximately $1.0
million and recruitment costs of approximately $0.4 million. Additionally,
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<PAGE>
mass marketing expenses increased approximately $1.2 million related to the
Company's telemarketing strategy. These increases were offset by a decrease of
$1.1 million in advertising costs.
General and administrative expenses increased $15.7 million, or 184%, to
$24.3 million for the three months ended June 30, 1998 versus $8.6 million for
the three months ended June 30, 1997. The increase was due primarily to an
increase in the number of operations and administrative employees from
approximately 240 at June 30, 1997 to approximately 715 at June 30, 1998 to
support the growth in the customer base, which resulted in increases to salaries
and benefits of approximately $5.3 million, facility related costs of
approximately $4.8 million, professional fees of approximately $2.1 million,
billing costs of approximately $1.3 million and increased bad debt expense of
approximately $1.2 million.
Interest and other income increased to $12.9 million for the three months
ended June 30, 1998 from $0.4 million for the three months ended June 30, 1997
due primarily to a gain on the sale of marketable securities in the second
quarter of 1998.
Interest expense increased to $7.4 million for the three months ended June
30, 1998 from $2.1 million for the three months ended June 30, 1997. This
increase was due primarily to interest expense attributable to the 14 5/8%
Senior Notes issued in August 1997 and the Consent Notes issued in January 1998.
As a result of the factors described above, the Company had a net loss of
$34.8 million for the three months ended June 30, 1998 compared to a net loss of
$26.7 million for the three months ended June 30, 1997. Net loss per common
share for the second quarter of 1998 was $1.50 compared to $3.74 for the second
quarter of 1997. The second quarter 1998 EBITDA was a negative $35.8 million
versus a negative $24.0 million in the second quarter of 1997.
Six Months Ended June 30, 1998 Compared to Six Months Ended June 30, 1997
Net service revenue increased to $82.1 million for the six months ended
June 30, 1998 from $11.7 million for the six months ended June 30, 1997. The net
increase in access lines was 104,357 lines for the first six months of 1998
compared to 56,778 lines for the first six months of 1997. The increase in net
service revenue is attributable to the above mentioned increase in customer base
as well as the acquisition of Hatten Communications in the first quarter, which
added $16.8 million to net service revenue.
Gross profit increased to $16.8 million for the six months ended June 30,
1998 from $1.2 million for the six months ended June 30, 1997. The gross margin
percentage was 20.5% for the first six months of 1998, up from 10.3% for the
first six months of 1997. The increase in gross profit is attributable to the
above mentioned increase in customer base, improvements in the Company's billing
systems and revenue assurance processes, as well as the acquisition of Hatten
Communications in the first quarter of 1998.
Sales and marketing expenses increased $24.1 million, or 88%, from $27.3
million for the six months ended June 30, 1997 to $51.4 million for the six
months ended June 30, 1998. The increase was due primarily to increased
headcount, which resulted in increases to salaries and benefits of
14
<PAGE>
approximately $15.7 million, facility and office related expenses of
approximately $3.8 million, travel and training costs of approximately $2.7
million and recruitment costs of approximately $1.7 million. Additionally, mass
marketing expenses increased approximately $2.0 million related to the Company's
telemarketing strategy. These increases were offset by a decrease of $2.0
million in advertising costs.
General and administrative expenses increased $29.4 million, or 196%, to
$44.4 million for the six months ended June 30, 1998 versus $15.0 million for
the six months ended June 30, 1997. The increase was due primarily to increased
headcount, which resulted in increases to salaries and benefits of approximately
$8.9 million, facility related costs of approximately $7.4 million, professional
fees of approximately $4.5 million, increased bad debt expense of approximately
$3.4 million and billing costs of approximately $3.2 million.
Interest and other income increased to $14.5 million for the six months
ended June 30, 1998 from $1.0 million for the six months ended June 30, 1997 due
primarily to the above mentioned gain on the sale of marketable securities.
Interest expense increased to $14.5 million for the six months ended June
30, 1998 from $4.1 million for the six months ended June 30, 1997. This increase
was due primarily to interest expense attributable to the 14 5/8% Senior Notes
issued in August 1997 and the Consent Notes issued in January 1998.
As a result of the factors described above, the Company had a net loss of
$79.0 million for the six months ended June 30, 1998 compared to a net loss of
$44.3 million for the six months ended June 30, 1997. Net loss per common share
for the six months ended June 30, 1998 was $4.22 compared to $6.22 for the six
months ended June 30, 1997. EBITDA for the first six months of 1998 was a
negative $72.3 million versus a negative $39.5 million in the first six months
of 1997.
LIQUIDITY AND CAPITAL RESOURCES
Since inception, the Company has funded its operations primarily through
proceeds from the issuance of debt and equity securities. As of June 30, 1998,
the Company had cash and cash equivalents of $56.4 million and working capital
of $70.8 million. The Company's operating activities utilized cash of
approximately $46.0 million and $86.3 million for the three and six month
periods ended June 30, 1998, respectively, and $20.5 million and $37.5 million
for the three and six month periods ended June 30, 1997, respectively.
The Company's investing activities for the three months ended June 30, 1998
of $113,000 consist of $11.6 million for the purchase of property and equipment
related to the development of systems infrastructure and the increase in
computer equipment and office buildouts related to the corresponding increase in
headcount, offset by the $11.7 million proceeds from the sale of marketable
securities. Investing activities for the six months ended June 30, 1998 consist
of $69.1 million for the purchase of Hatten Communications and property and
equipment purchases of $17.4 million related to the areas mentioned above. For
the three and six month periods ended June 30, 1997, the Company's investing
activities consisted of $4.3 million and $7.2 million, respectively, of property
and equipment purchases for sales office expansions in the Company's geographic
markets. The
15
<PAGE>
Company anticipates approximately $11 million of additional capital
expenditures in the last six months of 1998. This amount includes expenditures
for information systems, leasehold improvements, and facilities for the initial
deployment of DSL services.
The Company's financing activities utilized $5.9 million for the three
month period ended June 30, 1998 and generated $129.9 for the six month period
ended June 30, 1998. In January 1998, the Company issued $13.0 million aggregate
principal amount at maturity of Consent Notes for an aggregate purchase price of
$10.0 million. In February 1998, the Company issued and sold 8,600,000 shares of
Common Stock (of which 600,000 shares were sold pursuant to the underwriters'
over-allotment options) in its initial public offering for net proceeds of
approximately $127.0 million. In March 1998, the Company issued and sold 28,861
additional shares pursuant to the exercise of the underwriters' over-allotment
option for net proceeds of $0.4 million. Additionally, the Company utilized cash
for deposits related to sales office expansions totaling $5.7 million and $7.1
million for the three and six month periods ended June 30, 1998, respectively.
Cash utilized for financing activities for the three and six month periods ended
June 30, 1997 of approximately $300,000 and $422,000 related primarily to the
repayment of capital lease obligations and notes payable.
The Company will require additional capital in the fourth quarter in order
to meet planned capital expenditures and to fund its operations due to the
Company's negative operating cash flow position. Sources of funding for the
Company's future financing requirements may include public offerings or private
placements of equity and/or debt securities and additional capital contributions
from new or existing stockholders. The Company has entered into a letter of
intent with respect to the sale of $30 million to $50 million of equity
securities and has engaged in discussions with other parties that are interested
in investing in the Company. The Company anticipates that such investment, if
made, would be completed in conjunction with a high yield debt offering. An
additional or alternative source of potential financing may be bank financing,
although the Company currently does not have an available credit facility. There
can be no assurance that any additional financing will be available to the
Company, or, if available, that it can be obtained on a timely basis and on
terms acceptable to the Company and within limitations contained in the
indentures with respect to the Company's 14% Senior Notes and 14 5/8% Senior
Notes. Failure to obtain such financing will result in the delay or abandonment
of the Company's development and expansion plans and could have a material
adverse effect on the Company's results of operations and financial condition.
DISCLOSURE REGARDING FORWARD-LOOKING STATEMENTS
This document includes "forward-looking statements" within the meaning of
Section 27A of the Securities Act and Section 21E of the Exchange Act, including
statements containing the words "believes," "anticipates, "expects" and words of
similar import. All statements other than statements of historical facts
regarding the Company or any of the transactions described herein are
forward-looking statements. Although the Company believes that the expectations
reflected in such forward-looking statements are reasonable, it can give no
assurance that such expectations will prove to have been correct. Actual results
may differ materially from those projected in forward-looking statements. The
Company believes that its primary risk factors include, but are not limited to:
the number and size of competitors in its markets; law and regulatory policy;
dependence on technology and third parties, including provisioning and billing
systems and services; and the mix of products and services offered in its target
markets. The Company undertakes no obligation to update publicly any forward-
16
<PAGE>
looking statements whether as a result of new information, future events or
otherwise. Any statements should be evaluated in light of these important
factors.
17
<PAGE>
PART II OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
From time to time the Company is party to routine litigation and
proceedings in the ordinary course of its business. The Company and its
subsidiaries are not aware of any current or pending litigation that the Company
believes would have a material adverse effect on the Company's results of
operations or financial condition. The Company and its subsidiaries continue to
participate in regulatory proceedings before the FCC and state regulatory
agencies concerning the authorization of services and the adoption of new
regulations.
ITEM 2. CHANGES IN SECURITIES
None.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
(a) The Company's 1998 Annual Meeting of Stockholders was held on May
29, 1998, in Chicago, Illinois (the "Annual Meeting").
(b) Dennis B. Dundon and James P. Hynes were elected to the Board of
Directors at the Annual Meeting. Richard J. Brekka, Ronald W.
Gavillet, Eugene A. Sekulow, J. Thomas Elliott, William H.
Johnston and David C. Mitchell continued to serve as directors
following the Annual Meeting.
(c) (i) A total of 17,123,721 votes (74.0% of all votes entitled to
vote at the Annual Meeting) were represented by proxy or ballot at
the Annual Meeting. The stockholders of the Company were requested
to elect two directors as nominated by management. Both nominees
were elected as indicated by the following vote tabulation:
Name For Withheld
---- --- --------
Dennis B. Dundon 17,100,746 22,975
James P. Hynes 17,100,746 22,975
(ii) The stockholders were requested to ratify the appointment of
Deloitte & Touche LLP as the Company's independent auditors for
the fiscal year ending December 31, 1998. The appointment of
Deloitte & Touche LLP was ratified by stockholders, as 17,097,625
votes were cast for the proposal, 12,826 votes were cast against
the proposal, and 13,270 votes abstained.
18
<PAGE>
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBITS
27. Financial Data Schedule
(b) REPORTS ON FORM 8-K
Form 8-K/A dated May 6, 1998 to report certain financial statements and pro
forma financial information relating to the Company's acquisition of Hatten
Communications.
19
<PAGE>
SIGNATURE
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.
USN COMMUNICATIONS, INC.
(Registrant)
Date: August 13, 1998 /s/ GERALD J. SWEAS
------------------------------
Executive Vice President and
Chief Financial Officer
(Duly authorized officer and
principal financial officer
of the registrant)
20
<PAGE>
INDEX TO EXHIBITS
SEQUENTIALLY
EXHIBIT NUMBERED
NUMBER EXHIBIT DESCRIPTION PAGE
- ------ ------------------- ----
27 Financial Data Schedule 22
21
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<S> <C> <C>
<PERIOD-TYPE> 3-MOS 6-MOS
<FISCAL-YEAR-END> DEC-31-1998 DEC-31-1998
<PERIOD-START> APR-01-1998 JAN-01-1998
<PERIOD-END> JUN-30-1998 JUN-30-1998
<CASH> 56,372 56,372
<SECURITIES> 0 0
<RECEIVABLES> 66,873 66,873
<ALLOWANCES> 8,409 8,409
<INVENTORY> 1,249 1,249
<CURRENT-ASSETS> 122,221 122,221
<PP&E> 39,393 39,393
<DEPRECIATION> 7,403 7,403
<TOTAL-ASSETS> 256,988 256,988
<CURRENT-LIABILITIES> 51,455 51,455
<BONDS> 194,212 194,212
0 0
0 0
<COMMON> 260,234 260,234
<OTHER-SE> (249,447) (249,447)
<TOTAL-LIABILITY-AND-EQUITY> 256,988 256,988
<SALES> 49,633 82,053
<TOTAL-REVENUES> 49,633 82,053
<CGS> 38,601 65,237
<TOTAL-COSTS> 38,601 65,237
<OTHER-EXPENSES> 51,283 95,796
<LOSS-PROVISION> 1,922 4,364
<INTEREST-EXPENSE> 7,443 14,506
<INCOME-PRETAX> (34,752) (78,972)
<INCOME-TAX> 0 0
<INCOME-CONTINUING> (34,752) (78,972)
<DISCONTINUED> 0 0
<EXTRAORDINARY> 0 0
<CHANGES> 0 0
<NET-INCOME> (34,752) (78,972)
<EPS-PRIMARY> (1.50) (4.22)
<EPS-DILUTED> (1.50) (4.22)
</TABLE>
