<PAGE>
UNITED STATES 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 December 31, 1998
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
EXCHANGE ACT OF 1934.
For the transition period from ____________, 19__ to __________, 19__.
Commission File Number: 0-25482
EQUALNET COMMUNICATIONS CORP.
(Exact Name of Registrant as Specified in its Charter)
TEXAS 76-0457803
(State of Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification Number)
1250 WOOD BRANCH PARK DRIVE
HOUSTON, TEXAS 77079
Address of Principal Executive Offices, Including Zip Code
(281) 529-4600
(Registrant's Telephone Number, Including Area Code)
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
----- -----
There were 18,385,832 shares of the Registrant's $.01 par value common stock
outstanding as of February 16, 1999.
<PAGE>
Part I Financial Information
Item 1. Financial Statements
EQUALNET COMMUNICATIONS CORP.
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
June 30, December 31,
1998 1998
----------- -------------
(Note) (Unaudited)
<S> <C> <C>
Assets
Current assets
Cash and equivalents $ 459,581 $ -
Accounts receivable, net of allowance
for doubtful accounts of $1,034,253 at June 30,
1998 and $1,821,414 at December 31, 1998 5,839,284 9,909,274
Due from agents 1,596,590 603,429
Advance on acquisition purchase price 3,014,000 -
Prepaid expenses and other 109,684 735,742
----------- -----------
Total current assets 11,019,139 11,248,445
Property and equipment
Computer equipment 17,824,993 17,937,062
Office furniture and fixtures 1,209,032 1,209,032
Leasehold improvements 1,177,592 1,185,927
----------- -----------
20,211,617 20,332,021
Accumulated depreciation and amortization (4,837,626) (6,546,152)
----------- -----------
15,373,991 13,785,869
Customer acquisition costs, net of
accumulated amortization of $14,381,407
at June 30, 1998 and $17,240,636 at
December 31, 1998 355,984 6,297,219
Other assets 1,011,333 688,346
----------- -----------
Total assets $27,760,447 $32,019,879
============ ===========
</TABLE>
Note: The balance sheet at June 30, 1998 has been derived from the audited
financial statements at that date.
2
<PAGE>
EQUALNET COMMUNICATIONS CORP.
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
June 30, December 31,
1998 1998
-------------- ---------------
(Note) (Unaudited)
<S> <C> <C>
Liabilities and shareholders' equity
Current Liabilities Not Subject to Compromise
Payable to providers of long distance services $ 6,627,711 $ 1,499,770
Accounts payable 4,237,310 4,605,200
Accrued expenses 3,838,315 1,456,624
Accrued sales taxes 205,108 994,244
Notes payable to long distance providers 1,183,059 -
Debt in default 5,752,535 -
Debt in default to an Affiliate 400,000 -
Contractual obligations with regard to receivable
sales agreement 2,334,710 2,189,446
Notes Payable - 1,256,300
------------ -----------
Total Current Liabilities Not Subject to Compromise 24,578,748 12,001,584
Current Liabilities Subject to Compromise (NOTE 2) - 15,292,049
------------ -----------
Total current liabilities 24,578,748 27,293,633
Deferred rent 223,917 -
Notes Payable - 6,626,056
Convertible Debt - 2,514,275
Shareholders' equity (deficit)
Preferred stock, $.01 par value
5,000,000 shares authorized at June 30, 1998
Series A Convertible Preferred Stock (non-voting)
aggregate liquidation preference of $2.1
million; Issued and outstanding shares -
2,000 at June 30, 1998 and 2,000 at
December 31, 1998 2,000,000 2,000,000
Series B Convertible Preferred Stock (voting)
aggregate liquidation preference of $3.0
million; Issued and outstanding shares -
3,000 at June 30, 1998 and 3,000 at
December 31, 1998 3,000,000 3,000,000
Series C Convertible Preferred Stock (voting)
aggregate liquidation preference of $5.3
million; Issued and outstanding shares -
0 at June 30, 1998 and 196,553 at
December 31, 1998 - 5,400,000
Series D Convertible Preferred Stock (voting),
$.01 par value,
aggregate liquidation preference of $3.50
million; Issued and outstanding shares -
0 at June 30, 1998 and 3,799 at
December 31, 1998 - 1,945,250
</TABLE>
3
<PAGE>
EQUALNET COMMUNICATIONS CORP.
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
June 30, December 31,
1998 1998
------------ ------------
(Note) (Unaudited)
<S> <C> <C>
Common stock, $.01 par value 217,935 217,935
Authorized shares - 50,000,000 at June 30, 1998
and December 31, 1998. Issued and outstanding
21,385,832 at June 30, 1998 and 18,385,832 at
December 31, 1998. - -
Treasury stock at cost; 400,447 shares at June 30,
1998 at 3,400,447 at December 31, 1998 (817,153) (2,506,153)
Additional paid in capital 37,063,468 37,513,468
Stock warrants 1,763,240 2,511,077
Deferred compensation (115,826) (115,826)
Retained deficit (40,153,882) (54,379,836)
------------ ------------
Total shareholders' equity (deficit) 2,957,782 (4,414,085)
------------ ------------
Total liabilities and shareholders' equity
(deficit) $ 27,760,447 $ 32,019,879
============ ============
</TABLE>
Note: The balance sheet at June 30, 1998 has been derived from the audited
financial statements at that date.
4
<PAGE>
EQUALNET COMMUNICATIONS CORP.
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
December 31, December 31,
1997 1998 1997 1998
---------- ---------- ---------- -----------
<S> <C> <C> <C> <C>
Revenues $ 6,481,336 $ 7,617,444 $ 14,808,555 $ 16,010,585
Cost of Revenues 4,728,835 9,464,319 10,993,553 17,349,333
---------- ---------- ---------- ----------
1,752,501 (1,846,875) 3,815,002 (1,338,748)
Selling, general and administrative expenses 2,588,125 2,567,403 5,255,731 6,160,105
Depreciation and amortization 1,043,588 2,914,273 2,155,788 5,129,896
---------- ---------- ---------- ----------
Operating loss (1,879,212) (7,328,551) (3,596,517) (12,628,749)
Other income (expense)
Interest income 33 16 1,163 876
Interest expense (432,069) (527,640) (785,454) (1,334,941)
Miscellaneous 132,765 (252) 105,428 17,101
---------- ---------- ---------- ----------
(299,271) (527,876) (678,863) (1,316,964)
---------- ---------- ---------- ----------
Loss before federal income taxes and reorganization costs (2,178,483) (7,856,427) (4,275,380) (13,945,713)
Benefit for federal income taxes - - - -
---------- ---------- ---------- ----------
Loss before reorganization costs (2,178,483) (7,856,427) (4,275,380) (13,945,713)
Reorganization costs - (71,000) - (142,658)
---------- ---------- ---------- ----------
Net loss $ (2,178,483) $(7,927,427) $ (4,275,380) $(14,088,371)
========== ========== ========== ==========
Preferred stock dividends $ - $ (96,250) $ - $ (137,583)
Net loss available to Common shareholders $ (2,178,483) $(8,023,677) $ (4,275,380) $(14,088,371)
Net loss per share - basic and diluted $ (0.35) $ (0.44) $ (0.68) $ (0.73)
Weighted average number of shares 6,287,724 18,385,832 6,328,294 19,448,324
</TABLE>
5
<PAGE>
EQUALNET COMMUNICATIONS CORP.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
<TABLE>
<CAPTION>
Six Months Ended
December 31,
1997 1998
------------ ------------
<S> <C> <C>
OPERATING ACTIVITIES
Net loss $ (4,275,380) $ (14,088,371)
Adjustments to reconcile net income to
cash provided by (used in) operating activities
Depreciation and amortization 2,155,788 5,129,896
Provision for bad debt 754,225 4,062,811
Amortization of discount on convertible debt - 60,716
Interest charge on convertible debt issued at discount 150,000 450,000
Change in deferred rent 9,573 (223,917)
Compensation expense recognized for common stock issue 35,002 -
Change in operating assets and liabilities:
Accounts receivable 2,972,843 (3,468,695)
Due from agents 769,650 431,570
Prepaid expenses and other (104,108) (626,058)
Other assets (742,152) 247,438
Accounts payable and accrued liabilities
not subject to compromise (1,483,429) (6,833,940)
Accounts payable and accrued liabilities
subject to compromise - 14,108,990
------------ ------------
Net cash provided by (used in) operating activities 242,012 (749,560)
INVESTING ACTIVITIES
Purchase of property and equipment (74,724) (120,404)
Cash paid for acquisition - (555,000)
Proceeds from sale of equipment - 74,775
------------ ------------
Net cash used in investing activities (74,724) (600,629)
FINANCING ACTIVITIES
Proceeds from subordinated notes payable 957,260 2,923,245
Net repayments on revolving line of credit (4,555,442) -
Net proceeds on contractual obligations with regard
to receivable sales agreement 2,317,276 (145,264)
Repayments on capital lease obligations (42,000) -
Proceeds from issuance of stock 350,000 -
Proceeds from issuance of warrants 42,740 -
Repayments on long-term debt - (4,887,373)
Proceeds from convertible debt - 2,800,000
Proceeds from exchange of Common Stock for Preferred Stock - 200,000
------------ ------------
Net cash provided by (used in) financing activities (930,166) 890,608
------------ ------------
Net decrease in cash (762,878) (459,581)
Cash, beginning of period 828,478 459,581
------------ ------------
Cash, end of period $ 65,600 $ -
============ ============
</TABLE>
6
<PAGE>
EQUALNET COMMUNICATIONS CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 1 - MANAGEMENT'S REPRESENTATION
The consolidated financial statements included herein have been
prepared by the management of Equalnet Communications Corp. (the
"Company") without audit. Certain information and note disclosures
normally included in consolidated financial statements prepared in
accordance with generally accepted accounting principles have been
omitted. In the opinion of the management of the Company, all
adjustments considered necessary for fair presentation of the
consolidated financial statements have been included and were of a
normal recurring nature, and the accompanying consolidated financial
statements present fairly the financial position of the Company as of
December 31, 1998, and the results of operation and cash flows for the
three months and six months ended December 31, 1997 and 1998.
It is suggested that these consolidated financial statements be read
in conjunction with the consolidated financial statements and notes
for the three years ended June 30, 1998, included in the Company's
Annual Report on Form 10-K for the year ended June 30, 1998, which was
filed with the Securities and Exchange Commission. The interim
results are not necessarily indicative of the results for a full year.
NOTE 2 - CHAPTER 7 AND 11 FILING
The Company's consolidated financial statements have been prepared in
accordance with statement of Position No. 90-7, "Financial Reporting
by Entities in Reorganization Under the Bankruptcy Code", and include
disclosure of liabilities subject to compromise. EqualNet Corporation
("EqualNet"), one of the Company's operating subsidiaries, and
EqualNet Wholesale Services, Inc. ("Wholesale"), a wholly owned non-
operating subsidiary of EqualNet filed voluntary petitions for relief
under Chapter 11 ("Chapter 11") of the United States Bankruptcy Code
(the "Bankruptcy Code") on September 10, 1998 (the "Petition Date") in
the United States Bankruptcy Court for the Southern District of Texas
(the "Bankruptcy Court"), Houston, Texas. Under Chapter 11, certain
claims against EqualNet in existence prior to the filing of the
petitions for relief under the federal bankruptcy laws are stayed
while EqualNet continues business operations as a debtor-in-
possession. These claims are reflected in the December 31, 1998
balance sheet as "liabilities subject to compromise." Additional
claims (liabilities subject to compromise) may arise subsequent to the
filing date resulting from rejection of executory contracts, including
leases, and from the determination by the court (or agreed to by
parties in interest) of allowed claims for contingencies and other
disputed amounts.
On October 2, 1998 Wholesale filed its motion to convert its
bankruptcy proceeding from a Chapter 11 reorganization to a Chapter 7
liquidation. Pursuant to Sections 1107 and 1108 of the Bankruptcy
Code, EqualNet as debtor-in-possession, will continue to manage and
operate EqualNet's assets and business pending the confirmation of a
reorganization plan and subject to the supervision and orders of the
Bankruptcy Court. The Company has filed its disclosure statement
which includes its reorganization plan.
7
<PAGE>
A Bankruptcy Court hearing to consider the disclosure statement for
EqualNet's plan of reorganization is scheduled for March 1, 1999.
As a debtor-in-possession, EqualNet is authorized to operate its
business, but may not engage in transactions outside of the normal
course of business without approval, after notice and hearing, of the
Bankruptcy Court. A creditors' committee was formed in October, 1998,
which has the right to review and object to business transactions
outside the ordinary course.
The consolidated financial statements do not purport to show (a) the
realizable value of assets on a liquidation basis or their
availability to satisfy liabilities; (b) ultimate pre-petition
liability amounts that may be allowed for claims or contingencies or
the status or priority thereof; (c) the effect of any changes that may
be made to the capitalization of EqualNet; or (d) the effect of any
changes that may be made in EqualNet's business operations. The
outcome of these matters is not presently determinable.
Although management intends that EqualNet will emerge from bankruptcy
in a prompt and expeditious manner during the third or fourth quarter
of fiscal year 1999, there can be no assurance that a
reorganization will be consummated.
In the event EqualNet's plan of reorganization is formulated and
approved by the Court, continuation of the Company's business is
dependent upon the success of future operations and the Company's
ability to meet its obligations as they become due. The Company's
consolidated financial statements have been prepared on a going
concern basis, which contemplates continuity of operations,
realization of assets, including the Company's Switches and acquired
customer bases, and liquidation of liabilities and commitments in the
normal course of business. The Chapter 11 filing by EqualNet, as well
as related circumstances and the losses from operations, continue to
raise substantial doubt about the Company's ability to continue as a
going concern. The consolidated financial statements included herein
do not include any adjustments relating to the commencement of
EqualNet's bankruptcy case or to reflect the possible future effects
on the recoverability and classification of assets or the amounts and
classification of liabilities that may result from the outcome of the
uncertainty of the Company's ability to continue as a going concern.
The principal categories of claims classified as "Current Liabilities
Subject to Compromise" on the Company's consolidated balance sheet are
identified below:
Payable to providers of long distance services $ 9,833,383
Accounts payable 3,065,030
Accrued expenses 1,210,577
Notes Payable to long distance provider 1,183,059
-----------
$15,292,049
===========
8
<PAGE>
The following condensed financial statements present the financial
position of EqualNet as of December 31, 1998 and the results of its
operations and cash flows for the six months ended December 31,
1998, and have been prepared on the same basis as the Company's
consolidated financial statements.
EQUALNET CORPORATION
BALANCE SHEET
(UNAUDITED)
December 31, 1998
(Unaudited)
Assets
Current assets
Cash and equivalents $ -
Accounts receivable, net of allowance for doubtful 5,046,632
accounts of $1,457,160
Due from agents 602,429
------------
Total current assets 5,649,061
Property and equipment
Computer equipment 4,547,284
Office furniture and fixtures 1,209,032
Leasehold improvements 1,185,927
------------
6,942,243
Accumulated depreciation and amortization (4,516,454)
------------
2,425,789
Other assets 290,018
------------
Total assets $ 8,364,868
============
LIABILITIES AND SHAREHOLDERS' DEFICIT
Current Liabilities Not Subject to Compromise
Payable to providers of long distance services $ 606,769
Accounts Payable 1,806,015
Accrued Expenses 306,384
Accrued sales taxes 502,017
Debt in Default to an Affiliate 400,000
Contractual obligations with regard to
receivable sales agreement 650,761
Intercompany Note Payable 10,000,000
------------
Total Current Liabilities Not Subject to Compromise 14,271,946
Current Liabilities Subject to Compromise
Payable to providers of long distance services 9,833,383
Accounts payable 3,065,030
Accrued expenses 1,210,577
Notes Payable to long distance providers 1,183,059
Intercompany Note Payable 27,898,534
------------
Total Current Liabilities Subject to Compromise 43,190,583
------------
Total Current Liabilities 57,462,528
Shareholders' deficit
Common Stock 1
Retained deficit (49,097,660)
------------
Total shareholders' deficit (49,097,661)
------------
Total liabilities and shareholders' deficit $ 8,364,868
============
9
<PAGE>
EQUALNET CORPORATION
STATEMENT OF OPERATIONS
(Unaudited)
Six Months Ended
December 31, 1998
(Unaudited)
Revenues $ 8,868,886
Cost of Revenues 10,635,616
------------
(1,766,730)
Selling, general and administrative expenses 4,354,885
Depreciation and amortization 1,374,892
------------
Operating loss (7,496,507)
Other income (expense)
Interest income 869
Interest expense (203,501)
Miscellaneous -
------------
(202,632)
------------
Loss before federal income taxes and other item (7,699,139)
Benefit for federal income taxes -
------------
Loss before other item (7,699,139)
Reorganization Costs (142,658)
------------
Net loss $ (7,841,797)
------------
Reorganization expenses, which represent professional fees, incurred during the
six months ended December 31, 1998 totaled approximately $142,658.
10
<PAGE>
EQUALNET CORPORATION
STATEMENT OF CASH FLOWS
(UNAUDITED)
Six Months
Ended
December 31, 1998
-----------------
OPERATING ACTIVITIES $ (7,841,797)
Net loss
Adjustments to reconcile net loss to cash used in
operating activities
Depreciation and amortization 1,374,892
Provision for bad debt 2,563,640
Change in deferred rent (223,917)
Change in operating assets and liabilities:
Accounts receivable (1,770,989)
Due from agents 432,658
Other assets 188,983
Accounts payable and accrued liabilities not subject
to compromise (11,203,896)
Accounts payable and accrued liabilities
subject to compromise 15,020,165
------------
Net cash used in operating activities (1,460,261)
INVESTING ACTIVITIES
Purchase of property and equipment (120,404)
------------
Net cash used in investing activities (120,404)
FINANCING ACTIVITIES
Net proceeds from intercompany note payable 2,807,290
Net change on contractual obligations with regard
to receivable sales agreement (1,683,949)
------------
Net cash provided by financing activities 1,123,341
------------
Net decrease in cash (457,324)
Cash, beginning of period 457,324
------------
Cash, end of period $ 0
============
NOTE 3 - DIP FINANCING AND EXIT FACILITY
Prior to filing for bankruptcy protection, EqualNet and RFC Capital
Corporation ("RFC") entered into an agreement whereby RFC agreed to
amend certain financing agreements with EqualNet to eliminate
EqualNet's bankruptcy filing as an event of default and, subject to
bankruptcy court approval, to continue to finance EqualNet's
receivables under a debtor in possession ("DIP") facility. On
November 24, 1998, the bankruptcy court approved the DIP financing
which allowed EqualNet to continue to obtain funds from RFC in the
same manner as it did prior to the bankruptcy filing. The financing
cost of the DIP financing is prime rate plus seven percent (7%).
EqualNet will be required to seek additional financing to obtain the
approval of creditors of its plan of reorganization. The Company does
not have the capital to provide the exit facility and does not
currently have sufficient commitments from outside sources. (See
however Note 10 regarding contingent equity commitments.) The
11
<PAGE>
Company does intend to raise the needed capital from outside investors
and provide EqualNet with the exit facility. If the Company is able
to successfully provide the exit facility, the Company would continue
to own EqualNet after the bankruptcy proceedings.
NOTE 4 - SA TELECOM ACQUISITION
On January 21, 1998, the Company signed an agreement with SA
Telecommunications, Inc. ("SA Telecom"), a switch based, long distance
telecommunications carrier serving customers primarily in Texas and
California to acquire certain assets and customer bases in exchange
for a combination of shares of stock, cash and assumption of certain
liabilities. The transaction was subject to certain conditions,
including approval of the bankruptcy court supervising the
reorganization of SA Telecom under Chapter 11 of the United States
Bankruptcy Code. On March 9, 1998, the Company won approval from the
bankruptcy court. The purchase of SA Telecom was approved by the
Company's shareholders on June 30, 1998 for approximately $3.47
million in cash and approximately $5.4 million of Series C Preferred
Stock and the assumption of approximately $4 million in debt, payable
to Greyrock Business Credit, subject to final closing adjustments.
The Company's newly formed wholly owned subsidiary, USC Telecom, Inc.
("USC Telecom"), acquired the SA Telecom assets on July 23, 1998.
Prior to the closing of this transaction and for the purpose of
providing for a smooth transaction of the acquired customer base, the
Company and SA Telecom entered into a management agreement pursuant to
which the Company managed the operations of SA Telecom from April 1,
1998 until the close of the transaction whereby the Company was
responsible for any losses from SA Telecom's operations on or after
April 1, 1998. SA Telecom has provided the Company with notice that
the Company owes SA Telecom for operating losses during the period the
management agreement was effective. The Company has disputed the
amount of operating losses as provided by SA Telecom. Additionally, SA
Telecom is disputing the final purchase price settlement and has
requested additional funding. On December 23, 1998, the bankruptcy
court in the SA Telecom case ruled in favor of SA Telecom and entered
a judgment requiring USC Telecom to pay approximately $817,000 to SA
Telecom. The Company is appealing this decision and is also in
settlement negotiations with SA Telecom. The estimated amount of this
liability has been recorded as additional purchase consideration.
The Company accounted for the SA Telecom acquisition using the
purchase method of accounting. Accordingly, the results of operations
of the acquired business is included in the Company's consolidated
results of operations from the date of acquisition.
Purchase consideration (in thousands):
Cash paid $ 3,569
Fair value of preferred stock issued 5,400
Liabilities assumed 4,495
-------
Fair value of assets acquired (including intangibles) $13,464
=======
The Company booked an asset for customer acquisition costs of
approximately $8.7 million. This asset is being amortized by applying
the estimated attrition rate of the acquired customer base per month
against the unamortized balance of the previous month (declining
balance method) switching to the straight line method when the
straight line method results in greater amortization over a five-year
period.
12
<PAGE>
The Company issued 196,553 shares of Series C Preferred Stock to SA
Telecom as part of the purchase price. The Series C Preferred Stock
is convertible at the holder's option into shares of the Company's
common stock ("Common Stock") at the rate of ten (10) shares of Common
Stock per share of Series C Preferred Stock, or an aggregate of
1,965,530 shares of Common Stock. The Series C Preferred Stock has a
liquidation preference equal to $27.50 (plus any accrued but unpaid
dividends) per share of Series C Preferred Stock.
The following results of operations have been prepared assuming the SA
Telecom acquisition occurred as of the beginning of the periods
presented. The pro forma operating results are not necessarily
indicative of future operating results nor of results that would have
occurred had the acquisitions been consummated as of the beginning of
the periods presented.
Six Months Ended
December 31,
1997 1998
---------- ----------
(in thousands, except
per share amounts)
Revenues $34,728 $ 16,977
Net income (loss) $(8,021) $(13,970)
Net loss per share $ (1.27) $ (0.72)
======= ========
NOTE 5 - DEBT
Netco Acquisition Corp. ("Netco"), a wholly owned subsidiary of the
Company, defaulted on its note payable in the original principal
amount of $6.05 million during the first quarter, due to failure to
make the monthly payments beginning with the July 1998 payment. These
payment defaults were cured in September, 1998. Since September,
1998, the Company has been making interest-only payments on this loan
under an agreement with the lender. The principal amount outstanding
at June 30, 1998 is classified as Debt in Default, a current
liability. The principal amount outstanding as of December 31, 1998 of
approximately $5.5 million is classified as a Note Payable and
considered to be a long-term liability to the extent principal
payments are due in more than one year.
As of September 30, 1998, the Company was in default on its $0.4
million cash flow bridge loan obtained from Netco Acquisition, LLC, an
entity owned 50% by the Willis Group, LLC ("Willis Group"), an
affiliate of the Company, as no principal or interest payments have
been made. The principal amount is classified as Debt in Default to an
Affiliate at June 30, 1998. Effective December 31, 1998, the loan was
modified to extend its maturity to July 31, 1999, and, therefore, the
Company was not in default at the end of the current quarter.
EqualNet entered into an agreement with RFC, effective June 18, 1997,
which is essentially a receivable purchase arrangement which bases
borrowing capacity on a percentage of EqualNet's outstanding
receivables up to a maximum allowable amount of $10.0 million and
allows for the lender to cease funding of new receivables without
prior written notice at the lender's option. The program fee applied
to the outstanding balance of net purchased receivables was prime plus
4.5% per annum (13% at June 30, 1998), but changed to prime plus 7% on
September 17, 1998 (after Chapter 11 filing). As of December 31,
1998, the amount owed to RFC under this agreement is approximately $.6
million with a credit reserve of $ 30,000. This RFC agreement was
extended on July 19, 1998 and subsequently amended and approved by
EqualNet's bankruptcy court on November 23, 1998.
13
<PAGE>
On July 23, 1998, the Company entered into a Loan and Security
Agreement with RFC which was subsequently amended on September 8, 1998
(the agreement as amended, "RFC Loan"). RFC loaned the Company
approximately $1.5 million. Periodic monthly principal and interest
payments of $14,812 are due commencing on November 30, 1998. The
balance due on the RFC Loan is payable on June 30, 2000. Interest is
payable on the outstanding principal balance in an amount equal to the
prime lending rate plus 5.5%. The RFC Loan is secured by all of the
assets of the Company and the stock of EqualNet and USC Telecom. In
connection with the RFC Loan, the Company granted to RFC a warrant for
the purchase of up to 294,000 shares of Common Stock at the exercise
price equal to the arithmetic average of the closing price of the
Common Stock on Nasdaq for the three trading days immediately
preceding the consummation of the RFC Loan. The warrant expires July
23, 2003. Proceeds from the RFC Loan were primarily used to retire a
portion of the Greyrock Business Credit Loan which was owed by SA
Telecom (see below). After taking into account the discount
associated with the warrants, the RFC Loan is recorded on the
Company's books at December 31, 1998 in the amount of $1,091,873.
In connection with the July 23, 1998 SA Telecom acquisition, the
Company assumed a note payable to Greyrock Business Credit of
approximately $4.0 million. In August 1998, this loan was paid off
with the proceeds from various RFC loans and the proceeds from a new
$558,370 loan from Greyrock. The loan bears interest at a rate of
prime plus 2.5% and is secured by the assets of USC Telecom. The
principal balance of the Greyrock loan is payable on February 22,
1999. The Company is currently unable to pay the principal balance
and is in discussions with Greyrock related to amending the loan
agreement. There can be no assurance the Company will renegotiate
repayment terms with Greyrock. If Greyrock does not agree to amend
its note, the Company will default on this obligation.
In August 1998, USC Telecom entered into a receivables purchase
arrangement with RFC and used the proceeds of the initial funding of
$2.1 million to pay off a portion of the debt to Greyrock Business
Credit ("Greyrock"), which was assumed in the SA Telecom transaction.
This facility is USC Telecom's primary source of working capital. The
maximum purchase commitment amount from RFC is $4.0 million, and the
program fee is prime rate plus 4.0%. The term of the facility is two
years from the funding date. As of December 31, 1998, the amount owed
to RFC under the USC Telecom agreement was approximately $1.5 million.
On September 2, 1998, the Company executed a loan agreement in favor
of the Willis Group in the amount of $241,106. The loan documented
certain advances which the Willis Group had made on the Company's
behalf. The Willis Group loan is secured by the assets of the Company
and each of its subsidiaries. This loan bears interest at 11% and its
maturity has been extended from January 31, 1999 to July 31, 1999.
Effective July 31, 1998, the Company issued two 6% Senior Secured
Convertible Notes due in 2001 (the "2001 Notes") in the amount of $1.5
million each to the Willis Group, an affiliate of the Company, and
Genesee Fund Limited - Portfolio B ("Genesee"), a British Virgin
Islands corporation, both accredited investors. The 2001 Notes are
convertible into a variable number of shares of the Company's Common
Stock. The 2001 Notes bear interest at 6% and interest payments are
due each February 15, May 15, August 15 and November 15 commencing on
November 15,1998. The 2001 Notes were issued with an original issue
discount ("OID") in an initial amount of $100,000 for each note.
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The 2001 Notes rank equally with all other unsubordinated debt
obligations of the Company. The Company's obligations under the 2001
Notes are secured by certain collateral pursuant to security
agreements. A holder of the 2001 Note may require the Company to
repurchase the 2001 Note if an event of default occurs. Events of
default include among other things, the Nasdaq delisting of the Common
Stock.
In connection with the issuance of the 2001 Notes, the Company issued
to each of the Willis Group and Genesee a warrant ("Warrant") to
purchase 333,116 shares of Common Stock at a purchase price of $0.9006
per share. The Warrants expire on September 4, 2003. After taking
into account the OID and an allocation of the purchase price to the
Warrants, the 2001 Notes are recorded on the Company's December 31,
1998 Balance Sheet in the amount of $2.5 million. As explained below,
the 2001 Notes are convertible to Common Stock at a discount to
market. The net conversion discount of $0.5 million is recorded to
interest expense and paid in capital.
Any holder of a 2001 Note may convert the 2001 Note, in whole or in
part, into shares of Common Stock at a conversion price per share
equal to the lesser of:
The product of (1) the average of the lowest sales price
of the Company's Common Stock on Nasdaq for the five days
immediately preceding the date of conversion and (2) 85%
(subject to reduction pursuant to the terms of the 2001
Notes); and
$0.9006 (subject to reduction pursuant to the terms of the
2001 Notes).
The Note Agreements are being submitted to the shareholders for
approval and ratification at the annual meeting of the shareholders
tentatively scheduled in May, 1999. This is being done to comply
with rules of Nasdaq Stock Market that require such approval for any
transaction involving the issuance of common stock (or securities
convertible into or exercisable for common stock) equal to 20% or more
of the issuer's outstanding common stock for less than the market
value of the common stock.
If the Note Agreements are not ratified by the shareholders at the
Meeting, the holders of the 2001 Notes and the Series D Preferred
Stock will have the right to require the Company to redeem, at a 15%
premium, all of the 2001 Notes and the Series D Preferred Stock. The
payment of the entire principal amount of the 2001 Notes and the
entire value of the outstanding Series D Preferred Stock, and the 15%
premium thereon, would have a material adverse effect on the Company's
financial condition. The Company may not have adequate funds to
effect any such redemption. If the Company is required to effect such
redemption, the Company may be forced to seek protection under the
United States bankruptcy laws.
NOTE 6 - SERIES D PREFERRED STOCK
In connection with the 2001 Notes transaction, the Company issued to
certain buyers, in the aggregate, approximately 3,750 shares of Series
D Preferred Stock in exchange for, in the aggregate, 3,000,000 shares
of Common Stock and exchange fees of, in the aggregate, $200,000.
Each share of Series D Preferred Stock will be entitled to receive
dividends at a rate of $60 per share per year, payable in cash or
additional shares of Series D Preferred Stock.
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Holders of shares of Series D Preferred Stock have the right to
convert each of their shares into a number of shares of Common Stock
equal to the quotient of:
the sum of (1) $1,000 (subject to adjustment pursuant to
the Series D Preferred Stock documents), (2) accrued but
unpaid dividends to the applicable conversion date on the
share of Series D Preferred Stock being converted and (3)
accrued but unpaid interest on the dividends on the share
of Series D Preferred Stock being converted; and
an amount equal to the lesser of:
the product of (1) the average of the lowest sales
price of the Common Stock on Nasdaq for any five
trading days during the 25 trading days immediately
preceding the conversion date and (2) 85% (subject to
downward adjustment, if applicable, pursuant to the
Series D Preferred Stock documents); and
$1.2281 (subject to reduction pursuant to the Series
D Preferred Stock documents),
subject to adjustment pursuant to the anti-dilution provisions.
The Company has the option to redeem any of the shares of Series D
Preferred Stock which has not been previously converted at a
redemption price determined by a formula which includes a substantial
premium to the underlying liquidation preference. The Series D
Preferred Stock has a liquidation preference equal to $1,000 (plus
accrued and unpaid dividends plus interest thereon) per share of
Series D Preferred Stock.
The Series D Preferred shareholders can require the Company to redeem
all shares if any of a number of events occur. The Series D Preferred
shareholders have agreed to waive certain redemption rights effective
September 30, 1998, to allow the Series D Preferred Stock to be
classified as equity on the Company's Balance Sheet as of December 31,
1998. The Company has recorded $1.9 million of Series D Preferred
Stock as of December 31, 1998. This amount was equal to the exchange
fees plus the product of 3,000,000 shares of Common Stock exchanged in
the transaction multiplied by the closing price per share of Common
Stock on the date of the exchange plus the value of 44 shares issued
as a dividend on November 15, 1998.
NOTE 7 - INCOME TAXES
The Company recorded a valuation allowance amounting to the entire net
deferred tax asset balance at December 31, 1998, due to operating
losses which give rise to uncertainty as to whether the deferred tax
asset is realizable. The Company has recorded no income tax benefit
for the period ended December 31, 1998.
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NOTE 8 - LIQUIDITY AND WORKING CAPITAL DEFICIT
The Company's sole current source of capital is provided by receivable
sales agreements with RFC. The Company's two operating subsidiaries,
EqualNet and USC Telecom, have accounts receivable purchase agreements
with RFC. Funding under these agreements are based on specific
accounts receivable eligibility requirements with the primary factor
being the collections history per account. Funding percentages have
declined during the quarter due to billing delays, errors in bills and
related collections problems.
The Company continues to incur operating deficits and is exploring
ways to increase revenue and reduce operating costs. To operate
profitably, the Company must reduce its variable long-distance carrier
costs, right-size and make efficient its back office and
administrative operations and increase revenues by implementing new
sales and marketing plans. In addition, the Company intends to
continue its strategy to acquire distressed companies, substantially
eliminate their overhead, and therefore recognize positive cash flow
from the acquired assets.
The Company recently completed the acquisitions of ACMI and BCI (see
Note 10). The Company expects to immediately generate a profit from
the former BCI customer base. The ACMI acquisition provides sales and
marketing activities the Company needs to replace its eroding customer
base. ACMI is a network marketing company with over 2,500 agents who
will be selling the Company's long distance and other
telecommunications services. The Company has also initiated an
inbound telemarketing program using the distribution of debit cards as
the mechanism to generate incoming calls.
The Company intends to simplify its operations once EqualNet emerges
from bankruptcy. Eliminating the duplicate costs associated with
having two long distance carriers (i.e., USC Telecom and EqualNet)
could be accomplished after the bankruptcy plan is consummated. The
Company has recently hired members of management who are capable of
assessing long distance carrier costs and identifying alternatives to
reduce the Company's cost of service.
The Company continues to develop its strategy and is considering a
number of alternatives including expanding its service offerings to
include a number of bundled telecommunications services.
There can be no assurance the Company will have the capital resource
necessary to implement these measures and return to profitability. It
is highly likely the Company will need additional capital to continue
in business during its restructuring phase.
NOTE 9 - COMMITMENTS AND CONTINGENCIES
At September 30, 1998 EqualNet had an agreement with AT&T which was
scheduled to expire in April 2000. The agreement covered the pricing
of the services and established minimum semi-annual revenue
commitments ("MSARCs") which must be met to receive the contractual
price and to avoid shortfall penalties. The commitment with AT&T was
segregated into components differentiated by the type of traffic.
EqualNet estimated its shortfall position to be approximately $11.6
million at the end of the third MSARC period in October 1998. As a
result of the contract termination, EqualNet may be liable for the
total amount of the unsatisfied MSARC for the period in which the
discontinuance occurs and for 50% of the MSARCs for each semi-annual
period remaining in the contract tariff term, which amounts to an
estimate of $29.1 million.
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Effective October 31, 1998, EqualNet rejected its contract with AT&T.
Any liabilities for MSARC relating to periods after the rejection date
will likely be treated in the bankruptcy as pre-petition unsecured
indebtedness. Due to the amount of EqualNet's secured indebtedness
(approximately $16.0 million), it is unlikely AT&T would realize
significant benefits even if it does assert its claim for additional
MSARC payments.
On October 31, 1998, EqualNet entered into a switchless resale
operator agreement with U.S. Republic Communications, Inc. ("U.S.
Republic"). As a result of this agreement, EqualNet was able to
replace its AT&T contract, which was rejected in bankruptcy, with a
wholesale carrier agreement with U.S. Republic. This was a seamless
transition for EqualNet's customers since U.S. Republic provides its
carrier services on the AT&T network. The term of the agreement is
month-to-month and there are no MSARC requirements. EqualNet is
required to prepay for services provided by U.S. Republic and has
entered into an agreement whereby RFC remits funds directly to U.S.
Republic.
In August, 1998, the Company executed a telecommunications services
agreement with Frontier Communications of the West, Inc. ("Frontier").
The Company's operating subsidiaries are utilizing this switchless
resale agreement to provide services to a portion of their customers.
Beginning in December, 1998, this contract requires an MSARC of
$250,000 per month. The Company believes it will meet this MSARC
requirement throughout the term of the agreement which extends to
September, 2000. Frontier received a subordinated security interest
in the customers of the Company as collateral for the extension of
credit under this agreement.
From time to time the Company is involved in what it believes to be
routine litigation or other legal proceedings that may be considered
as part of the ordinary course of its business.
On August 7, 1998, Robert H. Turner ("Turner") filed suit against the
Company, Mark A. Willis and Willis Group, LLC in the 61st District
Court of Harris County, Texas in case number 98-37682 alleging an
unspecified amount of damages based upon an alleged breach of his
employment contract and other claims. The Company vehemently denies
any wrongdoing or liability in the matter, and intends to vigorously
defend itself in this action. Since no significant discovery has
taken place in this matter, it is impossible to state with any degree
of certainty the amount of damages, if any, that the Company may
incur, or if it will be successful in asserting any cross claims or
counterclaims it may have in connection with the employment of Turner.
On August 13, 1998, Steverson & Company, Inc. filed suit against the
Company in case number 704,244 in the County Civil Court at Law Number
2 of Harris County Texas seeking damages in the amount of $22,892.78
plus attorneys fees and court costs. The Company maintains that these
charges were for temporary services personnel utilized by EqualNet,
and not the Company. The invoices are addressed to EqualNet
Communications, the former name of EqualNet Corporation before its
name change on November 28, 1994. The dates on the invoices run from
June 16, 1998 through August 11, 1998. EqualNet Holding Corp. did not
formally change its name to Equalnet Communications Corp. until June
30, 1998. Due to the fact that these charges may be a claim in the
bankruptcy proceedings of EqualNet discussed below, it is impossible
at this time to state with any degree of certainty the ultimate
exposure of either the Company or EqualNet in this matter.
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On August 13, 1998, Centillion Data Systems, Inc. filed suit against
EqualNet in case number 49D029808CP001147 in the Superior Court of
Marion County, Indiana, seeking damages in the amount of $115,490.50
for billing and other services allegedly provided to EqualNet, plus
interest, attorneys fees and court costs. The fact that these charges
are a claim in the bankruptcy proceedings of EqualNet discussed below
make it impossible at this time to state with any degree of certainty
the ultimate exposure of EqualNet in this matter.
On September 3, 1998, the Company received a demand from New Boston
Systems through their attorneys, Steadman & Steele, for the payment of
placement fees for personnel hired by EqualNet. Although New Boston
System's engagement letter was with the Company, the personnel it
placed were hired as employees of EqualNet. It is the position of the
Company that any payment due to New Boston Systems would be due from
EqualNet and not the Company. The amount claimed as due to New Boston
Systems is $10,526.25.
On September 15, 1998, Technigrafiks, Inc. filed suit against EqualNet
dba Creative Communications in case number 705,562 in the County Civil
Court at Law Number 1 of Harris County, Texas, seeking damages in the
amount of $24,399 for the printing of plastic cards for debit card
sales, plus interest, attorneys fees and court costs. The fact that
these charges are a claim in the bankruptcy proceedings of EqualNet
discussed below make it impossible at this time to state with any
degree of certainty the ultimate exposure of EqualNet in this matter.
On September 17, 1998, KISS Catalog Ltd. filed suit against the
Company as assignee from Creative Communications International, Inc.
of certain contract rights from KISS Catalog Ltd. in case number 98
CIV. 6570 in the United States District Court for the Southern
District of New York, seeking payment of $100,000 in license fees,
attorneys fees, and any royalties which may be owing under the license
agreement. In 1996, the Company agreed to assume the obligations
under a merchandising license agreement, including the obligation to
make payments of royalties and license fees, with a minimum guarantee
royalty fee of $100,000 and a license fee of $150,000. Payments of
the minimum guarantee of $100,000 and $50,000 of the license fee were
made. Payment of the remaining $100,000 of the license fee has not
been made.
On September 17, 1998, Comerica Leasing Corporation filed suit in the
270th District Court of Harris County, Texas in case number 98-44481
against the Company and EqualNet for breach of a settlement agreement
arising out of previous litigation for the enforcement of equipment
and office furnishings leases filed on February 12, 1998 in the 157th
District Court of Harris County, Texas in case number 98-06841. A
settlement agreement was entered into by the parties dismissing the
earlier litigation and adding the Company as an obligor for the
payment of the settlement amounts. The remaining amounts due under
the settlement agreement and remaining lease obligations represent an
amount in excess of $1,000,000.
On September 21, 1998, Cyberserve, Inc., WSHS Enterprises, Inc. and
William Stuart (collectively "Bluegate") filed suit in the 215th
District Court of Harris County, Texas in case number 98-45115 against
the Company, Willis Group, LLC, Mark A. Willis, and Netco Acquisition
LLC alleging damages for breach of contract, breach of an employment
agreement, fraud and fraud in the inducement, statutory fraud in a
stock transaction, tortious interference with a contract, conspiracy,
and quantum meruit. The matters complained of originated with a
letter of intent dated on or about October 28, 1997,
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wherein the Company proposed the purchase of certain assets of
Cyberserve, Inc. and WSHS Enterprises, Inc. subject to the performance
of due diligence by the parties. Bluegate and certain of its
shareholders had threatened to sue the Company in the event the
proposed transaction was not consummated substantially in conformity
with the terms set forth in the Letter of Intent. The damages Bluegate
alleges it incurred were as a result of, among other things, the
claimed modification of its business to its detriment in anticipation
of the integration of its operations with those of EqualNet. It is
impossible to determine with any degree of certainty what, if any,
liability EqualNet, or any of its subsidiaries, may incur in this
matter. The total amount of damages are unspecified, but include a
demand for a cash payment of $685,000, a sufficient number of shares
of Common Stock of the Company for the payment of $585,000, an
additional 525,000 shares of Common Stock, and other damages. The
Company vehemently denies any wrongdoing or liability in this matter
and intends to vigorously defend itself against all claims of the
plaintiffs.
On September 29, 1998, SA Telecommunications Incorporated asserted
claims pursuant to the Purchase Agreement against USC Telecom, Inc.
and the Company for (i) $654,934 in operating losses for the period
from April 1 through July 22, 1998, (ii) $278,377 for damages for
delayed or unbillable revenue through USBI/ZPDI, (iii) reimbursement
of $8,149 for switch site leases, (iv) payment of Specified Network
Contracts Liabilities (amount not specified), (v) delivery of 5,358
shares of Series C Preferred escrowed at closing, and (vi) for return
of certain leased equipment not owned by SA Telecommunications but
previously in its possession and allegedly removed by EqualNet or USC
Telecom. On December 28, 1998, the court signed an order approving SA
Telecom's claims in the amount of $812,772. The Company and USC
Telecom disputed the monetary claims asserted by SA Telecommunications
in its demand and have filed a notice of appeal of the court's order
in these proceedings.
During the past several months, EqualNet and the Company have
experienced severe liquidity problems and have received numerous
notices of default in payment of trade creditors and other financial
obligations. For example and without providing an exhaustive list,
EqualNet has received notice of default of its agent agreements with
Walker Direct, Inc., Future Telecom Networks, Inc., Global Pacific
Telecom, Inc. and others, making demand for the payment of commissions
due and for mediation pursuant to the terms of their agent agreements.
Netco Acquisition LLC presented a notice dated August 25, 1998 under
the terms of the Tri-Party Agreement and Assignment dated January 20,
1998 between Netco Acquisition LLC, EqualNet Corporation and
Cyberserve, Inc. that EqualNet had defaulted in the repayment of its
$400,000 promissory note, and as a result, it was enforcing its rights
to foreclose on the web page customer base of EqualNet. In additional
EqualNet defaulted in making timely payments under the $1,183,059.03
promissory note payable to Sprint Communications Company L.P., in the
timely payments to AT&T Corp., Premier Communications and MCI WorldCom
for carrier services. In addition, EqualNet received notice it was in
default of its lease agreement with Caroline Partners Ltd., the
landlord for the office space occupied by the Company and its
subsidiaries, and that the landlord had exercised its right to offset
rents due against the letter of credit EqualNet has provided as a
security deposit for the landlord's benefit. Norwest Equipment
Finance, Inc. has notified EqualNet of its default in the payment for
leased furniture currently being utilized by EqualNet in the operation
of its business. The remaining amount owed under such lease is in
excess of $100,000. The bankruptcy proceedings of EqualNet discussed
below make it impossible at this time to state with any degree of
certainty the ultimate exposure of EqualNet in these matters.
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As a result of the liquidity problems listed in the foregoing
paragraph and other matters, on September 10, 1998, EqualNet filed for
protection under Chapter 11 of Title 11 of the United States Code, in
case number 98-39561-H5-11 in the United States District Court for the
Southern District of Texas and Wholesale filed for protection under
Chapter 11 of Title 11 of the United States Code, in case number
98-39560-H4-11 in the United States District Court for the Southern
District of Texas. On October 2, 1998, Wholesale filed a motion
seeking to convert its Chapter 11 reorganization proceeding to a
Chapter 7 liquidation proceeding. It is impossible to state at this
time whether or not EqualNet as a debtor in bankruptcy will be able to
reorganize its liabilities or to confirm a plan of reorganization in
bankruptcy.
NOTE 10 - SUBSEQUENT EVENTS
The Company's Common Stock currently trades on Nasdaq. If the Company
fails to maintain the minimum bid price or the minimum tangible assets
requirements of Nasdaq, the Common Stock could be subject to delisting
therefrom. On September 30, 1998, Nasdaq notified the Company it
would be delisted on December 31, 1998 if its average closing bid
price does not equal or exceed the $1.00 minimum bid price requirement
for a minimum of ten consecutive trading days during the 90 day period
ending December 29, 1998. On October 8, 1998, Nasdaq also notified
the Company that it would be delisted if the market value of its
public float was not equal to or greater than $5.0 million for a
minimum of ten consecutive trading days during the period from October
9, 1998 to January 6, 1999.
On October 16, 1998, based on the Company's financial position at June
30, 1998, the Nasdaq Stock Market, Inc. ("Nasdaq") also notified the
Company that the Company was not in compliance with Nasdaq's tangible
net assets requirements. Nasdaq informed the Company that failure to
comply with this requirement could result in the removal of the
Company's stock from trading on the Nasdaq National Market. Nasdaq
also requested additional information regarding the Company's plan to
achieve compliance with Nasdaq National Market listing requirements.
As of December 31, 1998, the Company was again not in compliance with
Nasdaq's tangible net assets requirements.
The Company submitted its plan to comply with the tangible assets
requirements in January, 1999. On February 4, 1999, Nasdaq held an
oral hearing in the matter of the continued listing of the Company,
and at such time the Company was in compliance with both the minimum
bid price and the minimum market value of public float requirements.
As of this date, Nasdaq has not ruled in the Company's continued
listing. If Nasdaq rules against the Company, the Company's common
stock will immediately be delisted without any required notification
to the Company.
If the Company can not comply with Nasdaq's continued listing
requirements then the Company's common stock would be subject to being
removed from trading on the Nasdaq National Market. Although trading
in the Company's stock could continue on the Over-the-Counter Bulletin
Board of the National Association of Securities Dealers (the "OTC"),
such Nasdaq delisting could have an adverse effect on the liquidity of
the Company's Common Stock.
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In January, 1999, the Company's newly formed wholly owned subsidiary,
ACMI Acquisition Corp. ("ACMI Acquisition") acquired substantially all
of the assets of Limit, LLC d/b/a ACMI ("ACMI"), a network marketing
company with approximately 2,500 independent agents. The Company
issued 1 million shares of Common Stock to ACMI and ACMI Acquisition
assumed a note payable of $1 million. In addition, the Company is
required to issue up to an additional 1.5 million shares of Common
Stock if ACMI generates $670,000 per month of revenue from new
customers within six (6) months of the closing date. If new customer
revenues are less than $670,000 per month at the end of the six (6)
month period, then the number of additional shares issuable will be
prorated based on the percentage of actual monthly revenue to
$670,000. In the event the Company's Common Stock's average closing
price is below seventy-five cents (75c) per share for the period
between 150 and 180 days after the closing date, additional Common
Stock is issuable to ACMI.
In addition to the foregoing, ACMI is entitled to earn more Common
Stock ("Earn Out Shares") if it attains certain performance measures
based on sales at the end of each year over a three year period. AMCI
is not entitled to any Earn Out Shares if its revenues for an twelve
month period are less than $2.5 million.
On October 19, 1998, the Company signed an agreement with S4
Communications Corporation ("S4") to acquire all of the equity
interest of S4. S4 is a provider of telecommunications services in
the Chicago, Illinois area. Closing of the transaction was subject to
the satisfactory completion of due diligence. This transaction is
currently being renegotiated and there can be no assurance it will
ultimately close.
On January 27, 1999, USC Telecom purchased substantially all of the
assets of Brittan Communications International Corporation ("BCI")
from BCI's secured lender in a foreclosure sale. USC Telecom
primarily acquired BCI's customer base which consisted of
approximately 80,000 residential long distance telephone customers.
In the transaction, USC Telecom assumed a $1.5 million term loan,
BCI's obligation under its receivable funding agreement which had a
net value of approximately $5 million on the closing date, and BCI's
obligations under its billing agreement. The Company also issued
300,000 warrants to the secured lender which entitle the holder to
purchase 300,000 shares of Common Stock at $1.33 per share during a
five year period.
On January 10, 1999, EqualNet filed a Disclosure Statement with the
bankruptcy court which included a proposed plan of reorganization.
Subsequently, EqualNet has been negotiating the terms of the
reorganization with the committee of unsecured creditors. Based on
these negotiations, EqualNet filed an amended Disclosure Statement on
February 9, 1999, which it believes contains a reorganization plan
that is acceptable to the unsecured creditors of EqualNet. The
revised reorganization plan proposes to pay $1.1 million plus issue $3
million in Common Stock to EqualNet's unsecured creditors. If the
plan is approved, EqualNet will be relieved of approximately $15
million in debt. The Company must raise at least $3 million in equity
to consummate this plan. A bankruptcy court hearing is scheduled on
March 1, 1999 to consider the disclosure statement for EqualNet's plan
of reorganization. There can be no assurance that a reorganization
plan will be confirmed.
On January 21, 1999, the Company entered into a subscription agreement
with Kevin Pirolo whereby Mr. Pirolo committed to purchase $2 million
of Common Stock of the Company at a purchase price per share equal to
90% of the average closing price of the shares of Common Stock for the
ten (10) trading days prior to the date of the confirmation of the
plan of reorganization of EqualNet. This subscription is subject to
the confirmation of plan of reorganization of EqualNet and the
continued listing of the Company's Common Stock on the Nasdaq National
Market.
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On February 5, 1999, the Company entered into a subscription agreement
with LaMonda Management Family Limited Partnership ("LaMonda").
LaMonda has committed to purchase 500,000 shares of the Company's
Common Stock, warrants to purchase 50,000 shares of Common Stock at
$1.00 per share, warrants to purchase 50,000 shares of Common Stock at
$1.50 per share, and warrants to purchase 50,000 shares of Common
Stock at $2.00 per share for an aggregate purchase price of $.5
million. $75,000 of the subscription was funded on February 8, 1999,
with the balance of the commitment to be funded on March 4, 1999. The
Company is obligated to furnish one-half of the consideration to
Intelesis Group, Inc. in exchange for an equity interest in Intelesis
Group Inc.
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NOTE 11 - FIXED ASSETS
During fiscal year 1998, the Company acquired nine telecommunications
switches (the "Switches") from the Willis Group, LLC ("Willis Group")
for $7.6 million of aggregate consideration. In a related
transaction, the Company acquired Netco, a corporation controlled by
the Willis Group, which held certain intangible rights related to the
operation of the Switches and assets previously acquired by the Willis
Group. The Company acquired Netco for $5.6 million in aggregate
consideration. As a result of these two transactions, the Company
recorded $13.2 million as its cost basis of the Switches and related
network. The Company incurred additional direct cost to purchase,
install and implement the Switches and related network of
approximately $1 million which have been capitalized as cost of the
Switches and related network.
Netco, the owner of the Switches, subsequently entered into an
agreement with EqualNet whereby EqualNet assumed the operating
responsibilities of the Switches. EqualNet
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incurred substantial costs in the fourth quarter of fiscal 1998 in
extending the network's access to most of the large metropolitan areas
in the United States in anticipation of a national marketing effort.
This marketing effort did not produce a significant number of sales
due to EqualNet's internal provisioning problems and the lack of
sufficient capital. Utilization of the Switches and national network
without sufficient traffic to support the fixed costs created negative
operating margins and created an event that indicated the $14.2
million asset might be impaired.
In October, 1998, EqualNet completed the process of turning off the
Switches and network in an effort to reduce significant fixed charges.
At that time, the Company intended to reconfigure the network in Texas
and Southern California to improve operating margins on customers
located in those geographical areas. The Company has not, however,
completed this reconfiguration as it has not consummated certain
carrier agreements which are needed to originate or terminate calls
from the Switches. The Company has started a program to partition or
lease ports on the Switches to other carriers. The Company has
entered into one agreement to partition approximately 110 ports from
its Texas Switches. The entire network of Switches has over 1,400
ports.
At the end of calendar year 1998, the Company classified the Switches
and network as operating assets and has supported the carrying value
of the assets through a projected undiscounted cash flow analysis
based on partitioning ports as discussed above. Additionally, as part
of the plan of reorganization and plan to return the Company to
profitability, the Company will continue to evaluate the best economic
use of the Switches and related network. As part of this continued
evaluation, the Company may elect to sell all or a portion of the
Switches and related network. Management believes that the carrying
value of the assets will be realized through the operations of the
assets or a combination of operating the assets and potential sale of
the assets. However, it is reasonably possible that the undiscounted
cash flows may change in the near future resulting in the need to
write-down those assets to fair value.
25
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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
The following discussion of operations and financial condition of the Company
should be read in conjunction with the Financial Statements and Notes thereto
included elsewhere in this Quarterly Report on Form 10-Q. Special Note:
Certain statements set forth below constitute "forward-looking statements"
within the meaning of Section 27A of the Securities Act of 1933, as amended,
and the Securities Exchange Act of 1934, as amended. See "Special Note
Regarding Forward-Looking Statements" and "Cautionary Statements".
Results of Operations
Sales for the three months ended December 31, 1998 increased 17% to $7.6
million compared to sales of $6.5 million for the same period of the prior
year. Gross margin decreased during the current quarter to a deficit of $1.8
million compared to a positive gross margin of $1.7 million for the same
period of the prior year. The net loss for the three months ended December 31,
1998, was $7.9 million and included no tax benefit. The net loss for the
corresponding period in the previous year was $2.2 million and included no tax
benefit. The net loss for the three month period ended December 31, 1998
includes the write off of approximately $3.3 million of accounts receivable.
The following table sets forth for the fiscal periods indicating the
percentages of total sales represented by certain items reflected in the
Company's consolidated statements of income:
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<PAGE>
<TABLE>
<CAPTION>
Three Months Ended Six Months Ended
December 31, December 31,
1997 1998 1997 1998
------- ------- -------- --------
<S> <C> <C> <C> <C>
100.0% 100.0% 100.0% 100.0%
Cost of revenues 73.0% 124.2% 74.2% 108.4%
------- ------- ------- -------
Gross margin 27.0% (24.2%) 25.8% (8.4%)
Selling, general & administrative expenses 39.9% 33.7% 35.5% 38.5%
Depreciation and amortization 16.1% 38.3% 14.6% 32.0%
------- ------- ------- -------
Operating income (loss) (29.0%) (96.2%) (24.3%) (78.9%)
Other income (expense)
Interest income 0.0% 0.0% 0.0% 0.0%
Interest expense (6.6%) (6.9%) (5.3%) (8.3%)
Miscellaneous 2.0% 0.0% 0.7% 0.1%
------- ------- ------- -------
(4.6%) (6.9%) (4.6%) (8.2%)
Loss before federal income taxes
and reorganization cost (33.6%) (103.1%) (28.9%) (87.1%)
Provision for federal income taxes 0.0% 0.0% 0.0% 0.0%
------- ------- ------- -------
Net Loss before reorganization costs (33.6%) (103.1%) (28.9%) (87.1%)
Reorganization costs 0.0% (0.9%) 0.0% (0.9%)
------- ------- ------- -------
Net Loss (33.6%) (104.0%) (28.9%) (88.0%)
======= ======= ======= =======
</TABLE>
Sales
-----
The Company's sales in the three months ended December 31, 1998 increased to
$7.6 million compared to $6.5 million for the comparable period of the prior
year. For the six months ended December 31, 1998, sales increased 8.1% to
$16.0 million compared to $14.8 million for the same period in the previous
year. During the current quarter, the Company reported sales of $3.8 million
related to the customers acquired on July 23, 1998 from SA Telecom. Excluding
sales from the acquired customers, the Company's sales decreased 42.5% to $3.8
million in the current quarter compared to $6.5 million for the comparable
period of the prior year. Total billable minutes for the quarter ended
December 31, 1998 increased 100% to 40.4 million minutes from 20.2 million
minutes for the same period of the prior year. During the current quarter,
24.1 million billable minutes were attributable to the SA Telecom customers.
Total billable minutes for the six month period ended December 31, 1998
increased 59.7% to 79.4 million minutes from 49.7 million in the same period
last year.
The decline in revenues and billable minutes of the Company's historical
customer base, exclusive of the SA Telecom customers, was the result of the
continued rate of attrition for existing customers and a decline in sales and
marketing efforts. The Company's continuing liquidity problems during this
time frame have not allowed for the funding of any significant marketing
activities.
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<PAGE>
Cost of Sales
The cost of sales for the three months ended December 31, 1998, increased
102.1% to $9.5 million compared to $4.7 million for the comparable period of
the prior year. The current quarter increase was primarily attributable to a
write off of accounts receivable in the current quarter of $3.3 million. Cost
of sales for the six months ended December 31, 1998 increased 57.8% to $17.3
million compared to $11.0 million for the same period last year. Excluding
the accounts receivable write off, cost of sales as a percentage of sales
increased to 80.9% for the three months ended December 31, 1998, from 73.0%
for the corresponding period in the previous year. The primary cause of this
increase of cost of sales as a percentage of sales, relates to lower rates per
billed minute for the acquired SA Telecom customer base as compared to the
Company's historical customer base.
The Company's cost of long-distance (which is a component of cost of sales)
increased as a percentage of sales to 69.0% and 70.9% from 52.0% and 53.4% for
the three and six months ended December 31, 1998 and 1997, respectively. The
increase in the percentage in the fiscal year is the result of the costs
associated with the Company's network of switches ("Network") and higher costs
related to SA Telecom customers. The cost of long distance for the SA Telecom
customer base was 73% of sales for the current quarter. The total long
distance costs during the first and second quarters of fiscal 1999 of $6.1 and
$5.3 million, respectively, includes approximately $1.7 and $.2 million,
respectively, related to the Network.
Commission expense as a percent of sales decreased to 1.8% for the second
quarter of fiscal 1999, compared to 6.9% for the second quarter of fiscal
1998. EqualNet discontinued paying commissions as a result of rejecting its
agent agreements in its bankruptcy case. Commission expenses as a percent of
sales for the six months ended December 31, 1998 was 5.0% as compared to 7.2%
in the prior period.
Billing expense as a percentage of sales decreased to 4.7% for the three
months ended December 31, 1998 compared to 8.1% for the same period in the
previous year and 5.9% for the six months ended December 31, 1998 compared to
8.3% in the same period in fiscal 1998. This is a result of the small number
of SA Telecom customers billing through Local Exchange Carriers ("LECs") as
compared to the high percentage of LEC billings by the Company's historical
customer base. Billings through the LECs represented 16.0% and 41.9% of the
Company's revenues for the three months ended December 31, 1998 and 1997,
respectively. The cost of billing through LECs is generally greater than
billing customers directly.
Bad debt expense as a percentage of sales for the three and six months ended
December 31, 1998 was 48.1% and 25.6%, respectively, as compared to 5.7% and
5.1%, respectively, for the three and six months ended December 31, 1997. The
increase resulted from a $3.3 million write off of accounts receivable in the
current quarter.
Selling, General and Administrative Expenses
Selling, general and administrative expenses of $2.6 million for the three
months ended December 31, 1998 was approximately the same amount incurred in
the same period of the prior year. Selling, general and administrative
expenses decreased as a percentage of sales to 33.7% for the three months
ended December 31, 1998, from 39.9% for the same period of the prior year. The
decrease in selling, general and administrative expenses as a percentage of
sales relates to the increase in the Company's revenues during the current
three month period. For the six months ended December 31, 1998, selling,
general and administrative expenses increased to 38.5% of sales from 35.5% of
sales for the same period last year.
28
<PAGE>
Salary expense decreased $155,973 for the quarter ended December 31, 1998,
compared to the same quarter of the previous year and increased by $174,604
for the six months ended December 31, 1998 versus the same period in 1997.
During the comparative three month periods, departmental direct expenses
including reorganization costs increased $424,000. Departmental expenses
increased by $990,000 during the six month period ended December 31, 1998
compared to the same period last year. The increase in departmental expenses
resulted in part from an increase in legal and professional fees associated
with EqualNet's bankruptcy and other transactions and registration fees
associated with USC Telecom.
Depreciation and Amortization
Depreciation and amortization increased 179.3% to $2.9 million for the quarter
ended December 31, 1998, as compared to $1.0 million for the same period in
the previous year. Depreciation and amortization expense increased 138.0% for
the six month period ended December 31, 1998 over the same period of 1997.
The increase relates to current quarter costs for depreciation of the Network
of $0.6 million and amortization of the SA Telecom customer acquisition costs
of $1.3 million. The Company did not own either of these assets during the
same period of the prior year.
Liquidity and Capital Resources
The Company utilized $749,560 in cash flow from operations for the six months
ended December 31, 1998, compared to generating $242,000 for the same period
of the prior year. Cash flow deficits in the current six months were
attributable to operating losses incurred by the Company.
Cash used in investing activities totaled $600,629 for the six months ended
December 31, 1998, compared to $74,724 for the same period of the previous
year. The primary use of cash for investing activities during the period
ended December 31, 1998, was for cash paid in connection with the SA Telecom
acquisition.
Net cash generated in financing activities was $.9 million for the six months
ended December 31, 1998, compared to the utilization of $0.9 million for the
same period of the previous year. The majority of this amount was generated
from the proceeds received from the issuance of the 2001 Notes. The Company's
declining revenue base, and the resulting reduction in receivables, have
resulted in a decrease in funds available under the Company's receivables
funding arrangement.
As more fully described in Note 5 to the Consolidated Financial Statements,
the Company is submitting to its shareholders for approval of the 2001 Note
and Series D Preferred Stock transactions. If these transactions are not
approved, the shareholders have the right to require the Company to redeem the
2001 Notes and Series D Preferred Stock. The Company does not have adequate
funds to effect such redemption.
The conversion to the IDI system has created a significant number of billing
problems including delays in mailing bills, duplicate charges, and issues
related to matching call detail records with customer accounts. The delay in
billing and corrections of bills issued in error have resulted in significant
problems in the Company's ability to collect receivables. This has created
severe cash flow problems for the Company. Although the Company is addressing
and correcting these problems, there can be no assurance these issues will be
resolved in a timely manner.
As discussed in the notes to the financial statements, the Company has
significant potential additional liabilities which might result from the
bankruptcy proceedings or reorganization. The Company currently does not have
the capital to settle these potential future liabilities. The Company will
continue to seek additional capital should these liabilities materialize.
However, no assurance can be made that such capital will be available to meet
these potential obligations and the Company may be required to seek additional
protection under the bankruptcy laws.
29
<PAGE>
YEAR 2000 READINESS DISCLOSURE
The Company's Year 2000 ("Y2K") project is intended to address potential
processing errors in computer programs that use two digits, rather than four,
to define the applicable year. The Company is providing Y2K disclosure
because its assessment of Y2K issues is not complete and because if these
issues are not resolved by its software vendors and its underlying carriers
(i.e., MCI Worldcom, AT&T, Frontier and others), it will have material adverse
consequences to the Company.
State of Readiness
The Company's Y2K issues relate primarily to its internal billing systems, the
Network and the systems of its third party carriers. The Company uses two
billing systems, the Costguard system developed by IDI, which utilizes
Microsoft's SQL Server software, and a system internally developed by BCI with
a Novell platform. The Company believes the BCI billing system is Y2K
compliant, however, the Costguard system is not Y2K compliant. The Company is
relying on IDI and Microsoft to modify these systems to be Y2K compliant.
Each of these companies is developing system modifications to be Y2K
compliant. The Company does monitor the progress of its software vendors and
anticipates receiving Y2K compliant versions of its billing software no later
than September 30, 1999.
The Company's Network comprises nine switches manufactured by Siemens Telecom
Networks ("Siemens"). These switches utilize software that is not currently
Y2K compliant. The Company has received a commitment from Siemens that it
will provide Y2K compliant software prior to the end of the calendar year
1999.
The Company provides its customers with long distance telephone services
through resale agreements with AT&T, Frontier Communications, MCI Worldcom and
Qwest Communications. These are very large public companies with the
resources necessary to develop and maintain Y2K compliant systems. The
Company monitors Y2K development activities of these companies primarily
through their public disclosures concerning Y2K.
The Company is in the process of auditing its existing computer hardware for
Y2K compliance and making required changes.
Costs
To date, the Company has not expended any money to deal with Y2K issues. It
does, however, anticipate purchasing software updates from its third party
billing system vendors to update its system to be Y2K compliant. Although the
Company has not received quotes from these vendors, it does not believe its
Y2K software upgrade costs will exceed $100,000. The Company is not obligated
to bear any costs related to the Y2K compliant costs being incurred by its
underlying carriers.
Risks
The Company is engaged in the long distance telecommunications business and,
therefore, connects directly with hundreds of other carriers. While many
carriers have announced plans to assess and remediate their networks, there is
risk that some carriers will not address or resolve Y2K issues. Failure of
these carriers to resolve Y2K issues could result in disruption of service to
the Company's customers or the inability to bill for services. These problems
could result in the Company either losing its customers or misbilling its
customers for long distance services until the problem is remediated.
30
<PAGE>
The Company's Network has an $11 million book basis as recorded on its
consolidated balance sheet at December 31, 1998. If Siemens is unable to
develop and provide the Company with Y2K compliant software, the value of the
Network will be substantially impaired.
The billing system utilized by the Company has been developed by third party
vendors and currently is not Y2K compliant. Without these billing systems,
the Company cannot bill its customers or collect for services. The inability
of these systems to function after 1999 would severely impair the Company's
ability to continue its business.
Contingency Plans
The Company is monitoring its Y2K issues relating to the progress being made
by its software vendors, Siemens and its underlying carriers. The Company
does not have any significant internally developed software required to
conduct its business, therefore, it does not require significant internal
assessment or development plans. The Company anticipates being Y2K compliant
by the end of 1999, but cannot control issues that involve other carriers and
outside vendors. The Company is monitoring Y2K issues of its carriers and
software vendors and, to the extent the Company becomes aware of Y2K
compliance problems of those companies, it intends to move its client base to
Y2K compliant carriers or purchase Y2K compliant software. There can be no
assurance that the Company will be able to utilize the services of any Y2K
compliant carrier or acquire Y2K compliant software needed to utilize its
Network or bill or service its clients.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
No significant change.
31
<PAGE>
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
From time to time the Company is involved in what it believes to be routine
litigation or other legal proceedings that may be considered as part of the
ordinary course of its business.
On September 29, 1998, SA Telecommunications Incorporated ("SA Telecom")
asserted claims pursuant to the Purchase Agreement against USC Telecom, Inc.
and the Company for (i) $654,934 in operating losses for the period from April
1 through July 22, 1998, (ii) $278,377 for damages for delayed or unbillable
revenue through USBI/ZPDI, (iii) reimbursement of $8,149 for switch site
leases, (iv) payment of Specified Network Contracts Liabilities (amount not
specified), (v) delivery of 5,358 shares of Series C Preferred escrowed at
closing, and (vi) for return of certain leased equipment not owned by SA
Telecommunications but previously in its possession and allegedly removed by
EqualNet or USC Telecom. On December 28, 1998, the court signed an order
approving SA Telecom's claims in the amount of approximately $812,772. The
Company and USC Telecom disputed each of the claims asserted by SA
Telecommunications in its demand and have filed a notice of appeal of the
court's order in these proceedings.
On September 10, 1998, EqualNet filed for protection under Chapter 11 of Title
11 of the United States Code, in case number 98-39561-H5-11 in the United
States District Court for the Southern District of Texas and Wholesale filed
for protection under Chapter 11 of Title 11 of the United States Code, in case
number 98-39560-H4-11 in the United States District Court for the Southern
District of Texas. On October 2, 1998, Wholesale filed a motion seeking to
convert its Chapter 11 reorganization proceeding to a Chapter 7 liquidation
proceeding. It is impossible to state at this time whether or not EqualNet as
a debtor in bankruptcy will be able to reorganize its liabilities or to
confirm a plan of reorganization in bankruptcy.
ITEM 2. CHANGES IN SECURITIES
On July 23, 1998, the Company issued to RFC Capital Corporation a warrant for
the purchase of 294,000 shares of Common Stock at an exercise price of
approximately $1.83 per share, subject to adjustment (the "RFC Warrant"). The
RFC Warrant is exercisable for five years. The RFC Warrant was issued in
connection with a loan transaction pursuant to which the Company received a
loan in the aggregate amount of approximately $1.5 million.
Effective July 31, 1998, the Company issued two 6% Senior Secured Convertible
Notes due in 2001 (the "2001 Notes") in the amount of $1.5 million each to
Willis Group LLC and Genesee Fund Limited-Portfolio B ("Genesee"), both
accredited investors. The 2001 Notes are convertible into a variable number
of shares of the Company's Common Stock. Ownership percentage upon conversion
is currently limited to no more than 4.9% of the outstanding shares of Common
Stock. The 2001 Notes bear interest at 6% and interest payments are due each
February 15, May 15, August 15 and November 15 commencing on November 15,
1998; such interest may be paid in the form of cash or by the issuance of
additional notes.
Any holder of a 2001 Note may convert the 2001 Note, in whole or in part, into
shares of Common Stock at a conversion price per share equal to the lesser of:
the product of (1) the average of the lowest sales price of the Company's
Common Stock on Nasdaq for the five days immediately preceding the date
of conversion and (2) 85% (subject to reduction pursuant to the terms of
the 2001 Notes); and
32
<PAGE>
$0.9006 (subject to reduction pursuant to the terms of the 2001 Notes).
In connection with the issuance of the 2001 Notes, the Company issued to each
of Willis Group LLC and Genesee a warrant (each, a "Warrant," and
collectively, the "Warrants") to purchase 333,116 shares of Common Stock at a
purchase price of $0.9006 per share, subject to adjustments. The Warrants are
exercisable for five years. In addition, the Company issued to Willis Group
LLC and Advantage Fund Limited, an accredited investor, 3,750 shares of its
Series D Convertible Preferred Stock ("Series D Preferred").
Each share of Series D Preferred will be entitled to receive dividends at a
rate of $60.00 per share per year, payable if declared by the Board of
Directors. Any dividends that accrue on the Series D Preferred may be paid,
at the Company's option (subject to certain limitations), in cash or, in whole
or in part, by issuing additional shares of Series D Preferred. Under the
terms of the Series D Preferred, the Company cannot declare or distribute any
dividends to holders of Common Stock unless all dividends on the Series D
Preferred have been paid.
Holders of shares of Series D Preferred will have the right to convert each of
their shares into a number of shares of Common Stock equal to the quotient of:
the sum of (1) $1,000 (subject to adjustment pursuant to the Series D
Preferred documents), (2) accrued but unpaid dividends to the applicable
conversion date on the share of Series D Preferred being converted and
(3) accrued but unpaid interest on the dividends on the share of Series D
Preferred being converted; and
an amount equal to the lesser of:
the product of (1) the average of the lowest sales price of the
Common Stock on Nasdaq for any 5 trading days during the 25 trading
days immediately preceding the conversion date and (2) 85% (subject
to downward adjustment, if applicable, pursuant to the Series D
Preferred documents); and
$1.2281 (subject to reduction pursuant to the Series D Preferred
documents), subject to adjustment pursuant to the anti-dilution
provisions.
The 2001 Notes, the Warrants and the Series D Preferred were issued in
exchange for aggregate consideration of $3,000,000 and 3,000,000 shares of
Common Stock. The Company has reserved an aggregate of 13,043,468 shares of
Common Stock for issuance upon conversion of the 2001 Notes and the Series D
Preferred and exercise of the Warrants and 294,000 shares of Common Stock for
issuance upon the exercise of the RFC Warrant.
The Company believes that the offering and sale of each of the 2001 Notes, the
Series D Preferred, the Warrants and the RFC Warrant is exempt from
registration under Section 4(2) of the Securities Act of 1933, as amended.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
The Company has agreed to enter into an Amendment Agreement, to be dated as of
July 31, 1998, with MCM Partners, the holder of the Company's Series A
Convertible Preferred Stock. Under the Amendment Agreement, MCM Partners will
waive its right to receive existing accrued and unpaid dividends on the Series
A Preferred in consideration for an amendment to the terms of the Series A
Preferred Stock to be submitted for approval by the Company's shareholders at
the annual meeting of shareholders with respect to fiscal year 1998.
33
<PAGE>
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS:
This Quarterly Report on Form 10-Q includes "forward-looking statements"
within the meaning of Section 27A of the Securities Act of 1933, as amended,
and Section 21E of the Securities Exchange Act of 1934, as amended (the
"Exchange Act"). All statements other than statements of historical facts
included in this report, including without limitation, statements regarding
the Company's financial position, business strategy, products, products under
development, markets, budgets and plans and objectives of management for
future operations, are forward-looking statements. Although the Company
believes that the expectation of such forward-looking statements are
reasonable, it can give no assurance that such expectations will prove to have
been correct. Important factors that could cause actual results to differ
materially from the Company's expectations ("Cautionary Statements") are
disclosed under "Cautionary Statements" and elsewhere in this Report,
including, without limitation, in conjunction with the forward-looking
statements included in this Report. All subsequent written and oral forward-
looking statements attributable to the Company, or persons on its behalf, are
expressly qualified in their entirety by the Cautionary Statements.
CAUTIONARY STATEMENTS:
See "Special Note Regarding Forward-Looking Statements".
NO ASSURANCE OF ADDITIONAL NECESSARY CAPITAL - EqualNet and Wholesale filed
for Chapter 11 protection in September of 1998. The Company will need
additional capital to obtain the creditor's approval of a plan of
reorganization for EqualNet. In addition, it is likely that additional
capital may be needed to fund operating deficits of the Company's other
subsidiaries during the foreseeable future. Although the Company has no
current funding sources, it believes it can attract additional funding if it
is able to reduce the liabilities of EqualNet through the plan of
reorganization. There can be no assurances that the Company will be able to
obtain the necessary capital or sufficiently reduce EqualNet's liabilities to
continue to operate the Company.
ATTRITION RATES - In the event the Company experiences attrition rates in
excess of those anticipated either as a result of increased provisioning times
by its underlying carrier, the purchase of poorly performing traffic, or the
inability to properly manage the existing customer base, additional charges
that affect earnings may be incurred.
DEPENDENCE ON INDEPENDENT MARKETING AGENTS - USC Telecom has a small internal
sales force and obtains the majority of its new customers from independent
marketing agents ("Agents"). USC Telecom's near-term ability to expand its
business depends upon whether it can continue to maintain favorable
relationships with existing Agents and recruit and establish new relationships
with additional Agents. No assurances can be made as to the willingness of
the existing Agents to continue to provide new orders to USC Telecom or as to
USC Telecom's ability to attract and establish relationships with new Agents
DEPENDENCE ON OTHER FACILITIES-BASED CARRIERS - The Company, even though it
now owns nine switches, depends upon other carriers to provide the
telecommunications services that it resells to its customers and the detailed
information upon which it bases its customer billings. The Company's near-
term ability to expand its business partially depends upon whether it can
34
<PAGE>
continue to maintain relationships with S4 Communications, MCI WorldCom,
Frontier and U.S Republic. The loss of the telecommunications services that
the Company receives from any of these vendors could have a material adverse
effect on the Company's results of operations and financial condition.
CARRIER COMMITMENTS - The Company and EqualNet have significant commitments
with certain carriers to resell long-distance services. The Company's
contract with its carrier contains clauses that could materially and adversely
impact the Company should the Company incur a shortfall in meeting its
commitments.
To the extent that these carriers are considered to be utilities in EqualNet's
bankruptcy proceeding, these carriers will be entitled to adequate assurance
of payment for carrier services after September 10, 1998, the Bankruptcy
Filing Date. Adequate assurance may be in the form of cash deposits or
advance payments in an amount determined by the court as sufficient to provide
these carriers with adequate assurance of payment. The failure to provide
adequate assurance of payment for future services would give these carriers
the right to discontinue to provide such services. Current sources of funds
from operations and working capital may not be sufficient to provide the
amount of adequate assurance of payment required by these carriers. There can
be no assurance that EqualNet will be able to secure funding for the amount of
any adequate assurance that may be required of EqualNet.
BILLING SYSTEM PROBLEMS - EqualNet converted to a new customer management,
billing and rating system - AMS, purchased from Platinum Communications in
March 1998. Unlike NetBase (the system used for most of fiscal year 1998
prior to conversion), AMS has capabilities required for switch-based data
gathering, rating and billing. The conversion coincided with the acquisition
of a new customer base (SA Telecom) and a migration to a switch based
environment, considerable billing errors and delays occurred. Additionally,
there are aspects of AMS that could require continuing support from Platinum
Communications. This reliance upon an outside source for billing system
troubleshooting has slowed the conversion recovery process. In December,
1998 EqualNet converted its billing system to CostGuard ENTERPRISE, an
industrial class rating, billing and customer care system built on a Microsoft
SQL Server database platform. This system was purchased from Info Directions,
Inc., "IDI" and should improve rating speed and billing accuracy. Also,
EqualNet expects to be able to more readily extract meaningful data and
management reports from CostGuard. The system design is flexible enough to
respond to rapid changes in the telecommunications marketplace. In fiscal
year 1998, EqualNet recorded a write-off of $270,000 for NetBase and estimated
the useful file of AMS to be approximately one year until the CostGuard system
can be implemented. The new system, CostGuard, will cost $272,000 initially,
then $68,000 per year in subsequent years for ongoing support and software
upgrades. The conversion to the IDI system has created numerous billing
problems including delays in mailing bills, billing errors and issues related
to matching call detail records with customer accounts. The Company is
currently correcting these problems. However, there can be no assurance that
the IDI billing system will fully meet EqualNet's current and on going needs
or that the initial billing problems can be resolved. If the IDI system fails
to provide the expected results, EqualNet may need to invest in other
alternative billing systems.
RELATIONSHIPS WITH STATE REGULATORY AGENCIES - EqualNet's and USC
Telecom's intrastate long-distance telecommunications operations are subject
to various state laws and regulations, including prior certification,
notification or registration requirements. EqualNet and USC Telecom must
generally obtain and maintain certificates of public convenience and necessity
from regulatory authorities in most states in which it offers service. Any
failure to maintain proper certification in jurisdictions in which either of
these companies provide a significant amount of intrastate long-distance
service could have a material adverse effect on the Company's business.
VOLATILITY OF SECURITIES PRICES - Historically, the market price of the Common
Stock has been highly volatile. During the period July 1, 1997, to December
31, 1998, the market price for
35
<PAGE>
the Common Stock as reported by The Nasdaq Stock Market has ranged from a high
of $3.25 per share to a low of $.18 per share. There can be no assurance that
the market price of the Common Stock will remain at any level for any period
of time or that it will increase or decrease to any level. Changes in the
market price of the Common Stock may bear no relation to the Company's actual
operational or financial results.
In addition, if the Company fails to maintain the minimum bid price ($1.00 per
share) or the minimum net tangible assets ($4.0 million) requirements of
Nasdaq, the Common Stock would be subject to delisting by Nasdaq. On
September 30, 1998, Nasdaq notified the Company that it would be delisted if
the closing bid price for its Common Stock is not equal to or greater than
$1.00 for a minimum of ten consecutive trading days during the period from
October 1, 1998 to December 29, 1998. On October 8, 1998, Nasdaq also notified
the Company that it would be delisted if the market value of its public float
was not equal to or greater than $5.0 million for a minimum of ten consecutive
trading days during the period from October 9, 1998 to January 6, 1999. On
October 8, 1998, Nasdaq notified the Company that it would be delisted if it
does not submit an acceptable plan to increase its minimum net tangible assets
from the present level to the $4 million requirement. The Company currently
meets the minimum bid price and minimum public float requirements of Nasdaq.
It does not, however, meet the minimum tangible net worth requirement. The
Company submitted a plan in January, 1999 which estimated that the Company
would meet the tangible net worth requirement after the consummation of a
bankruptcy plan of EqualNet. A Nasdaq hearing was held on February 4, 1999 to
consider said plan. As of the date hereof, Nasdaq has not made a final
decision concerning the Company's listing on Nasdaq's National Market. There
can be no assurance the Common Stock will continue to be listed on Nasdaq.
Item 6. Exhibits and Reports on Form 8-K
a. Exhibits
Exhibit No. Description
----------- -----------
3.1 Articles of Incorporation of the Registrant, as amended
(incorporated by reference to Exhibit 3.1 to Amendment No.
1 to the Registrant's Registration Statement on Form S-1
Registration No. 33-88742; filed on February 13, 1995).
3.2 Statement of Resolution Establishing Series of Shares
(Series A Convertible Preferred Stock) (incorporated by
reference to Annex B to the Company's Schedule 14A filed
with the Commission on February 17, 1998).
3.3 Statement of Resolution Establishing Series of Shares
(Series B Senior Convertible Preferred) (incorporated by
reference to Annex G to the Company's Schedule 14A filed
with the Commission on June 15, 1998).
3.4 Statement of Resolution Establishing Series of Shares
(Series C Convertible Preferred Stock) (incorporated by
reference to Annex A to the Company's Schedule 14A filed
with the Commission on June 15, 1998).
3.5 Form of Statement of Resolution of Board of Directors
Establishing and Designating Series D Convertible
Preferred Stock and Fixing the Rights and Preferences of
such Series (incorporated by reference to exhibit 10.26 to
the Company's Annual Report on Form 10-K for the fiscal
year ended June 30, 1998, filed with the Commission on
October 13, 1998).
3.6 Bylaws of the Registrant (incorporated by reference to
Exhibit 3.2 of the Registrant's Registration Statement on
Form S-1 (Registration No. 33-88742), filed with the
Commission on January 24, 1995).
27.1 Financial Data Schedule
36
<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.
EQUALNET COMMUNICATIONS CORP.
/s/ Mitchell H. Bodian
Date: 2/16/99 -------------------------------------------
Mitchell H. Bodian, Chief Executive Officer
(duly authorized officer and principal
financial officer)
37
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<FISCAL-YEAR-END> JUN-30-1999
<PERIOD-START> OCT-01-1998
<PERIOD-END> DEC-31-1998
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