<PAGE> 1
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
----------------------------------------
FORM 8-K
CURRENT REPORT
PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
Date of Report (Date of earliest event reported): August 2, 1996
MIDCOM Communications Inc.
--------------------------
(Exact name of registrant as specified in its charter)
Washington
----------
(State or other jurisdiction of incorporation or organization)
000-26118 91-1438806
--------- ----------
(Commission File Number) (I.R.S Employer Identification No.)
1111 Third Avenue Seattle, Washington 98101
-------------------------------------------
(Address of principal executive offices)
(206) 628-8000
(Registrant's telephone number, including area code)
Page 1 of 25 pages.
Exhibit index at page 24.
<PAGE> 2
Item 5. Other Events
NOTICE OF PROPOSED UNREGISTERED OFFERING
On August 2, 1996 MIDCOM Communications Inc. (the "Company") issued a
press release under Securities and Exchange Commission Rule 135c giving notice
of an unregistered private offering of $75,000,000 principal amount of
convertible subordinated notes due in 2003. The text of that press release is
included with this report as Exhibit 99.1.
RECENT DEVELOPMENTS AND OTHER INFORMATION
The following information is provided for the purpose of disclosing
certain recent developments and updating information previously reported by the
Company. This report contains certain forward-looking statements which involve
known and unknown risks, uncertainties and other factors which may cause actual
results, performance or achievements of the Company or industry trends to differ
materially from those expressed or implied by such forward-looking statements.
Such factors include, among others, those discussed in "Risk Factors" and
elsewhere in this report and those described from time to time in the Company's
other filings with the Securities and Exchange Commission, press releases and
other communications.
Recent Operating Results. For the fiscal quarter ended June 30, 1996,
the Company expects to report revenue in the range of $40.0 to $42.0 million,
negative EBITDA (defined as operating income plus depreciation, amortization,
loss on impairment of assets and restructuring charges) in the range of $4.0 to
$4.5 million and a net loss of approximately $45.0 million, including a
write-down of approximately $19 million, primarily relating to intangible
assets, and a charge in the amount of $8.8 million representing payment in
connection with satisfaction of past shortfalls and a substantial reduction in
the Company's minimum commitment under its carrier supply contract with AT&T.
The expected decline in second quarter revenue, from $53.0 million in the first
quarter of 1996, is primarily attributable to the loss of a major reseller in
March 1996 and customer attrition principally with respect to the Company's
acquired customer bases. Final second quarter results are expected to be
announced prior to August 14, 1996. In addition, the Company expects that, over
the next nine to 12 months, revenue will decline as a result of customer
attrition and other factors and profitability will be adversely affected as a
result of substantial increases in the Company's investment in sales, marketing,
customer support, systems development, capital expenditures and other factors.
The Company and its New Strategy. MIDCOM Communications Inc. provides
long distance voice and data telecommunications services. As primarily a
nonfacilities-based reseller, Midcom principally utilizes the network switching
and transport facilities of Tier I long distance carriers, such as AT&T Corp.
("AT&T"), Sprint Corporation ("Sprint") and WorldCom, Inc. ("WorldCom"), to
provide a broad array of integrated long distance telecommunications services on
a seamless and highly reliable basis. Midcom's service offerings include basic
"1 plus" and "800" long distance, frame relay data transmission and wireless
communications service, as well as enhanced telecommunications services such as
dedicated private lines between customer locations, facsimile broadcast
services, calling cards and conference calling.
Midcom focuses on serving small to medium-sized businesses. The Company
currently invoices approximately 125,000 customer locations per month, a
significant majority of which are located in the major metropolitan areas of
California, Florida, Illinois, New York, Ohio and Washington. The Company
believes that the larger long distance carriers, such as AT&T, Sprint, WorldCom
and MCI Communications Corporation ("MCI"), tend to focus their sales and
customer support efforts on residential and large commercial customers and do
not routinely provide significant pricing discounts for small to medium-sized
businesses. By purchasing large usage volumes from the facilities-based carriers
at wholesale prices, Midcom seeks to offer its customers more favorable pricing
than they could obtain from such carriers directly. In addition, the Company
believes that
2
<PAGE> 3
businesses in this market segment do not typically have in-house
telecommunications expertise and therefore require more assistance with the
assessment and management of their telecommunications requirements. As a result,
the Company believes that it is able to differentiate its service offerings from
the larger carriers in this market segment on the basis of price, breadth of
service offerings, customer service and support and the ability to provide
customized solutions to the telecommunications requirements of its customers.
See "Customer Concentrations."
Midcom believes that the recently enacted Telecommunications Act of
1996 (the "Telecommunications Act") will substantially expand its market
opportunities. The Telecommunications Act removes substantial legal barriers to
competitive entry into the local telecommunications market and directs incumbent
local exchange carriers ("ILECs") to allow competing telecommunications service
providers such as the Company to interconnect their facilities with the local
exchange networks, to lease network components on an unbundled basis and to
resell local telecommunications services. According to Federal Communications
Commission ("FCC") estimates, in 1995, long distance providers reported revenue
of $72.4 billion while local telecommunications providers reported revenue of
$102.9 billion. See "Telecommunications Act."
Subsequent to its initial public offering in July 1995, Midcom
completed numerous acquisitions of businesses and customer bases. Although these
acquisitions contributed to substantial growth, they have also placed
significant demands on management resources and have disrupted Midcom's normal
business operations. In particular, the Company has been unable to fully
integrate the sales and marketing, customer support, billing and other functions
of certain acquired operations. The lack of integration of the acquired
operations has increased the Company's overall cost structure and has resulted
in lower profitability and cash flows. During the same period, the Company was
in the process of implementing a new management information system, including
the installation of a new billing system. Problems encountered in this
implementation process contributed to the Company's operational difficulties. In
addition, certain reports generated by the new management information system
that were used to estimate unbilled revenue for the third quarter of 1995 failed
to fully reflect all discounts that were properly included in the bills
subsequently sent to the Company's customers. Primarily as a result of this
failure, reported revenue was overstated for the third quarter of 1995 and the
Company's Quarterly Report on Form 10-Q for that period had to be amended to
restate reported results. In addition, the Company's profitability has been
reduced as a result of the Company's supply contract with AT&T which provides
for higher rates than those obtained from competitive suppliers. (The Company
and AT&T have entered into a letter of intent contemplating substantial
modifications to this contract which will be beneficial to the Company. See
"Risk Factors -- Minimum Volume Commitments and Existing Shortfalls.") These
factors have contributed to defaults under the Company's Revolving Credit
Facility (as defined below) and caused the Company's auditors to include a going
concern qualification in their report on the Company's consolidated financial
statements for the year ended December 31, 1995. The Company's auditors also
identified certain material weaknesses in the Company's internal financial
controls. See "Risk Factors -- Material Weaknesses in Internal Financial
Controls and Restatement of Financial Results."
Strategy. In response to the foregoing developments, Midcom has
recently recruited a new executive management team with extensive experience and
expertise in the telecommunications industry. In May 1996, the Company hired
William H. Oberlin as its President and Chief Executive Officer, appointed Mr.
Oberlin, Marvin C. Moses and John M. Zrno to its Board of Directors and engaged
Mr. Moses and Mr. Zrno as consultants. These individuals formerly held senior
management positions at ALC Communications Corporation ("ALC"), a leading
provider of long distance and other services to small and medium-sized
businesses. During their tenure, ALC completed a successful turn-around and
experienced profitable growth. From the fiscal year ended December 31, 1991
through the 12 months ended June 30, 1995 (prior to ALC's merger into Frontier
Corporation), ALC's revenue increased from $346.9 million to $672.2 million and
net income increased from $2.7 million to $75.3 million. In addition, in July
1996 the Company appointed Daniel M. Dennis to the Company's Board of Directors.
Mr. Dennis has served in a number of management positions with MCI for over 23
years.
Midcom's new executive management team has developed a restructuring,
network and marketing strategy which it plans to implement over the next 12 to
18 months and which is designed to address the Company's recent
3
<PAGE> 4
operational challenges and increase internally generated sales and
profitability. Principal components of the Company's strategy are set forth
below. Although the Company believes that its new management team has the
relevant skills and experience necessary to implement this strategy, its ability
to do so is subject to a number of risks and uncertainties, and there can be no
assurance that this strategy will be successfully implemented or that the
intended positive results will be achieved. See "Risk Factors."
Operational Restructuring Strategy
Continue to Build Management Team. Midcom will continue to seek
opportunities to augment management with individuals who have telecommunications
industry experience and expertise. The Company has recently appointed 10
individuals to key operational management positions. These individuals have
extensive experience in the operation of a telecommunications company, including
(i) network design, implementation and operation, (ii) marketing and sales,
(iii) management information systems and (iv) bill processing and collection.
Midcom believes that the experience and depth of this management team will
improve the Company's ability to address its current operational challenges and
to pursue its transition from primarily a nonfacilities-based reseller of long
distance and other telecommunications services to a switch-based provider of
integrated telecommunications services.
Integrate and Improve Information Systems. Midcom intends to focus on
consolidating and integrating the Company's multiple information and billing
systems and other redundant functions of certain acquired operations, enlarging
and enhancing the Company's information system and financial reporting
functions. The Company believes that these activities will (i) reduce the
overhead and maintenance costs associated with its management information
systems, (ii) improve the amount and type of information that can be accessed
about customers, sales and operations, (iii) increase the speed with which
information can be processed and (iv) reduce the Company's working capital
investment by shortening the time it takes for the Company to produce and
distribute customer bills.
Renegotiate Carrier Agreements. The Company currently resells network
switching and transport facilities of long distance carriers such as AT&T,
Sprint and WorldCom. Midcom believes its relationships with these carriers
enables it to provide customers a broad array of integrated long distance
telecommunications services on a seamless and highly reliable basis. Despite the
Company's successful resale of telecommunication services using these network
facilities, the Company's profitability has been reduced as a result of a supply
contract with AT&T which provides for higher rates than those obtained from
alterative suppliers. (The Company and AT&T have entered into a letter of intent
contemplating substantial modifications to this contract which will be
beneficial to the Company. See "Risk Factors -- Minimum Volume Commitments and
Existing Shortfalls.") The Company believes the successful renegotiation of its
supply agreement with AT&T will substantially improve the financial performance
of the Company while enabling the Company to continue to provide the same level
of service to its customers.
Network Strategy
Currently, Midcom owns and operates limited capacity switches in nine
locations. The Company intends to use a portion of the proceeds of this Offering
to acquire and install state-of-the-art high capacity switches, with local and
long distance functionality, in areas of the country where it has a sufficient
volume of long distance traffic and where the regulatory environment and market
conditions will permit it to provide local service at acceptable margins. The
Company believes that, in the cities where it intends to deploy switches, there
will be significant local circuit capacity at attractive rates available from
CLECS, ILECs and 38GHz wireless providers. Using its own switches will enable
the Company to direct customer call traffic over multiple networks which is
expected to minimize costs and improve gross margin. In addition, deployment of
switches is expected to enable the Company to (i) switch local traffic, thereby
increasing the economic viability of entering the market for local
telecommunication services, (ii) shield proprietary information regarding its
customers from the underlying carriers and thereby increase customer control,
(iii) facilitate access to can data records and (iv) implement differentiating
features and billing enhancements without involving the underlying carrier.
4
<PAGE> 5
Marketing Strategy
Reorganize and Expand Sales Efforts. To take full advantage of its
planned switching facilities network and expanded product offerings, Midcom
intends to reorganize its direct sales force into (i) a special accounts group
consisting of highly experienced sales personnel focused on larger customers
with sophisticated telecommunications requirements and (ii) a general accounts
group focused on smaller customers. Both groups will be located in major
metropolitan areas where the Company believes it has significant market
opportunities and can compete effectively on the basis of price. The Company
intends to implement training programs and financial incentives designed to
increase the cross-selling efforts of its direct sales force and further
integrate the Company's broad array of service offerings. In addition to
reorganizing its sales efforts, the Company intends to increase the number of
sales representatives over the next 12 to 18 months from approximately 40 to
approximately 200. The Company will continue to supplement its direct sales
force with its existing network of resellers and distributors. In addition to
its existing distributors, the Company intends to develop a new tier of
distributors who will be offered long-term financial incentives and who will be
required to market and sell the Company's service offerings exclusively within
selected territories. The Company believes that these long-term financial
incentives and exclusive marketing arrangements win result in improved
performance and increased loyalty to the Company and its service offerings.
Expand and Enhance Customer Support Efforts. Midcom intends to support
its expanded sales efforts and reduce customer attrition by building an enhanced
customer service and support operation. The Company intends to increase its
customer service and support staff over the next 12 to 18 months from
approximately 45 to approximately 60. This expanded operation will include (i) a
staff of trained customer service representatives available during normal
business hours at a number of integrated customer service centers, (ii) trained
account representatives assigned and dedicated to individual customers with
sophisticated telecommunications requirements and (iii) teams of technical
specialists available to develop customized solutions for a customer's
telecommunication needs.
Resell Local Services and Provide a Single-Source Solution. Regulatory
changes resulting from the Telecommunications Act significantly expand the
number and types of services Midcom is permitted to offer. As a result, Midcom
intends to offer its customers local dial tone and a variety of other local
telecommunications services primarily in locations where it has a significant
sales and marketing presence or where it plans to deploy switching facilities.
The Company believes that its large and geographically concentrated customer
base of small to medium-sized businesses represents a significant potential
market for these additional services. These additional services will afford the
Company the opportunity to provide its customers with a single-source solution
for local, long distance, wireless and enhanced telecommunications services. The
Company believes that bundling these services will provide substantial
advantages to its customers, including lower overall costs and a higher level of
service due to a single source for ordering, installation, customer service and
account management. In addition, Midcom believes that offering a single source
for telecommunications services will permit the Company to (i) leverage its
significant customer base and increase sales by increasing its share of the
telecommunications expenditures of its customers and (ii) improve customer
control and retention by strengthening its relationships with its customers.
The Company believes it will require between 12 and 18 months to
implement this strategy. As a result of restructuring costs, customer attrition
and other matters, the Company expects that in the near term, revenue is likely
to decrease and selling, general and administrative expenses are likely to
increase substantially. These expected trends will have a material adverse
impact on the Company's near term profitability and levels of cash flows. If
Midcom successfully implements its new operating strategy, it anticipates that,
over the long term, (i) revenue will increase as a result of its reorganized and
expanded direct sales efforts, the development of a new tier of distributors and
reduced customer attrition and (ii) operating expenses will decrease as a result
of deploying its network of switching facilities and obtaining more favorable
terms from its suppliers. As a result of these expected trends, the Company
expects that gross margin as a percentage of revenue will, over the long term,
be comparable
5
<PAGE> 6
to other telecommunications providers despite an anticipated increase in costs
associated with its larger sales force and customer support efforts. Although
the Company believes that its new management team has the relevant skills and
experience necessary to implement this strategy, its ability to do so is subject
to a number of risks and uncertainties, and there can be no assurance that this
strategy will be successfully implemented or that the intended positive results
will be achieved. See "Risk Factors."
Customer Concentrations. The Company currently invoices approximately
125,000 customer locations. Certain Midcom customers receive multiple billing
invoices because they have multiple locations. At this time, the Company is
unable to aggregate the invoices of such customers to determine an exact
customer count. During 1994, 1995 and the first quarter of 1996, no one customer
accounted for more than 5.0% of Midcom's revenues. Midcom believes that the loss
of any single customer would not have a material adverse effect on its business,
financial condition or results of operations.
Legal Proceedings. The Company, its Chairman of the Board of Directors
and largest shareholder, the Company's former President, Chief Executive Officer
and director and the Company's former Chief Financial Officer are named as
defendants in a securities action filed in the U.S. District Court for the
Western District of Washington (the "Complaint"). The Complaint purports to be
filed on behalf of a class of purchasers of the Company's Common Stock during
the period beginning on July 6, 1995, the date of the Company's initial public
offering, and ending on March 4, 1996 (the "Class Period"). An amended complaint
(the "Amended Complaint") was filed on July 8, 1996. The Amended Complaint
alleges, among other things, that the registration statement and prospectus
relating to the Company's initial public offering contained false and misleading
statements concerning the Company's billing software and financial condition.
The Amended Complaint further alleges that, throughout the Class Period, the
defendants inflated the price of the Common Stock by intentionally or recklessly
making material misrepresentations or omissions which deceived the public about
the Company's financial condition and prospects. The Amended Complaint alleges
claims under the Securities Act and the Exchange Act as well as various state
laws, and seeks damages in an unstated amount. Defendants answer or any
preliminary motions are due on August 7, 1996, and all discovery proceedings
have been stayed until that time and will be further stayed in the event
defendants file a motion to dismiss. While the Company believes that it has
substantive defenses to the claims in the Amended Complaint, intends to
vigorously defend this lawsuit and is in the process of preparing a motion to
dismiss the Amended Complaint for failure to state a claim on which relief can
be granted, it is unable to predict the outcome of this action.
The Company was informed in May 1996 that the Securities and Exchange
Commission was conducting an informal inquiry regarding the Company's initial
public offering and the restatement of its 1995 third quarter results. The
Company has voluntarily provided the documents requested by the Commission, but
has not been informed whether or not the Commission intends to commence a formal
action against the Company or any of its affiliates. The Company is, therefore,
unable to predict the ultimate outcome of the investigation. In the event that
the Commission elects to initiate a formal enforcement proceeding, the Company
and its officers could be subject to civil or criminal sanctions including
monetary penalties and injunctive measures. Any such enforcement proceeding
could have a material adverse effect on the Company's business, financial
condition and results of operations.
In September and December 1995, the Company acquired two significant
customer bases from Cherry Communications. The first transaction ("Cherry I")
provided for the purchase of long distance customer accounts having monthly
revenues for the three months preceding the date of closing of $2.0 million, net
of taxes, customer credits and bad debt. The second transaction ("Cherry II")
provided for the purchase of long distance customer accounts having monthly
revenues which were to average $2.0 million per month over the 12 months
following the transaction, net of taxes, customer credits and bad debt. The
Company is responsible for the underlying carrier costs associated with the
customer traffic acquired from Cherry Communications at a rate which would yield
to the Company a gross profit on such traffic at an agreed rate. The purchase
price payable with respect to Cherry I was a total of $10.5 million, of which
$5.5 million was paid in cash and the balance was paid by the delivery of
317,460
6
<PAGE> 7
shares of Common Stock (subject to a possible increase in such number based on
the future value of the Common Stock), of which 126,984 shares are held in
escrow to be applied to indemnity claims or to cover shortfalls in revenue from
the $2.0 million monthly average. The purchase price for "Cherry II" was $18.0
million of which $7.0 million has been paid in cash. Additional installments of
$3.4 million were due in December 1995 and each of the first four months of
1996, of which $400,000 of each installment was to be placed in an escrow
account for satisfaction of indemnity claims or to cover shortfalls in revenue
from the $2.0 million monthly average. The parties later agreed that the Company
could pay up to $9.0 million of the Cherry II payments either in cash or by
delivery of shares of Common Stock, although the terms of the Revolving Credit
Facility prohibit the Company from paying any portion of this obligation in cash
without the lenders' prior written consent. Separately, the Company also agreed
to pay Cherry Communications $40,000 per month per customer base for servicing
customer accounts on behalf of the Company. The acquired customer bases have not
generated the required minimum revenue levels and Cherry Communications has
failed to remit to the Company collections received by Cherry Communications
from a portion of the acquired customers. Accordingly, the Company has withheld
the final three installment payments for Cherry 11 (a total of $9.0 million
excluding escrowed sums), payment of invoices for carrier service for the
acquired bases (approximately $7.5 million through June 30, 1996) and accrued
customer service charges through June 30, 1996 of $680,000. Negotiations between
Cherry Communications and the Company failed to produce a settlement of these
disputes.
Cherry Communications filed a lawsuit against the Company in the United
States District Court for the Northern District of Illinois, Eastern Division.
In its First Amended Complaint filed on July 18, 1996, Cherry Communications
seeks recovery of (i) approximately $7.2 million plus interest and attorneys'
fees alleged to be due and owing under a Rebiller/Reseller Agreement for
Switched Services between Cherry Communications and the Company, (ii)
approximately $9.0 million plus interest and attorney's fees alleged to be due
and owing under the November 1, 1995 Customer Base Purchase and Sale Agreement
between Cherry Communications and the Company (the "Cherry II Agreement"), and a
Promissory Note executed in connection with the Cherry II Agreement, (iii)
customer service charges of $40,000 per month for each month of customer service
Cherry Communications has provided to the Company under the September 1, 1995
Customer Base Purchase and Sale Agreement between Cherry Communications and the
Company (the "Cherry I Agreement"); and (iv) customer service charges of $40,000
per month for each month of customer service Cherry Communications has provided
to the Company under the Cherry II Agreement. It is the position of the Company
that Cherry Communications has breached its obligations under the September 1,
1995 and November 1, 1995 Customer Base Purchase and Sale Agreements by among
other breaches (i) failing to sell Midcom customer bases having the average
monthly revenues required by the customer base agreements, and (ii) failing to
remit to Midcom monies collected from the customer bases. It is also the
position of the Company that, as a result of Cherry Communication's breaches of
the September I and November 1, 1995 Customer Base Purchase and Sale Agreements,
as amended by certain addenda, that the Company has substantial offsets and
counterclaims against Cherry Communications. The Company is attempting to
negotiate a resolution of the disputes. In the event that a settlement is not
reached, the Company intends to vigorously defend the lawsuit filed by Cherry
Communications. However, the Company cannot be certain that the lawsuit filed by
Cherry Communications and the disputes between Cherry Communications and the
Company will be resolved on terms favorable to the Company.
On April 30, 1996, a lawsuit was filed in the Superior Court of the
State of Washington, King County, against the Company and certain of its
officers and directors by the former owner of Cel-Tech seeking rescission of his
sale of Cel-Tech to the Company. The complaint alleged misrepresentation of
facts concerning the value of the Company's Common Stock and breach of contract.
In addition to rescission of the sale transaction, plaintiff sought unspecified
damages and an injunction placing Cel-Tech under the plaintiffs control until
resolution of the dispute. The Plaintiff has filed a second amended complaint in
order to seek damages in lieu of rescission. The Company believes there is no
merit to the allegations in the amended complaint and plans to vigorously defend
this lawsuit and to file counterclaims on a variety of issues. However, the
Company is unable to predict the outcome of this lawsuit.
7
<PAGE> 8
On July 2, 1993, a complaint was filed in the Superior Court of the
State of New Jersey, Bergen County, Law Division, by Discom Corporation
("Discom") against the Company, Paul Pfleger, who is the largest shareholder and
Chairman of the Board of Directors, and Pamcom, Inc., a corporation wholly owned
by Mr. Pfleger ("Pamcom"), alleging unjustified customer provisioning delays,
customer rejections, improper changes in pricing policies and failure to deal in
good faith causing a breach of contract with a third party beneficiary. Discom
seeks compensatory damages of $3.0 million for lost profits and lost
commissions. The Company has filed counterclaims against Discom for unfair
competition and trademark infringement. Discom was a distributor of aggregation
services under a contract between AT&T and Midcom Consultants, Inc.
("Consultants"). In exchange for the right to place its own aggregation
customers under Consultant's contract with AT&T, the Company provided
provisioning, billing and other support services for all aggregation customers
under Consultant's aggregation contract, including Discom's customers. In
January 1995, the Company acquired certain of the assets and liabilities of
Consultants. Pamcom, Inc., the sole remaining co-defendant in this action, was
the sole shareholder of Consultants at the time of the alleged events that are
the subject of this action. On October 25, 1995, Discom filed notice for
arbitration in New York against Consultants alleging breach of the distributor
agreement between the parties. The Company moved to consolidate the pending
litigation between Discom and the Company with Discom's claim in arbitration
against Consultants. Pursuant to an order of the Superior Court, the entire case
has been transferred to arbitration in New York for disposition of the claims
and counterclaims. The panel of arbitrators is currently scheduled to begin
hearing the case in August 1996. The Superior Court proceeding has been stayed
with jurisdiction reserved solely to resolve any discovery disputes. The Company
has deposited $645,000 in an interest-bearing escrow account, which the Company
believes exceeds the total of all commissions payable to Discom from August 1,
1993 through December 31, 1995. Although the outcome of any litigation or
arbitration is uncertain, the Company believes that it has significant defenses
to the claims of Discom and intends to vigorously defend itself in this matter
and believes that the outcome of this matter will not have a material adverse
effect on the Company's business, financial condition, results of operations or
liquidity.
The Company has been notified by the sellers of ADNET Telemanagement,
Inc. ("Adnet") that they believe the Company made material misrepresentations
about its financial condition in connection with the Company's acquisition of
Adnet in December 1995. As a result, the sellers are requesting additional
consideration for Adnet. The Company is evaluating this request, including the
impact that issuing additional consideration may have on the accounting for this
acquisition as a pooling of interests. The Company has not committed to issue
additional consideration and is continuing discussions with the sellers about
possible resolutions.
The Company is also party to other routine litigation incident to its
business and to which its property is subject. The Company's management believes
the ultimate resolution of these matters will not have a material adverse effect
on the Company's business, financial condition or results of operations.
Telecommunications Act. On February 8, 1996, Congress enacted the
Telecommunications Act, which effected a sweeping overhaul of the Communications
Act of 1934 (the "Communications Act"). In particular, the Telecommunications
Act substantially amends Title II of the Communications Act, which governs
telecommunications common carriers. The Telecommunications Act was intended by
Congress to open telephone exchange service markets to full competition, to
promote competitive development of new service offerings, to expand public
availability of telecommunications services and to streamline regulation of the
industry. The Telecommunications Act makes all state and local barriers to
competition unlawful, prohibits state and local governments from enforcing any
law, rule or legal requirement that prohibits or has the effect of prohibiting
any person from providing interstate or intrastate telecommunications services
and directs the FCC to initiate rulemaking proceedings on local competition
matters.
Implementation of the provisions of the Telecommunications Act will be
the task of the FCC, the state public utility commissions and a joint
federal-state board. Much of the implementation of the Telecommunications Act
must be completed in numerous rulemaking proceedings with short statutory
deadlines. These proceedings are expected to address issues and proposals
already before the FCC in pending rulemaking proceedings affecting the
8
<PAGE> 9
long distance industry as well as additional areas of telecommunications
regulation not previously addressed by the FCC and the states. States retain
jurisdiction under the Telecommunications Act to adopt laws necessary to
preserve universal service, protect public safety and welfare, ensure the
continued quality of telecommunications services and safeguard the rights of
consumers.
Some specific provisions of the Telecommunications Act which are
expected to affect long distance service providers are summarized below:
Expanded Interconnection Obligations. The Telecommunications Act
establishes a general duty of all telecommunications carriers to interconnect
with other carriers, directly or indirectly. The Telecommunications Act also
contains a detailed list of requirements with respect to the interconnection
obligations of LECS. These interconnection obligations include resale, number
portability, dialing parity, access to rights-of-way and reciprocal
compensation.
ILECs have additional obligations including: to negotiate in good
faith; to provide for network interconnection at any technically feasible point
on terms that are reasonable and non-discriminatory; to provide
non-discriminatory access to facilities, equipment, features, functions and
capabilities on an unbundled basis; to offer for resale at wholesale rates any
service that ILECs provide on a retail basis; and to provide actual co-location
of equipment necessary for interconnection or access.
The Telecommunications Act establishes a framework for state
commissions to mediate and arbitrate negotiations between ILECs and carriers
requesting interconnection, services or network elements. The Telecommunications
Act establishes deadlines, policy guidelines for state commission decision
making and federal preemption in the event a state commission fails to act. The
FCC is in the process of promulgating rules to implement these provisions of the
Telecommunications Act, and the outcome of such proceedings and its effect on
the Company cannot be determined.
Provision of Interexchange Services. The Telecommunications Act
eliminates the previous prohibition on RBOC provision of interexchange services
originating (or in the case of "800" service, terminating) outside their local
service areas and all interexchange services associated with the provision of
most commercial mobile wireless services, including services originating within
their local service areas.
In addition, the Telecommunications Act allows RBOCs to provide
landline interexchange services in the states in which they provide landline
local exchange service; provided, however, that before engaging in landline long
distance services in a state in which it provides landline local exchange
service, an RBOC must (i) provide access and interconnection to one or more
unaffiliated competing facilities-based providers of telephone exchange service,
unless after 10 months after enactment of the Telecommunications Act no such
competing provider has requested such access and interconnection more than three
months before the RBOC has applied for authority and (ii) demonstrate to the FCC
its satisfaction of the Telecommunications Act's "competitive checklist."
The specific interconnection requirements contained in the "competitive
checklist," which the RBOCs must offer on a non-discriminatory basis, include
network interconnection and unbundled access to network elements, including
local loops, switching and transport; access to poles, ducts, conduits and
rights-of-way owned or controlled by them; access to emergency 911, directory
assistance, operator call completion and white pages; access to telephone
numbers, databases and signaling for call routing and completion; availability
of number portability; local dialing parity; reciprocal compensation
arrangements; and resale opportunities.
Review of Universal Service Requirements. The Telecommunications Act
contemplates that interstate telecommunications providers will "make an
equitable and non-discriminatory contribution" to support the cost of providing
universal service, although the FCC can grant exemptions in certain
circumstances. The FCC is in the
9
<PAGE> 10
process of promulgating rules to implement these provisions of the
Telecommunications Act, and the outcome of such proceedings and its effect on
the Company cannot be determined.
Limitation on Joint Marketing of Local and Long Distance Services. Long
distance providers that serve greater than five percent of presubscribed access
lines in the United States (which includes the nation's three largest long
distance providers) are precluded from jointly marketing local and long distance
service until the RBOCs are permitted to enter the long distance market, or
three years from the date of enactment of the Telecommunications Act, whichever
is sooner.
Deregulation. The FCC is authorized to forebear from applying any
statutory or regulatory provision that is not necessary to keep
telecommunications rates and terms reasonable or to protect consumers. A state
may not apply a statutory or regulatory provision that the FCC decides to
forebear from applying. In addition, the FCC must review its telecommunications
regulations every two years and change any that are no longer necessary.
RISK FACTORS
The investment community is strongly cautioned that an investment in
the Company's securities involves a very high degree of risk. The ability of the
Company's new management to (i) halt the deterioration of the Company's results
of operations and financial condition and (ii) successfully implement its new
operating strategy is subject to an unusual number of material risks and
uncertainties. The investment community should not dismiss the risk factors set
forth below as "boilerplate " or "customary" disclosure. The contingencies and
other risks discussed below could affect the Company in ways not presently
anticipated by its management and thereby impair its ability to continue as a
going concern and materially affect the value of its debt and equity securities.
A careful review and understanding of each of the risk factors set forth below,
as well as the other information contained in this report and other information
concerning the Company, is essential for an investor seeking to make an informed
investment decision with respect to the Company's securities.
Ability to Continue as a Going Concern; Default under Credit Facility;
Need for Additional Working Capital. As a result of Midcom's rapid growth,
substantial operating losses, billing and collection cycle, acquisition strategy
and other factors, the Company has required substantial external working
capital. At the date of this report, the Company's available sources of working
capital consisted of cash flows from operations and available borrowings under
its Revolving Credit Facility (to the extent permitted by the lenders in light
of existing defaults thereunder). Working capital requirements presently exceed
cash flows from operations and available borrowings. Accordingly, the Company
has sought extended payment terms from certain of its suppliers, delayed
payments to many of its suppliers and other vendors, delayed or cancelled
purchases and taken other steps to conserve operating capital. As a result,
suppliers and other vendors may place the Company on credit hold or take other
actions, including the termination of their supply relationship with the Company
or the initiation of collection actions. As of the date of this report, the
Company's lenders were continuing to permit borrowings under the Revolving
Credit Facility in spite of the existence of financial and other covenant
violations. The report of the Company's independent auditors with respect to the
Company's Consolidated Financial Statements included in the Company's Annual
Report on Form 10-K for the year ended December 31, 1995 states that the
Company's recurring operating losses, working capital deficiency and credit
agreement defaults raise substantial doubt about the Company's ability to
continue as a going concern. The Company's ability to continue as a going
concern, restructure its operations and implement its new operating strategy
depends largely on its ability to obtain additional working capital. The Company
estimates that it will require between $40.0 million and $50.0 million during
the next two years to fund (i) operating losses, (ii) working capital
requirements and (iii) capital expenditures, including approximately $22.0
million for the acquisition and installation of high capacity switches. On
August 2, 1996 the Company announced that it had commenced an offering of
$75,000,000 principal amount of convertible subordinated notes (the "Note
Offering"). Subject to the consummation of the Note Offering, the lenders under
the Revolving Credit Facility have agreed to waive all existing defaults and
amend the existing covenants to be consistent with Midcom's revised
10
<PAGE> 11
business plan. Assuming the Revolving Loans are paid in full upon consummation
of this Note Offering, the Company's maximum borrowing availability under the
Revolving Credit Facility, as amended, will be $43.0 million, subject to a
borrowing base equal to 85% of the Company's eligible accounts receivable less a
minimum excess availability requirement of $20.0 million for the months of
August 1996 through February 1997, declining in stages to $8.0 million for the
months of September through November 1997. As of June 30, 1996, after giving
effect to the amendment, the Company would have had a borrowing base of
approximately $26.0 million and a maximum borrowing availability, net of the
minimum excess availability requirement, of approximately $6.0 million.
The exact amount and timing of the Company's capital requirements will
be determined by numerous factors, including the level of, and gross margin on,
future sales, the outcome of outstanding contingencies and disputes such as
pending lawsuits, payment terms achieved by the Company and the timing of
capital expenditures associated with the proposed installation of new switching
facilities. The Company's current plans assume that the Company will be able to
replace or extend the Revolving Credit Facility after its expiration in November
1997. There can be no assurance that the Revolving Credit Facility will continue
to be available to the Company, that the Note Offering will be completed or that
the net proceeds from the Note Offering together with funds available under the
Revolving Credit Facility and cash flows from operations will be sufficient to
fully implement the Company's new operating strategy or meet its other capital
requirements. If (i) the Note Offering is not completed, (ii) the Company
experiences greater than anticipated capital requirements, (iii) it is
determined to be liable for, or otherwise agrees to settle or compromise, any
material claim against it, (iv) it is unable to make future borrowings under the
Revolving Credit Facility for any reason or (v) the implementation of the
Company's new operating strategy fails to produce the anticipated cash flows
from operations, the Company may be required to refinance all or a portion of
its existing debt, sell assets or obtain additional equity or debt financing.
There can be no assurance that any such refinancing or asset sales would be
possible or that the Company will be able to obtain additional equity or debt
financing, if and when needed, on terms that the Company finds acceptable. Any
additional equity or debt financing may involve substantial dilution to the
interests of the Company's shareholders. The failure of the Company to complete
the Note Offering or thereafter complete one or more of such alternatives or
otherwise obtain sufficient funds to satisfy its cash requirements could prevent
the Company from implementing its new operating strategy and, ultimately, could
force the Company to seek protection under the federal bankruptcy laws. Such
events would materially and adversely affect the value of the Company's debt and
equity securities.
Recent Losses and Anticipated Future Losses. The Company has
experienced significant losses since its inception. Net losses for 1994, 1995
and the first quarter of 1996 were approximately $3.0 million, $33.4 million and
$14.5 million, respectively. As a result of customer attrition and other
factors, the Company expects revenue to decline over the next nine to 12 months.
See "-- Customer Attrition." In addition, the execution of the Company's new
operating strategy will require the Company to substantially increase its
investment in sales, marketing, capital equipment, systems development and other
areas. The Company expects that a substantial portion of these expenditures will
be made before the Company realizes an increase in revenue or an improvement in
gross margin. The Company therefore expects that, over the next nine to 12
months, operating costs will increase both in actual dollars and as a percentage
of revenue and net losses will continue.
Material Weaknesses in Internal Financial Controls and Restatement of
Financial Results. In connection with the audit of Midcom's 1995 Consolidated
Financial Statements, Midcom's independent auditors identified two conditions
which were characterized as material weaknesses in its internal financial
controls. One material weakness identified by the auditors was the failure of
the accounting and finance systems to provide accurate information necessary to
monitor the Company's financial position, results of operations and liquidity,
as demonstrated by the restatement of the Company's third quarter results and
the difficulties in completing the 1995 year-end audit which resulted in
numerous material adjustments to preliminary fourth quarter results. Factors
identified as contributing to this weakness and requiring immediate attention
included insufficient staffing and systems to accommodate significant growth
from acquisitions, transitional difficulties associated with major new
information and billing systems, inadequate communication between senior
management and the finance department and demands associated with the Company's
initial public offering. The second material weakness identified by the auditors
was the
11
<PAGE> 12
Company's process of estimating unbilled receivables. With respect to this
material weakness, the auditors recommended that the Company review and revise,
as necessary, all policies and procedures with regard to its reconciliation of
unbilled receivables with actual billings to ensure that all unbilled amounts at
a reporting date represent properly recorded revenue.
It is the Company's practice, which is common in the long distance
industry, to include in reported revenue and accounts receivable an amount for
unbilled calls equal to an estimate of the amount that will be billed and
collected for calls occurring in that reporting period. During 1995, the Company
converted its customer billing function for those calls for which it provides
direct billing to a new billing system. The Company experienced difficulties in
implementing the new billing system which caused an increased number of calls to
be billed later than expected by the Company. Also, in the process of
reconciling unbilled accounts as of December 31, 1995 with amounts ultimately
billed, the Company discovered that certain reports generated by its new
information management system that were used for recognizing unbilled revenue
for the third quarter of 1995 failed to fully reflect all discounts that were
properly included in the bills subsequently sent to the Company's customers.
Primarily as a result of this failure, reported revenue was overstated for the
third quarter of 1995 and the Company's Quarterly Report on Form 10-Q for that
period had to be amended to restate reported results. The Company is in the
process of enhancing this billing system and converting and modifying the
customer support portions of its information systems. However, in light of the
foregoing and other weaknesses in the systems, the Company's financial
statements for 1995 included a $2.5 million partial write-down of its
capitalized software development costs for the management information system. In
addition, the Company had previously been required to restate its financial
statements for the year ended December 31, 1994 after determining that revenue
and accounts receivable had been overstated by approximately $1.8 million net of
reserves as a result of using historical averages of unbilled calls as the basis
for its revenue estimates, a practice that the Company discontinued in the first
quarter of 1995.
In light of the volume of financial data to be processed, the reliance
upon timely receipt of call data records from suppliers, the anticipated rate of
growth of the Company, the demands on key financial personnel, recent turnover
in key finance and accounting positions, the challenges associated with the
integration of acquired businesses and other factors, there can be no assurance
that the Company will not encounter additional billing delays, other internal
control weaknesses or other difficulties in future financial reporting.
Disputes and Litigation. The Company, its Chairman of the Board of
Directors and largest shareholder, the Company's former President, Chief
Executive Officer and a director, and the Company's former Chief Financial
Officer are named as defendants in a securities action filed in the U.S.
District Court for the Western District of Washington (the "Complaint"). The
Complaint purports to be filed on behalf of a class of purchasers of the
Company's Common Stock during the period beginning on July 6, 1995, the date of
the Company's initial public offering, and ending on March 4, 1996 (the "Class
Period"). An amended complaint (the "Amended Complaint") was filed on July 8,
1996. The Amended Complaint alleges, among other things, that the registration
statement and prospectus relating to the Company's initial public offering
contained false and misleading statements concerning the Company's billing
software and financial condition. The Amended Complaint further alleges that,
throughout the Class Period, the defendants inflated the price of the Common
Stock by intentionally or recklessly making material misrepresentations or
omissions which deceived the public about the Company's financial condition and
prospects. The Amended Complaint alleges claims under the Securities Act and the
Exchange Act as well as various state laws, and seeks damages in an unstated
amount. While the Company believes that it has substantive defenses to the
claims in the Amended Complaint and intends to vigorously defend this lawsuit,
it is unable to predict the outcome of this action. If determined adversely to
the Company, this lawsuit could have a material adverse effect on the Company's
business, financial condition and results of operations. See "Legal
Proceedings."
The Company was informed in May 1996 that the Securities and Exchange
Commission was conducting an informal inquiry regarding the Company's initial
public offering and the restatement of its 1995 third quarter results. The
Company has voluntarily provided the documents requested by the Commission, but
has not been
12
<PAGE> 13
informed whether the Commission intends to commence formal action against the
Company or any of its affiliates. The Company is, therefore, unable to predict
the ultimate outcome of the investigation. In the event that the Commission
elects to initiate a formal enforcement proceeding, the Company and its officers
could be subject to civil or criminal sanctions including monetary penalties and
injunctive measures. Any such enforcement proceeding could have a material
adverse effect on the Company's business, financial condition and results of
operations. See "Legal Proceedings."
In addition, by virtue of its rapid growth, acquisition activities and
large volume of business with suppliers, the Company is involved in litigation
or disputes with sellers of acquired operations, suppliers and other third
parties. See "-- Minimum Volume Commitments and Existing Shortfalls" and "Legal
Proceedings."
Although the Company intends to defend its existing litigation and
other disputes vigorously, it is unable to predict the nature or timing of any
resolution of such matters. If the Company is determined to be liable for, or
otherwise agrees to settle or compromise, any claim, it would most likely be
required to make a payment in the form of cash, indebtedness or equity
securities. Depending on the size, type and timing of any such payment, it could
materially impair the Company's limited capital resources or significantly
dilute the Company's existing shareholders. See "-- Ability to Continue as a
Going Concern; Default Under Credit Facility; Need for Additional Working
Capital." In addition, the Company's pending litigation, investigations and
disputes could result in substantial legal costs to the Company and divert
management's attention from the other business affairs of the Company for
substantial periods of time.
Minimum Volume Commitments and Existing Shortfalls. Midcom has entered
into multiple-year supply contracts with AT&T, Sprint and WorldCom and
short-term contracts with a number of other suppliers for the long distance
telecommunication services provided to its customers. To obtain favorable
forward pricing from certain of its suppliers, the Company has committed to
purchase minimum volumes of a variety of long distance services during stated
periods whether or not such volumes are used or, in one case, to pay a surcharge
equal to a percentage of the Company's shortfall from a specified quarterly
minimum volume. For the final six months of 1996, these commitments and maximum
surcharge total approximately $41.2 million (including approximately $23.2
million attributable to AT&T). As of June 30, 1996, Midcom's minimum volume
commitment under its supply contract with AT&T, its largest supply contract, was
$117.0 million. The Company estimates that, as of the next measurement date on
September 30, 1996, it will be in shortfall of its minimum commitments to AT&T
by approximately $27.6 million based on current contract requirements. On July
19, 1996 the Company and AT&T executed a letter of intent to settle this
anticipated liability as well as all other pending disputes between the Company
and AT&T, and to negotiate a new contract pursuant to which the Company's
minimum commitment to AT&T will be $17.0 million. The letter of intent also
provides for the payment by the Company to AT&T of $8.8 million in two
installments. The first payment of $5.0 million will be due on the earlier of
March 31, 1997 or 30 days after the consummation of this Offering, and the
remaining balance of $3.8 million will be due within 30 days of Midcom
announcing quarterly gross revenue in excess of $75.0 million, or upon
completion of a change in control. In addition, Midcom will obtain more
favorable pricing for certain network services provided by AT&T. Pursuant to the
same letter of intent, Midcom and AT&T have negotiated a payment schedule for
overdue payments which will bring the Company's obligations to AT&T current by
the middle of October, 1996. The settlement and new rate structure will not be
effective until the Company and AT&T have executed a mutually acceptable
definitive agreement, which the parties intend to pursue over the next 30 days;
however, there can be no assurance that a definitive agreement will be reached.
Another major supplier has agreed to forebear from exercising its rights to
shortfalls incurred through April 30, 1996 which would otherwise have required
the Company to pay a surcharge and caused pricing from this supplier to
increase. This supplier has indicated that it will work with Midcom to restate
applicable minimums so that their attainment is more realistic. There can be no
assurance that the negotiations described above will be concluded in a manner
favorable to the Company or that the Company will be able to obtain relief from
its minimum contractual commitments in the future. If existing or future
shortfalls are not eliminated, the Company may be required to make substantial
payments without associated revenue from customers or the supplier may terminate
service and commence formal action against the Company. Such payments
13
<PAGE> 14
are not presently contemplated in the Company's capital budgets and would have a
material adverse effect on the Company's business, financial condition and
results of operation.
Because of Midcom's commitments to purchase fixed volumes of use from
certain of its suppliers at predetermined rates, the Company could be adversely
affected if a supplier were to lower the rates it makes available to the
Company's target market without a corresponding reduction in the Company's
rates. Similarly, the Company could be adversely affected if its suppliers
failed to adjust their overall pricing, including prices to the Company, in
response to price reductions of other major carriers.
Ability to Implement New Operating Strategy. The Company's new
management team has developed an operating strategy which will emphasize the
installation of dedicated switching facilities to create a Company network and
the reorganization and expansion of the Company's existing sales and customer
support departments. See "Company Strategy." In addition to the capital
requirements associated with the new operating strategy, the Company's ability
to realize the full benefit of its operating strategy is contingent upon its
ability to (i) conclude its negotiations of a definitive agreement with AT&T,
(ii) hire and retain sufficient numbers of new sales personnel and (iii)
overcome the logistical challenges of entering the local telecommunications
market. Midcom has executed a letter of intent with AT&T and has made proposals
to other suppliers to modify its supply agreements in a manner that would be
consistent with its network strategy; however, no agreements have been signed
and there can be no assurance that the Company will be successful in its
efforts. See "-- Minimum Volume Commitments and Existing Shortfalls." The
Company plans to increase the number of sales representatives over the next 12
to 18 months from approximately 40 to approximately 200. There can be no
assurance that the Company will be able to hire and retain a sufficient number
of experienced or otherwise suitable employees to meet this goal. While the
Company's new operating strategy seeks to decrease the level of its sales force
turnover, there can be no assurance that its efforts to do so will be
successful. Prior to reselling local services to its customers, the Company must
complete a number of operational, marketing and regulatory tasks, including the
negotiation of interconnect agreements with local circuit providers, the
development of a billing, provisioning and customer service capability and the
creation of a local marketing, pricing and sales strategy. Failure to overcome
these logistical challenges would have a material adverse effect on the
Company's ability to implement its strategy to enter the local
telecommunications market.
Ability to Manage Growth. The Company intends to pursue substantial
growth in connection with the implementation of its new operating strategy. This
growth will place significant demands on the Company's management and systems of
financial and internal controls and will require an increase in the capacity,
efficiency and accuracy of its billing and customer support systems. Moreover,
this growth will require an increase in the number of the Company's personnel,
particularly sales, customer service and technical personnel. The market for
such personnel is highly competitive and there can be no assurance that the
Company will be able to attract the personnel required by its operating
strategy. Further, the Company will be required to expand, train, motivate and
manage its employee base. This will require an increase in the level of
responsibility for both existing and new management personnel. There can be no
assurance that the management skills and systems currently in place, or to be
implemented in connection with the Company's new operating strategy, will be
adequate or that the Company will be able to assimilate its new employees
successfully. Finally, the Company has experienced in recent periods a high
level of turnover in its sales force. The Company believes that this turnover is
attributable to, among other things, mobility and turnover common to the
reseller segment of the industry, the Company's recent operational difficulties
and recent changes in senior management. Although one objective of the Company's
new operating strategy is to decrease the level of turnover in its sales force,
there can be no assurance that this objective will be achieved. Failure to
attract and retain sufficient qualified personnel or to train, motivate and
manage such personnel, could have a material adverse effect on the Company's
business, financial condition and results of operations.
Dependence Upon New Management Team. Midcom's ability to implement its
new operating strategy is highly dependent upon its ability to retain its new
senior management team. These individuals are generally in high demand and are
often subject to competing employment opportunities. The loss of William H.
Oberlin, the
14
<PAGE> 15
Company's President and Chief Executive Officer and one of the Company's
directors, or the other key members of the management team could have a material
adverse effect on the Company's business, financial condition and results of
operations. Midcom believes that it will need to retain key management personnel
to meet the demands of its business. The Company's recent performance may make
the retention of key personnel more difficult.
Customer Attrition. Midcom's revenue is affected by customer attrition,
a problem inherent in the long distance industry. The attrition experienced by
the Company is attributable to a variety of factors, including the Company's
termination of customers for non-payment and the marketing and sales initiatives
of the Company's competitors such as, among other things, national advertising
campaigns, telemarketing programs and the use of cash or other incentives. In
particular, the Company commonly experiences high initial customer attrition
from acquired customer bases as these customers are transitioned to the
Company's services and systems. The Company believes that this attrition occurs
as a result of difficulties encountered in transitioning acquired customer bases
to the Company's services and systems, a process which often prompts customers
to consider competitive alternatives in the telecommunications marketplace.
Also, where the Company has not acquired the sales channel associated with an
acquired customer base, there is often a period of increased exposure to
competitors as the Company's sales force establishes a relationship with its new
customers. Moreover, in the past, one of the Company's selling points has been
the ability to accommodate its customers who express a preference for a
particular underlying long distance carrier, such as AT&T. In connection with
the establishment of its own network of switching facilities, the Company no
longer plans to accommodate such customer preferences. The Company expects that,
as a result, certain of its existing customers will discontinue or reduce their
purchases from the Company following the implementation of its network of
switching facilities. This is expected to contribute to anticipated declines in
revenue and could also impair the Company's ability to compete for customers.
Although one of the objectives of the Company's new operating strategy is to
reduce attrition, there can be no assurance that this attrition will not remain
at current levels or increase. Failure to reduce attrition could have a material
adverse effect on the Company's business, financial condition and results of
operations.
Rapid Technological Change. The telecommunications industry is
characterized by rapidly evolving technology. Midcom believes that its success
will increasingly depend on its ability to offer, on a timely basis, new
services based on evolving technologies and industry standards. Midcom intends
to increase its efforts to develop new services; however, there can be no
assurance that the Company will have the ability or resources to develop such
new services, that new technologies required for such services will be available
to the Company on favorable terms or that such services and technologies will
enjoy market acceptance. Further, there can be no assurance that the Company's
competitors will not develop products or services that are technologically,
superior to those used by the Company or that achieve greater market acceptance.
The development of any such superior technology by the Company's competitors, or
the inability of the Company to successfully respond to such a development,
could render Midcom's existing products or services obsolete and could have a
material adverse effect on the Company's business, financial condition and
results of operations.
Ability to Integrate Acquired Operations. Midcom experienced rapid
growth through the end of 1995. A significant portion of this growth,
particularly in 1995, was attributable to acquisitions of customer bases and
other telecommunications service providers. These acquisitions have placed
significant demands on the Company's management and have disrupted the Company's
normal business operations. For a number of reasons, the Company has not been
able to fully consolidate and integrate the sales and marketing, customer
support, billing and other functions of certain acquired operations. Pending
such integration, the Company has maintained a number of billing systems and
other functions of certain acquired operations, which has caused inefficiencies,
additional operational complexity and expense and greater risk of billing delays
and financial reporting difficulties. The Company believes that these
integration problems have also increased customer attrition and impaired the
Company's efforts to cross-sell the disparate products and services of certain
of the acquired operations. The Company's failure to fully integrate acquired
operations with its own operations could have a material adverse effect on the
Company's business, financial condition and results of operations.
15
<PAGE> 16
Dependence Upon Integrity of Call Data Records. Midcom depends on the
timeliness and accuracy of call data records provided to it by facilities-based
carriers supplying telecommunications services, and there can be no assurance
that accurate information will consistently be provided by the carriers on a
timely basis. Failure of the Company to receive prompt and accurate call data
records from its suppliers will impair the Company's ability to bill its
customers on a timely basis. Such billing delays could impair the Company's
ability to collect amounts owed by its customers. Due to the multitude of
billing rates and discounts which suppliers must apply to the calls completed by
the Company's customers, and due to routine logistical issues such as the
addition or termination of customers, the Company regularly has disagreements
with its suppliers concerning the amounts invoiced for its customers' traffic.
Since 1994, the Company has been paying its suppliers according to its own
calculation of the amounts owed as recorded on the computer tapes provided by
its suppliers. The Company's computations of amounts owed are frequently less
than the amount shown on the suppliers' invoices. Accordingly, the suppliers may
consider the Company to be in arrears in its payments until the amount in
dispute is resolved. Although these disputes have generally been resolved on
terms favorable to the Company, there can be no assurance that this will
continue to be the case. Future disputes which are not resolved favorably to the
Company could have a material adverse effect on the Company's business,
financial condition and results of operations.
Dependence Upon Facilities-Based Carriers. Midcom does not currently
own a transmission network and, accordingly, depends to a large extent on AT&T,
Sprint, WorldCom and other facilities-based carriers for actual transmission of
customer calls and other services. Further, the Company, like all other long
distance providers, is dependent upon local exchange carriers for call
origination (carrying the call from the customer's location to the long distance
network of the interexchange carrier selected to carry the call) and termination
(carrying the call off the interexchange carrier's network to the call's
destination). The Company's ability to maintain and expand its business depends,
in part, on its ability to obtain telecommunication services on favorable terms
from facilities-based carriers and the cooperation of both interexchange and
local exchange carriers in initiating and terminating service for its customers
in a timely manner (the process of initiating service for a customer is referred
to as "provisioning"). FCC policy currently requires all common carriers,
including interexchange carriers, to make their services available for resale
and to refrain from imposing unreasonable restrictions on such resale. Further,
the Telecommunications Act requires all ILECs both to offer their services for
resale at wholesale rates and to allow access to unbundled network elements at
cost-based rates. The ILECs are also required by the Telecommunications Act to
provide all interexchange carriers, including the Company, with equal access for
the origination and termination of long distance calls. If any of these
requirements were eliminated, the adverse impact on the Company could be
substantial. Access charges represent a substantial portion of the Company's
current cost of service. The FCC, however, has indicated that it will initiate
in the near future a comprehensive review of its access charge structure,
evaluating the embedded costs and subsidies that produce current access charge
levels. The FCC has also proposed to levy on interexchange carriers a new
per-call payphone usage fee for all toll-free and access code calls originated
from pay telephones. The level at which the FCC sets access charges, universal
service contributions and payphone use fees could have a material adverse effect
on the Company's business, financial condition and results of operation.
Moreover, implementation of a new access charge structure and repricing of local
transport could place many interexchange carriers, including the Company, at a
significant cost disadvantage relative to larger competitors.
In 1994, 1995 and the first quarter of 1996, AT&T, Sprint and WorldCom
were collectively responsible for carrying traffic representing approximately
97%, 67% and 61% of the Company's revenue, respectively, and for those periods
no single carrier was responsible for carrying traffic representing more than
46%, 31% and 31% of the Company's revenue, respectively. Recently the Company
has been substantially in arrears of its payment obligations to AT&T and other
suppliers. On July 16,1996, AT&T notified the Company that its was in breach of
its obligations to AT&T by virtue of its payment arrearages and provided notice
that service would be discontinued if payment defaults were not cured. On July
19, 1996, the Company and AT&T agreed on a payment schedule for overdue amounts
which require periodic payments which would bring the Company current by the
middle of October 1996. Although the Company is generally entitled to be given
notice of defaults and an opportunity to cure under the terms of its agreements
with its interexchange suppliers before such service can be terminated, and
although the Company has the ability to transfer its customers' traffic from one
supplier to another, provisioning a customer that is not serviced by a Midcom
switch to an alternate supplier takes several days. Accordingly, if a major
supplier were to decline to continue to carry the Company's traffic, due to
non-payment or otherwise, without sufficient notice for the Company to make
alternate arrangements, there is a possibility that the customers serviced by
that supplier would be temporarily without "1 plus" long distance calling which
could have a material adverse effect on the Company's business, financial
condition and results of operation.
16
<PAGE> 17
Competition. The long distance telecommunications industry is highly
competitive. Several of the Company's current and potential competitors have
substantially greater financial, technical, marketing and other resources than
the Company, and there can be no assurance that the Company will be competitive
in this environment. The Company's ability to compete may also be impaired by
its leveraged capital structure and limited capital resources.
The long distance telecommunications industry is significantly
influenced by the marketing and pricing activities of the major industry
participants, including AT&T, MCI, Sprint and WorldCom. While the Company
believes that AT&T, MCI and Sprint historically have chosen not to concentrate
their direct sales efforts on small to medium-sized businesses, these carriers
control approximately 85% of that market. Moreover, AT&T, MCI and Sprint have
recently introduced new service and pricing options that are attractive to
smaller commercial users, and there can be no assurance that they will not
market to these customers more aggressively in the future. AT&T and, as an
interim measure, the structurally separate interexchange affiliates of the seven
regional Bell operating companies ("RBOCs") have recently been reclassified as
non-dominant carriers and, accordingly, have the same flexibility as the Company
in meeting competition by modifying rates and service offerings without pricing
constraints or extended waiting periods. These reclassifications may make it
more difficult for the Company to compete for long distance customers. In
addition, a significant number of large regional long distance carriers and new
entrants in the industry compete directly with the Company by concentrating
their marketing and direct sales efforts on small to medium-sized commercial
users. Activities by competitors including, among other things, national
advertising campaigns, telemarketing programs and the use of cash or other forms
of incentives, contribute to significant customer attrition in the long distance
industry.
The Company contracts for call transmission over networks operated by
suppliers who may also be the Company's competitors. Both the interexchange
carriers and local exchange carriers providing transmission services for the
Company have access to information concerning the Company's customers for which
they provide the actual call transmission. Because these interexchange carriers
and local exchange carriers are potential competitors of the Company, they could
use information about the Company's customers, such as their calling volume and
patterns of use, to their advantage in attempts to gain such customers'
business. In addition, the Company's future success will depend, in part, on its
ability to continue to buy transmission services and access from these carriers
at a significant discount below the rates these carriers otherwise make
available to the Company's targeted customers.
Regulatory trends have had, and may have in the future, a significant
impact on competition in the telecommunications industry. As the result of the
recently enacted Telecommunications Act, the RBOCs are now permitted to provide,
and are providing or have announced their intention to provide, long distance
service originating (or in the case of "800" service, terminating) outside their
local service areas or offered in conjunction with other ancillary services,
including wireless services. Following application to and upon a finding by the
FCC that an RBOC faces facilities-based competition and has satisfied a
congressionally-mandated "competitive checklist" of interconnection and access
obligations, an RBOC will also be permitted to provide long distance service
within its local service area. The entry of these well-capitalized and
well-known entities into the long distance service market could significantly
alter the competitive environment in which the Company operates. See
"Telecommunications Act."
The Telecommunications Act also removes all legal barriers to
competitive entry into the local telecommunications market and directs ILECs to
allow competing telecommunications service providers such as the Company to
interconnect their facilities with the local exchange network, to lease network
components on an unbundled basis and to resell local telecommunications
services. Moreover, the Telecommunications Act seeks to facilitate the
development of local telecommunications competition by requiring ILECS, among
other things, to allow end users to retain their telephone numbers when changing
service providers and to place short-haul toll calls without dialing lengthy
access codes. In response to these regulatory changes, MCI and AT&T have each
announced plans to enter the local telecommunications market, including MCI's
announcement that it will invest more than $2.0 billion in fiber optic rings and
local switching equipment in major metropolitan markets throughout
17
<PAGE> 18
the United States, and AT&T's announcement that it has filed applications in all
50 states to provide local telecommunications services.
While the Telecommunications Act opens new markets to the Company, the
nature and value of the resultant business opportunities will be dependent in
large part upon subsequent regulatory interpretation of the statute's
requirements. The FCC is currently in the process of promulgating rules to
implement the local competition provisions of the Telecommunications Act and
each state will thereafter individually adopt regulations applying the resultant
national guidelines. The Company anticipates that ILECs will actively resist
competitive entry into the local telecommunications market and will seek to
undermine the operations and the service offerings of competitive providers,
leaving carriers such as the Company which are dependent on ILECs for network
services vulnerable to anti-competitive abuses. No assurance can be given that
the local competition provision of the Telecommunications Act will be
implemented and enforced by federal and state regulators in a manner which will
permit the Company to successfully compete in the local telecommunications
market or that subsequent legislative and/or judicial actions will not adversely
impact the Company's ability to do so. Moreover, federal and state regulators
are likely to provide ILECs with increased pricing flexibility for their
services as competition in the local market increases. If ILECs are allowed by
regulators to lower their rates substantially, engage in excessive volume and
term discount pricing practices for their customers, charge excessive fees for
network interconnection or access to unbundled network elements or decline to
make services available for resale at wholesale rates, the ability of the
Company to compete in the provision of local service could be materially and
adversely affected.
Regulation. Federal and state regulations, regulatory actions and court
decisions have had, and may have in the future, both positive and negative
effects on the Company and its ability to compete. The Company is subject to
regulation by the FCC and by various state public service or public utility
commissions as a non-dominant or resale provider of long distance services. The
Company is required to file tariffs specifying the rates, terms and conditions
of its interstate and international services with the FCC and is required to
file tariffs or obtain other approvals in most of the states in which it
operates. Neither the FCC nor the relevant state utility commissions currently
regulate the Company's profit levels, but they often reserve the authority to do
so. The large majority of states require long distance service providers to
apply for authority to provide telecommunications services and to make filings
regarding their activities. The multiplicity of state regulations makes full
compliance with all such regulations a challenge for multistate providers such
as the Company. There can be no assurance that future regulatory, judicial and
legislative changes or other activities will not have a material adverse effect
on the Company or that regulators or third parties will not raise material
issues with regard to the Company's compliance with applicable laws and
regulations. The Company believes, however, that the trend has been, and will
continue to be, toward significant relaxation of federal and state regulation of
its operations and services.
Pursuant to the terms of the 1984 court decree which required AT&T to
divest its local exchange operations, the RBOCs were prohibited from providing
long distance telecommunications service between certain defined geographic
areas, known as Local Access Transport Areas or "LATAs." However, the
Telecommunications Act allows for immediate provision by the RBOCs of long
distance service outside their respective local telephone service areas as well
as long distance service bundled with wireless, enhanced and certain other
services. The Telecommunications Act also provides a mechanism for eventual
entry by the RBOCs into the long distance market within their respective local
service areas. The competition faced by the Company will increase significantly
as the RBOCs expand their provision of inter-LATA services.
As a result of a 1994 court decision, the Company became obligated to
provide detailed rate schedules in all of its federal tariffs, and the Company
could possibly be liable for damages for following an FCC policy which did not
require the Company to file such detailed schedules of its domestic charges in
the past. The FCC has proposed to implement a policy of "mandatory detariffing"
for the domestic offerings of all nondominant interexchange carriers, which, if
adopted, would not only absolve the Company, as well as its principal suppliers
and competition, from any obligation to file domestic interexchange tariffs, but
would affirmatively prohibit all such tariff filings. Also, AT&T and, as an
interim measure, the structurally separate interexchange affiliates of the
18
<PAGE> 19
RBOCs have recently been reclassified as non-dominant carriers and, accordingly,
have the same flexibility as the Company in meeting competition by modifying
rates and service offerings without pricing constraints or extended waiting
periods. The reclassifications may make it more difficult for the Company to
compete for long distance customers.
Substantial Leverage. If the Note offering is successfully completed,
the Company will be highly leveraged. As of March 31, 1996, after giving pro
forma effect to the application of the estimated net proceeds of the Note
Offering, the Company's total indebtedness and shareholders' equity would have
been $93.9 million and $10.7 million, respectively. On the same pro forma basis,
the Company's earnings would have been insufficient to cover its fixed charges
by $29.4 million and $14.5 million for the year ended December 31, 1995 and the
three months ended March 31, 1996, respectively. The Company's ability to make
scheduled payments of the principal of, or interest on, its indebtedness will
depend on its future performance, which is subject to economic, financial,
competitive and other factors beyond its control.
Shares Eligible for Future Sale. At June 30, 1996, the Company had
outstanding 15,836,317 shares of Common Stock, of which 9,131,207 shares were
"restricted securities" subject to restrictions set forth in Rule 144
promulgated under the Securities Act. Of the restricted securities, 5,496,522
shares may be sold under Rule 144, 3,534,685 shares will be tradable pursuant to
Rule 144 upon the expiration of the applicable two-year holding period and
100,000 shares, sold in a transaction exempt from registration under Regulation
S of the Securities Act, will be tradeable pursuant to Rule 144 upon the
expiration of a one-year holding period. These periods will expire between
December 31, 1996 and December 30, 1997. If a proposed amendment to Rule 144 is
adopted, however, the two-year holding period would be reduced to one year. In
addition, as of June 30, 1996, the Company had reserved for issuance 4,211,463
shares of Common Stock under its Amended and Restated 1993 Stock Option Plan
(the "Stock Option Plan") (assuming shareholder approval of an increase in
options available for grant) and 258,625 shares of Common Stock for issuance
under its 1995 Employee Stock Purchase Plan (the "Stock Purchase Plan"). Under
the Stock Option Plan, as of June 30, 1996, options to purchase 3,226,542 shares
of Common Stock were outstanding and options to purchase 172,258 shares of
Common Stock were exercisable. Also, at June 30, 1996, warrants to purchase
874,970 shares of Common Stock were outstanding, including a warrant to purchase
815,470 shares of Common Stock issued in connection with a interim bridge loan.
This warrant is not exercisable until September 24, 1996 and will expire if the
bridge loan is repaid in full on or before September 24, 1996. In connection
with the issuance of a note payable to one seller of a customer base, the
Company issued a warrant to acquire $2 million of the Common Stock. In the event
of non-payment of the note, the exercise price of such warrant is cancellation
of the note, the principal amount of which is subject to adjustment, and the
number of shares to be issued upon exercise of the warrant would equal $2
million divided by the then current market price of the Common Stock.
In connection with certain acquisitions and financings, the Company has
granted to individuals or entities rights to require the Company to register the
offer and sale of approximately 1,876,000 shares of Common Stock (including
shares of Common Stock issuable upon conversion or exercise of outstanding
warrants) under the Securities Act beginning as early as August 1996. Holders of
a portion of these shares have indicated their intent to exercise their demand
registration rights and sell shares of Common Stock in the public market as soon
as or shortly after their registration rights become exercisable. If these
registration rights are exercised, the Company will be required to maintain the
effectiveness of a resale registration for periods of up to 180 days. However,
in connection with the Note Offering, shareholders holding 782,762 of these
shares, as well as the Company and certain of its officers and directors have
each agreed not to sell or grant any option for the sale of, or otherwise
dispose of, any Common Stock, or any securities convertible into or exchangeable
or exercisable for shares of Common Stock and not to file or request to be
filed, as the case may be, any registration statement with respect to the Common
Stock for a period of 90 days after the consummation of the Note Offering
without prior written consent. In part to obtain the 90-day lock-up commitment
referred to above, the Company has proposed to file a shelf registration under
the Securities Act with respect to approximately 134,643 shares of Common Stock
held by a portion of the holders of the above-described demand registration
rights. This shelf registration will provide for
19
<PAGE> 20
the continuous offering, subject to certain exceptions, of such shares in the
public market for a period of one year after the effective date of the shelf
registration. Creation of this commitment is subject to execution of new
agreements with each affected shareholder which provide, among other things, for
termination of all of the holders' other registration rights. There can be no
assurance such arrangements will be finalized.
Sales of substantial amounts of Common Stock in the public market under
Rule 144, pursuant to the exercise of registration rights or otherwise, and even
the potential for such sales, may have a material adverse effect on the
prevailing market price of the Common Stock and could impair the Company's
ability to raise capital through the sale of its equity securities.
Control by Principal Shareholders. At June 30, 1996, Midcom's directors
and executive officers beneficially owned or had the power to vote approximately
39.0% of the Common Stock. Although such shareholders will not have the ability
to control matters requiring shareholder approval, they may have the ability to
influence the affairs and management of the Company and the elections of
directors. This may have the effect of delaying, deferring or preventing a
change in control of the Company and could limit the price that certain
investors might be willing to pay in the future for the Common Stock.
Anti-Takeover Considerations. The Company is subject to the
anti-takeover provisions of Chapter 23B.17 of the Washington Business
Corporation Act (the "WBCA") which prohibits, subject to certain exceptions, a
merger, sale of assets or liquidation of a corporation involving a 20%
shareholder unless determined to be at a fair price or approved by disinterested
directors or two-thirds of the disinterested shareholders. In addition, Chapter
23B.19 of the WBCA prohibits a corporation registered under the Exchange Act
from engaging in certain significant transactions with a 10% shareholder.
Significant transactions include, among others, a merger with or disposition of
assets to the 10% shareholder. Further, the Company's Amended and Restated
Articles of Incorporation (the "Articles") require super-majority shareholder
approval of certain business combinations and provide for a classified Board of
Directors with staggered, three-year terms. Also, the Company has the authority
to issue up to 10 million shares of preferred stock in one or more series and to
fix the preferences and other rights thereof without any further vote or action
by the Company's shareholders. The issuance of preferred stock, together with
the effect of other anti-takeover provisions in the Articles and under the WBCA,
may have the effect of delaying, deferring or preventing a change in control of
the Company and could limit the price that certain investors might be willing to
pay in the future for the Common Stock.
Possible Volatility of Stock Price. The market price of the Common
Stock has been, and is likely to continue to be, volatile. There can be no
assurance that the market price of the Common Stock will not fluctuate
significantly from its current level. The market price of the Common Stock could
be subject to significant fluctuations in response to a number of factors, such
as actual or anticipated variations in the Company's quarterly operating
results, the introduction of new products by the Company or its competitors,
changes in other conditions or trends in the Company's industry, changes in
governmental regulations, changes in securities analysts' estimates of the
Company's, or its competitors' or industry's, future performance or general
market conditions. In addition, stock markets have experienced extreme price and
volume volatility in recent years, which has had a substantial effect on the
market prices of securities of many smaller public companies for reasons
frequently unrelated to the operating performance of such companies. These broad
market fluctuations may have a material adverse effect on the market price of
the Common Stock.
Limitations on Dividends. Since its incorporation in 1989, the Company
has not declared or paid cash dividends on its Common Stock, and the Company
anticipates that any future earnings will be retained for investment in its
business. Any payment of cash dividends in the future will be at the discretion
of the Company's Board of Directors and will depend upon, among other things,
the Company's earnings, financial condition, capital requirements, extent of
indebtedness and contractual restrictions with respect to the payment of
dividends. In addition, the terms of the Revolving Credit Facility prohibit the
payment of cash dividends without the consent of the Company's lenders.
20
<PAGE> 21
Item 7. Financial Statements, Pro Forma Financial Information and Exhibits.
(c) Exhibits
99.1 Press release dated August 2, 1996 issued under Securities and
Exchange Commission Rule 135c giving notice of a proposed
unregistered offering of convertible subordinated notes.
21
<PAGE> 22
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 hereunto duly authorized.
MIDCOM COMMUNICATIONS INC.
Dated: August 2, 1996 By: /s/ Paul P. Senio
---------------------------------
Paul P. Senio
Vice President and General Counsel
22
<PAGE> 23
MIDCOM COMMUNICATIONS INC.
EXHIBIT INDEX
to Interim Report on Form 8-K
<TABLE>
<CAPTION>
Page #
------
<S> <C>
99.1 Press release dated August 2, 1996 issued under Securities and
Exchange Commission Rule 135c giving notice of a proposed
unregistered offering of convertible subordinated notes. 24
</TABLE>
<PAGE> 1
Exhibit 99.1
FOR IMMEDIATE RELEASE
CONTACT: Robert J. Chamberlain Paul Senio
Chief Financial Officer General Counsel
(206) 628-5174 (206) 628-4900
MIDCOM COMMUNICATIONS INC.
ANNOUNCES $75,000,000 PRIVATE PLACEMENT
SEATTLE, WA August 2, 1996 -- MIDCOM Communications Inc. (NASDAQ: MCCI) today
announced that it has commenced a private offering of $75,000,000 principal
amount of convertible subordinated notes due in 2003. The notes will be
convertible, at the option of the holder, into shares of MIDCOM common stock.
The interest rate and conversion price for the notes will be determined prior to
closing of the offering.
If fully subscribed, the offering is expected to close by the end of
August. The net proceeds of the offering are expected to be used to repay
borrowings under the company's bridge loan and revolving credit facility, to
acquire and install high capacity switches, to bring current a number of
existing payment obligations, to settle pending disputes and reduce the
company's minimum commitment under a carrier supply contract with one of its
suppliers and for other working capital purposes.
The notes are being offered on behalf of MIDCOM to qualified
institutional buyers under SEC Rule 144A, to certain institutional accredited
investors and under Regulation S to certain non-U.S. persons in offshore
transactions. The notes have not been registered under the Securities Act of
1933 and may not be offered or sold in the United States absent registration or
an applicable exemption from registration requirements.
Founded in 1989, MIDCOM Communications Inc. provides a broad range of
telecommunications services to small and medium-sized businesses nationwide.
The company is headquartered in Seattle, Washington and has regional offices
throughout the nation. MIDCOM currently invoices approximately 125,000 customer
locations per month.
###
