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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
QUARTERLY REPORT ON FORM 10-Q
(MARK ONE)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2003
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM ______ TO ______
COMMISSION FILE NUMBER: 0-29279
----------------------------
CHOICE ONE COMMUNICATIONS INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
STATE OF DELAWARE 16-1550742
(STATE OR OTHER JURISDICTION (I.R.S. EMPLOYER
OF INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
100 CHESTNUT STREET, SUITE 600, ROCHESTER, NEW YORK 14604-2417
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
(585) 246-4231
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
----------------------------
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to the filing
requirements for the past 90 days. Yes X No _____
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes______ No X
As of August 1, 2003, there were outstanding 44,054,945 shares of the
registrant's common stock, par value $0.01 per share.
CHOICE ONE COMMUNICATIONS INC. AND SUBSIDIARIES FORM 10-Q
INDEX
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements (Unaudited)
Condensed Consolidated Balance Sheets as of June 30, 2003 and December 31, 2002.................. 2
Condensed Consolidated Statements of Operations for the three months ended June 30, 2003 and June
30, 2002......................................................................................... 3
Condensed Consolidated Statements of Operations for the six months ended June 30, 2003 and June
30, 2002......................................................................................... 4
Condensed Consolidated Statements of Cash Flow for the six months ended June 30, 2003 and June
30, 2002......................................................................................... 5
Notes to Condensed Consolidated Financial Statements............................................. 6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations............ 17
Item 3. Quantitative and Qualitative Disclosures about Market Risk....................................... 32
Item 4. Controls and Procedures.......................................................................... 32
PART II. OTHER INFORMATION
Item 1. Legal Proceedings................................................................................ 33
Item 2. Changes in Securities and Use of Proceeds........................................................ 33
Item 3. Defaults Upon Senior Securities.................................................................. 33
Item 4. Submission of Matters to a Vote of Security Holders.............................................. 34
Item 5. Other Information................................................................................ 34
Item 6. Exhibits and Reports on Form 8-K................................................................. 34
Signatures..................................................................................................... 35
(i)
PART I FINANCIAL INFORMATION
CHOICE ONE COMMUNICATIONS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEET
(AMOUNTS IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
JUNE 30, DECEMBER 31,
2003 2002
---- -----
(Unaudited)
ASSETS
Current Assets:
Cash and cash equivalents........................................................ $ 14,979 $ 29,434
Accounts receivable, net......................................................... 34,967 43,215
Prepaid expenses and other current assets........................................ 4,187 2,298
----------- -----------
Total current assets......................................................... 54,133 74,947
Property and equipment, net of accumulated depreciation............................... 312,868 336,711
Intangible assets, net of accumulated amortization.................................... 39,994 47,479
Other assets, net..................................................................... 4,997 4,813
----------- -----------
Total assets.......................................................................... $ 411,992 $ 463,950
=========== ===========
LIABILITIES AND STOCKHOLDERS' DEFICIT
Current Liabilities:
Current portion of capital leases for indefeasible rights to use fiber........... $ 523 $ 461
Accounts payable.................................................................. 6,047 14,717
Accrued expenses.................................................................. 44,633 58,381
----------- -----------
Total current liabilities..................................................... 51,203 73,559
Long-term debt, net.................................................................... 613,366 595,941
Interest rate swaps.................................................................... 17,852 19,308
Long-term portion of capital leases for indefeasible rights to use fiber............... 33,799 31,968
Other long-term liabilities............................................................ 3,683 3,581
----------- -----------
Total long-term debt and other liabilities.................................... 668,700 650,798
Commitments and Contingencies (Note 13)
Redeemable Preferred Stock:
Series A Preferred stock, $0.01 par value, 340,000 shares authorized;
251,588 shares issued and outstanding, at June 30, 2003 and December 31,
2002, respectively, ($316,418 liquidation value at June 30, 2003) ................ 268,733 243,532
Stockholders' Deficit:
Undesignated preferred stock, $0.01 par value, 4,600,000 shares
authorized, no shares issued and outstanding.................................... - -
Common stock, $0.01 par value, 150,000,000 authorized; 44,190,360 and
42,478,396 shares issued as of June 30, 2003 and December 31, 2002,
respectively.................................................................... 442 425
Treasury stock, 135,415 shares, at cost, at June 30, 2003 and December 31, 2002,
respectively.................................................................. (473) (473)
Additional paid-in capital........................................................ 474,511 498,439
Deferred compensation............................................................. (602) (391)
Accumulated other comprehensive loss.............................................. (17,852) (19,308)
Accumulated deficit............................................................... (1,032,670) (982,631)
---------- -----------
Total stockholders' deficit....................................................... (576,644) (503,939)
----------- -----------
Total liabilities and stockholders' deficit....................................... $ 411,992 $ 463,950
=========== ===========
The accompanying notes to condensed consolidated financial statements are
an integral part of these financial statements.
-2-
CHOICE ONE COMMUNICATIONS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(AMOUNTS IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
THREE MONTHS ENDING
JUNE 30,
2003 2002
---- ----
(Unaudited) (Unaudited)
Revenue $ 82,189 $ 73,191
Operating expenses:
Network costs.............................................................. 41,311 40,434
Selling, general and administrative, including non-cash
compensation of $186 and $2,037 in 2003 and 2002, respectively,
and non-cash management ownership allocation charge of $5,348 in 2002.... 30,723 56,554
Loss on disposition of assets.............................................. 29 533
Impairment loss on long-lived assets....................................... - 283,251
Depreciation and amortization.............................................. 17,154 16,533
----------- -----------
Total operating expenses................................................... 89,217 397,305
----------- -----------
Loss from operations............................................................ (7,028) (324,114)
Other income/(expense):
Interest and other income.................................................. 43 76
Interest expense........................................................... (16,789) (14,973)
----------- -----------
Total other income/(expense), net...................................... (16,746) (14,897)
----------- -----------
Net loss ....................................................................... (23,774) (339,011)
Accretion of preferred stock............................................... 2,742 2,011
Accrued dividends on preferred stock....................................... 10,105 8,806
----------- -----------
Net loss applicable to common stockholders...................................... $ (36,621) $ (349,828)
=========== ===========
Net loss per share, basic and diluted........................................... $ (0.68) $ (8.17)
=========== ===========
Weighted average number of shares outstanding, basic and diluted....... ........ 53,994,804 42,804,170
=========== ===========
The accompanying notes to condensed consolidated financial statements are
an integral part of these financial statements.
-3-
CHOICE ONE COMMUNICATIONS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(AMOUNTS IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
SIX MONTHS ENDING
JUNE 30,
2003 2002
---- ----
(Unaudited) (Unaudited)
Revenue $ 162,289 $ 143,786
Operating expenses:
Network costs.............................................................. 81,838 82,619
Selling, general and administrative, including non-cash
compensation of $661 and $4,146 in 2003 and 2002, respectively,
and non-cash management ownership allocation charge of $10,715 in 2002 .. 63,094 101,750
Restructuring credits...................................................... (535) -
Loss on disposition of assets.............................................. 88 778
Impairment loss on long-lived assets....................................... - 283,251
Depreciation and amortization.............................................. 34,723 32,707
----------- -----------
Total operating expenses................................................... 179,208 501,105
----------- -----------
Loss from operations............................................................ (16,919) (357,319)
Other income/(expense):
Interest and other income.................................................. 146 130
Interest expense........................................................... (33,266) (29,137)
----------- -----------
Total other income/(expense), net...................................... (33,120) (29,007)
----------- -----------
Net loss ....................................................................... (50,039) (386,326)
Accretion of preferred stock............................................... 5,334 3,997
Accrued dividends on preferred stock....................................... 19,867 17,313
----------- -----------
Net loss applicable to common stockholders...................................... $ (75,240) $ (407,636)
========== ===========
Net loss per share, basic and diluted........................................... $ (1.40) $ (9.60)
=========== ===========
Weighted average number of shares outstanding, basic and diluted................ 53,753,681 42,458,170
=========== ===========
The accompanying notes to condensed consolidated financial statements are
an integral part of these financial statements.
-4-
CHOICE ONE COMMUNICATIONS INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(AMOUNTS IN THOUSANDS)
SIX MONTHS ENDED
JUNE 30,
2003 2002
---- ----
Cash flows from operating activities:
Net loss.................................................................... $ (50,039) $ (386,326)
Adjustments to reconcile net loss to net cash used in operating activities:
Loss on disposition of assets........................................... 88 778
Depreciation and amortization........................................... 34,723 32,707
Interest payable in-kind on long-term debt.............................. 15,427 11,879
Amortization of deferred financing costs................................ 2,251 2,045
Amortization of discount on long-term debt.............................. 543 249
Non-cash compensation and management ownership allocation charge 661 14,861
Impairment loss on long-lived assets.................................... - 283,251
Changes in assets and liabilities:
Decrease in accounts receivable, net................................. 8,248 776
Increase prepaid expenses and other assets........................... (2,277) (30)
Decrease in accrued restructuring costs.............................. (1,109) -
(Decrease)/increase in account payable and accrued expenses.......... (20,402) 540
--------- ----------
Net cash used in operating activities............................. (11,886) (39,270)
Cash flows from investing activities:
Capital expenditures.................................................... (4,022) (12,180)
Proceeds from sale of assets............................................ 52 1,002
--------- ----------
Net cash used in investing activities................................ (3,970) (11,178)
Cash flows from financing activities:
Additions to long-term debt.......................................... 1,750 153,700
Principal payments of long-term debt.............................
- (98,700)
Payments under long-term capital leases for indefeasible rights
to use fiber......................................................... (349) (156)
--------- ----------
Net cash provided by financing activities................................... 1,401 54,844
--------- ----------
Net (decrease)/increase in cash and cash equivalents........................ (14,455) 4,396
--------- ----------
Cash and cash equivalents, beginning of period.............................. 29,434 14,415
--------- ----------
Cash and cash equivalents, end of period.................................... $ 14,979 $ 18,811
========= ==========
The accompanying notes to condensed consolidated financial statements are
an integral part of these financial statements.
-5-
CHOICE ONE COMMUNICATIONS INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE SIX MONTH PERIOD ENDED JUNE 30, 2003
(Unaudited)
(Amounts in thousands, except share and per share data)
NOTE 1. DESCRIPTION OF BUSINESS
Choice One Communications Inc. and its wholly-owned subsidiaries (the "Company")
is an integrated communications provider offering facilities-based voice and
data telecommunications services. The Company, incorporated under the laws of
the State of Delaware on June 2, 1998, provides these services primarily to
small and medium-sized businesses in 29 second and third tier markets in the
northeastern and midwestern United States. The Company's services include local
exchange and long distance services and high-speed data and Internet services.
The Company seeks to become the leading integrated communications provider in
each market it serves by offering a single source for competitively priced, high
quality, customized telecommunications services.
NOTE 2. BASIS OF PRESENTATION
The accompanying unaudited interim condensed consolidated financial statements
have been prepared in accordance with accounting principles generally accepted
in the United States of America ("GAAP") for interim financial information and
with the instructions to Form 10-Q and Article 10 of Regulation S-X.
Accordingly, they do not include all of the information required by GAAP for
complete financial statement presentation. The unaudited interim condensed
consolidated financial statements include the consolidated accounts of the
Company with all significant intercompany transactions eliminated. In the
opinion of management, all adjustments (consisting only of normal recurring
adjustments) necessary for a fair statement of the financial position, results
of operations and cash flows for the interim periods presented have been made.
These financial statements should be read in conjunction with the Company's
audited financial statements as of and for the year ended December 31, 2002. The
results of operations for the three and six month periods ended June 30, 2003
are not necessarily indicative of the results to be expected for other interim
periods or for the year ended December 31, 2003.
Certain amounts in the prior period's condensed consolidated financial
statements have been reclassified to conform to the current period presentation.
These reclassifications had no impact on the results of operations and cash
flows for the periods presented.
NOTE 3. GOING CONCERN MATTERS
The accompanying financial statements have been prepared on a going concern
basis, which contemplates the realization of assets and the satisfaction of
liabilities in the normal course of business.
The Company has experienced net losses applicable to common stockholders of
$36.6 million, $38.6 million and $349.8 million for the three months ended June
30, 2003, March 31, 2003 and June 30, 2002, respectively. At June 30, 2003, the
Company had $15.0 million in cash and cash equivalents and $1.8 million
available under its senior credit facility. The $1.8 million is available in two
equal quarterly installments on September 30, 2003 and December 31, 2003 and is
subject to no "material adverse change" in the business, as defined in the
Company's Third Amended and Restated Credit Agreement ("Credit Agreement"). The
Company generated negative cash flows from both operating and investing
activities during the years ended December 31, 2002 and 2001, and for the three
and six months ended June 30, 2003. The Company has a total stockholders'
deficit of $576.6 million as of June 30, 2003. These factors raise substantial
doubt about the Company's ability to continue as a going concern.
-6-
The Company has completed several steps intended to increase its liquidity and
better position the Company to compete under current conditions and anticipated
changes in the telecommunications industry. These include:
- - Completing an additional financing of $48.9 million in September 2002,
- - Maintaining a high client retention rate,
- - Completing operational initiatives to optimize the Company's network and
lower its cost structure,
- - Reducing general and administrative expenses through automation and
reductions in workforce,
- - Exiting one market that was found to be unprofitable,
- - Introducing new products to improve revenue growth and profitability, and
- - Redeploying assets held for use to reduce the requirement for capital
expenditures.
The Company has an operating plan for the year ended December 31, 2003 (the
"2003 plan"). Despite its net losses in prior years, if the Company is able to
substantially execute the 2003 plan, then it should have sufficient resources to
fund current operations through December 31, 2003. The Company's viability is
dependent upon its ability to continue to execute under its business strategy
and to begin to generate positive cash flows from operations during 2003. The
success of the Company's business strategy includes obtaining and retaining a
significant number of customers, generating significant and sustained growth in
its operating cash flows and managing its costs and capital expenditures to be
able to meet its debt service obligations. However, the Company's revenue and
costs may be dependent upon factors that are not within its control, including
regulatory changes, changes in technology, and increased competition. Due to the
uncertainty of these factors, actual revenue and costs may vary from expected
amounts, possibly to a material degree, and such variations could affect the
Company's future funding requirements.
The Company's continuation as a going concern is dependent on its ability to
substantially achieve its 2003 plan. While the substantial achievement of the
Company's 2003 plan should result in the Company having positive cash and cash
equivalents in excess of the $10.0 million minimum cash and committed financing
covenant established pursuant to the Credit Agreement, at December 31, 2003,
there can be no assurance that the Company will be successful in executing its
business strategy or in obtaining additional debt or equity financing, if
needed, on terms acceptable to the Company, or at all. There are conditions to
the Company's ability to borrow the remaining $1.8 million available under its
senior credit facility, including the continued satisfaction of covenants and
absence of a material adverse change, as defined in the Credit Agreement. These
covenants require the Company to maintain minimum cash and committed financing
of $10.0 million through July 1, 2004, and impose limits on the Company's
capital expenditures that vary annually as described in the Credit Agreement. A
default in the observance of these covenants, if unremedied in three business
days, could cause the lenders to declare the principal and interest outstanding
at that time to be payable immediately and terminate any commitments. The
Company can make no assurance that it will not be required to engage in asset
sales or pursue other alternatives designed to enhance liquidity or obtain
relief from its obligations, or that it will be successful in these efforts. As
of June 30, 2003, the Company was in compliance with these covenants and if the
Company is able to substantially execute its 2003 plan, then the Company expects
to be in compliance with these covenants for the remainder of 2003. The
financial statements do not include any adjustments relating to the
recoverability and classification of assets and the satisfaction and
classification of liabilities that might be necessary should the Company be
unable to continue as a going concern.
-7-
NOTE 4. NEW ACCOUNTING PRONOUNCEMENTS
In June 2001, the Financial Accounting Standards Board ("FASB") issued Statement
of Financial Accounting Standards ("SFAS") SFAS No. 143, "Accounting for Asset
Retirement Obligations". This standard addresses the financial accounting and
reporting for obligations associated with the retirement of tangible long-lived
assets and the associated asset retirement costs. The standard is effective for
fiscal years beginning after June 15, 2002. The Company adopted this standard on
January 1, 2003. The adoption of SFAS No. 143 did not have a material impact on
the Company's financial condition or results of operations.
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated
with Exit or Disposal Activities". This standard amends Emerging Issue Task
Force Issue No. 94-3, "Liability Recognition for Certain Employee Termination
Benefits and Other Costs to Exit an Activity". This statement requires that a
liability for costs associated with an exit or disposal activity be recognized
when the liability is incurred, rather than when an entity commits to an exit
plan. The standard also established the use of fair value for the measurement of
exit liabilities. The standard is effective for exit or disposal activities
initiated after December 31, 2002, with early application encouraged. The
Company adopted this standard on January 1, 2003. The adoption of this standard
did not have an impact on the Company's financial condition or results of
operations as it will only impact the Company's future exit or disposal
activities, if any.
In December 2002, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 148, "Accounting for
Stock-Based Compensation - Transition and Disclosure, an amendment of FASB
Statement No. 123". This standard amends SFAS No. 123, "Accounting for
Stock-Based Compensation". This statement permits two additional transition
methods for entities to apply when implementing the fair value recognition
provisions of SFAS No. 123. The standard also establishes new disclosure
requirements and requires prominent display of such disclosures. The standard is
effective for financial statements for fiscal years ending after December 31,
2002, with early application permitted. The Company adopted this standard
effective January 1, 2003, and the impact of the adoption is included in the
Company's results of operations for the three and six months ended June 30,
2003.
In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging Activities". This statement amends SFAS No.
133, "Accounting for Derivative Instruments and Hedging Activities". This
statement clarifies the accounting guidance on derivative instruments, including
certain derivative instruments embedded in other contracts, and hedging
activities. The standard is effective for contracts entered into or modified
after June 30, 2003. The Company does not expect the adoption of this standard
to have a material impact on its financial condition or results of operations.
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity." This statement
establishes standards for how an issuer classifies and measures in its statement
of financial position certain financial instruments with characteristics of both
liabilities and equity. It requires that an issuer classify a financial
instrument that is within its scope as a liability (or an asset in some
circumstances) because that financial instrument embodies an obligation of the
issuer. This statement is effective for financial instruments entered into or
modified after May 31, 2003 and otherwise is effective at the beginning of the
first interim period beginning after June 15, 2003, except for mandatorily
redeemable financial instruments of nonpublic entities. The Company will adopt
this Standard on July 1, 2003. Upon adoption, the Company will reclassify its
mandatorily redeemable preferred stock to long-term liabilities. The Company
will also begin to recognize dividends declared and accretion related to this
preferred stock as interest expense. The Company is currently assessing the
impact of adopting SFAS No. 150 on its financial condition and results of
operations.
-8-
In November 2002, the FASB issued Financial Interpretation ("FIN") No. 45,
"Guarantor's Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others". FIN No. 45 elaborates on the
existing disclosure requirements for most guarantees, and clarifies that at the
time a company issues a guarantee, the company must recognize an initial
liability for the fair value of the obligation it assumes under that guarantee
and must disclose that information in its interim and annual financial
statements. The initial recognition and measurement provisions apply on a
prospective basis to guarantees issued or modified after December 31, 2002. The
adoption of FIN No. 45 did not have a material impact on the Company's financial
condition or results of operations.
On January 17, 2003 the FASB issued Financial Interpretation ("FIN") No. 46,
"Consolidation of Variable Interest Entities." The objective of FIN No. 46 is to
improve financial reporting by companies involved with variable interest
entities. FIN No. 46 changes certain consolidation requirements by requiring a
variable interest entity to be consolidated by a company if that company is
subject to a majority of the risk of loss from the variable interest entity's
activities or entitled to receive a majority of the entity's residual returns or
both. The consolidation requirements apply to entities created before February
1, 2003, no later than the beginning of the first fiscal year or interim period
beginning after June 15, 2003. The Company does not expect the adoption of this
standard to have a material impact on its financial condition or results of
operations.
NOTE 5. PROPERTY AND EQUIPMENT
Property and equipment, at cost, consisted of the following:
JUNE 30, 2003 DECEMBER 31, 2002
------------- -----------------
Switch equipment................................... $ 303,672 $ 300,506
Computer equipment and software.................... 58,586 55,598
Office furniture and equipment..................... 9,891 9,950
Leasehold improvement.............................. 22,787 22,815
Indefeasible right to use fiber (IRU).............. 69,475 67,548
Assets held for use................................ 6,767 5,132
Construction in progress........................... 1,293 5,665
---------- ----------
Total property and equipment 472,471 467,214
Less: accumulated amortization on IRUs............. (7,179) (5,452)
accumulated depreciation.................... (152,424) (125,051)
---------- ----------
Property and equipment, net $ 312,868 $ 336,711
========== ==========
Depreciation expense, including amortization of IRUs, amounted to $14.3 million
and $13.9 million for the three months ended June 30, 2003 and June 30, 2002,
respectively, and $29.3 million and $27.4 million for the six months ended June
30, 2003 and June 30, 2002, respectively.
-9-
NOTE 6. INTANGIBLE ASSETS
The Company accounts for certain intangible assets with finite lives in
accordance with SFAS No. 142, "Goodwill and Other Intangible Assets". The
following schedule sets forth the major classes of intangible assets held by the
Company:
JUNE 30, 2003 DECEMBER 31, 2002
------------- -----------------
Amortized intangibles:
Customer relationships.......................... $ 53,635 $ 53,635
Deferred financing costs........................ 29,815 29,785
Less: accumulated amortization
Customer relationships............. (31,150) (25,787)
Deferred financing costs........... (12,306) (10,154)
-------- --------
Intangible assets, net ..................... $ 39,994 $ 47,479
======== ========
Deferred financing costs are amortized to interest expense over the term of the
related debt using the effective interest rate method. The Company continues to
amortize its intangible assets that have finite lives. The estimated
amortization expense on customer relationships, which have an estimated life of
five years, is as follows for the following fiscal periods:
July to December, 2003......................................... 5,364
2004........................................................... 10,616
2005........................................................... 6,027
2006........................................................... 370
2007........................................................... 109
Amortization expense was $2.7 million and $2.6 million for the three months
ended June 30, 2003 and 2002, respectively, and $5.4 million and $5.3 million
for the six months ended June 30, 2003 and June 30, 2002, respectively.
NOTE 7. ACCRUED EXPENSES
Accrued expenses consisted of the following:
JUNE 30, 2003 DECEMBER 31, 2002
------------- -----------------
Accrued network costs.............................. $ 27,452 $ 33,936
Accrued payroll and payroll related benefits....... 2,742 2,883
Accrued collocation costs.......................... 3,009 5,723
Accrued interest................................... 1,078 1,222
Accrued restructuring costs........................ 780 1,695
Deferred revenue................................... 5,039 4,990
Other.............................................. 4,533 7,932
------------ --------------
Total accrued expenses $ 44,633 $ 58,381
============ ==============
-10-
NOTE 8. DEBT
Long-term debt outstanding consists of the following:
JUNE 30, 2003 DECEMBER 31, 2002
------------- -----------------
Senior credit facility:
Term A loan.................................... $ 125,000 $ 125,000
Term B loan.................................... 125,000 125,000
Term C loan.................................... 43,284 41,389
Term D loan.................................... 2,625 875
Revolver....................................... 100,000 100,000
Subordinated notes................................. 217,457 203,677
--------- ---------
$ 613,366 $ 595,941
========= =========
Included in the subordinated notes is a discount on the notes of $2.5 million
and $2.8 million as of June 30, 2003 and December 31, 2002, respectively.
Included in the Term C loan is a discount of $3.9 million and $4.1 million as of
June 30, 2003 and December 31, 2002, respectively, and payable-in-kind ("PIK")
interest which accreted to principal of $2.7 million and $1.0 million as of June
30, 2003 and December 31, 2002, respectively.
The discount on the subordinated notes is being amortized over its nine-year
term. For the three months ended June 30, 2003 and 2002, $0.1 million and $0.1
million of the discount was amortized, respectively. For the six months ended
June 30, 2003 and 2002, $0.3 million and $0.2 million of the discount was
amortized, respectively. The discount on the Term C loan is also being amortized
over its seven and one-half year term. For the three and six months ended June
30, 2003, $0.1 million and $0.3 million, respectively, of the discount on the
Term C loan was amortized.
The Company's Credit Agreement provides the Company with the following borrowing
limits, maturities and interest rates:
PRINCIPAL
AMOUNT MATURITY
------ --------
Revolving credit facility........ $ 100,000 July 31, 2008
Term A loan...................... 125,000 July 31, 2008
Term B loan...................... 125,000 January 31, 2009
Term C loan...................... 44,500 March 31, 2009
Term D loan...................... 4,375 January 31, 2009
INTEREST RATE OPTIONS INTEREST TERMS
--------------------- --------------
Revolving credit facility........ LIBOR + 4.00% or Base Rate+3.00%* Payable monthly
Term A loan...................... LIBOR + 4.00% or Base Rate+3.00%* Payable monthly
Term B loan...................... LIBOR + 4.75% or Base Rate+3.75% Payable monthly
Term C loan...................... LIBOR + 5.75% or Base Rate+4.75% Accrues to principal
Term D loan...................... LIBOR + 4.00% or Base Rate+3.00%* Payable monthly
* - The applicable margin is determined by a grid tied to the Company's leverage
ratio. Initially, the applicable margin is 4.0% if the LIBOR rate is used, or
3.0% if the Base Rate is used.
-11-
The Credit Agreement contains certain covenants that are customary for credit
facilities of this nature, all of which are defined in the Credit Agreement.
These covenants require the Company to maintain an aggregate minimum amount of
cash and committed financing of $10.0 million through July 1, 2004, and impose
limits on the Company's capital expenditures that vary annually as described in
the Credit Agreement. A default in the observance of these covenants, if
unremedied in three business days, could cause the lenders to declare the
principal and interest outstanding at that time to be payable immediately and
terminate any commitments. The Company was in compliance with all covenants
under the Credit Agreement as of June 30, 2003.
As of June 30, 2003, the Company had principal borrowings of $216.1 million in
subordinated notes, excluding the discount of $2.5 million and PIK interest of
$3.9 million. Interest on the notes is fixed at 13% and accretes to the
principal semi-annually until November 2006. Thereafter interest will be payable
quarterly, in cash, based on LIBOR plus an applicable margin. During the six
months ended June 30, 2003, $13.3 million in PIK interest accreted to principal.
The subordinated notes mature on November 9, 2010.
As of June 30, 2003, the maximum borrowings under the Term A loan, Term B loan,
Term C loan, and the revolver loan were all outstanding. There was $2.6 million
outstanding under the Term D loan at June 30, 2003 and an additional $1.8
million was available subject to certain conditions. At June 30, 2003, $270.9
million was variable rate debt and $342.5 million was fixed rate debt, including
variable rate debt fixed by the interest rate swap agreement. The weighted
average floating interest rate and the weighted average fixed swapped interest
rate at June 30, 2003 were 5.60% and 11.40%, respectively.
NOTE 9. DERIVATIVE INSTRUMENTS
The Company accounts for its derivative instruments in accordance with SFAS No.
133, as amended, which requires that all derivative financial instruments, such
as interest rate swap agreements, be recognized in the financial statements and
measured at fair value regardless of the purpose or intent for holding them.
The Company uses derivative instruments to manage its interest rate risk. The
Company does not use the instruments for speculative purposes. Interest rate
swaps were employed as a requirement under the Company's Second Amended and
Restated Credit Agreement. The Third Amended and Restated Credit Agreement does
not have such a requirement. This agreement does prohibit the Company from
entering into any new interest rate swap, collar, cap, floor or forward rate
agreements without the prior written consent of the lenders. The interest
differential to be paid or received under the related interest rate swap
agreement is recognized over the life of the related debt and is included in
interest expense or income. The Company designates these interest rate swap
contracts as cash flow hedges. The fair value of the interest rate swap
agreement designated and effective as a cash flow hedging instrument is included
in accumulated other comprehensive loss. Credit risk associated with
nonperformance by counterparties is mitigated by using major financial
institutions with high credit ratings.
At June 30, 2003, the Company had an interest rate swap agreement with a
notional principal amount of $125.0 million expiring in February 2006. The
interest rate swap agreement is based on the three-month LIBOR, which is fixed
at 6.94%. Approximately 31% of the underlying credit facility debt is being
hedged with this interest rate swap. The fair value of the swap agreement was
$17.9 million and $19.3 million as of June 30, 2003 and December 31, 2002,
respectively. The fair value of the interest rate swap agreement is estimated
based on quotes from brokers and represents the estimated amount that the
Company would expect to pay to terminate the agreement at the reporting date.
The fair value of the interest rate swap agreements are included in the
accumulated other comprehensive loss on the consolidated balance sheet and the
change in the fair value of the interest rate swap
-12-
agreements is the only component of other comprehensive loss. The comprehensive
loss for the three months ended June 30, 2003 and June 30, 2002 was $23.4
million and $335.1 million, respectively. The comprehensive loss for the six
months ended June 30, 2003 and June 30, 2002 was $48.6 million and $384.7
million, respectively.
The Company also had an interest rate swap agreement with a notional principal
amount of $62.5 million that expired in May 2003.
NOTE 10. STOCK OPTION PLANS
In accordance with SFAS No. 148, the Company adopted the financial statement
measurement and recognition provisions of SFAS No. 123 effective January 1,
2003. Under SFAS No. 123, on a prospective basis, the Company recognizes
compensation expense for the fair value of all stock options granted after
December 31, 2002, over the vesting period of the options. The adoption of SFAS
Nos. 123 and 148 during the three and six month periods ending June 30, 2003
resulted in the Company recording $0.1 million and $0.5 million of compensation
expense for the fair value of options granted during the period and deferring
$0.6 million and $0.5 million to be recognized over the remaining vesting
period, respectively.
For stock options granted prior to December 31, 2002, the Company accounts for
stock based compensation issued to its employees in accordance with APB Opinion
No. 25, "Accounting for Stock Issued to Employees." Had compensation expense
been determined based on the fair value of the options at the grant dates for
awards granted prior to December 31, 2002 consistent with the method prescribed
in SFAS No. 123, the Company's net loss and net loss per share would have
increased to the pro forma amounts indicated below:
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30, JUNE 30, JUNE 30,
2003 2002 2003 2002
---- ---- ---- ----
Net loss as reported..................................... $ (23,744) $ (339,011) $ (50,039) $ (386,326)
Stock-based employee compensation expense included in
reported net loss, net of related tax effects............ 186 361 661 742
Total stock-based employee compensation expense
determined under fair value based method for all
awards, net of related tax effects....................... (520) (3,477) (825) (6,946)
---------- ---------- --------- ----------
Additional expense....................................... (334) (3,116) (164) (6,204)
---------- ---------- --------- ----------
Net loss pro forma....................................... $ (24,078) $ (342,127) $ (50,203) $ (392,530)
========== ========== ========= ==========
Net loss per share, basic and diluted:
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30, JUNE 30, JUNE 30,
2003 2002 2003 2002
---- ---- ---- ----
As reported....................................... $ (0.68) $ (8.17) $ (1.40) $ (9.60)
Pro forma......................................... $ (0.68) $ (8.25) $ (1.40) $ (9.76)
-13-
For purposes of the pro forma disclosures above, the fair value of each option
grant is estimated on the date of the grant using the Black-Scholes
option-pricing model and the following weighted average assumptions:
JUNE 30, 2003 JUNE 30, 2002
------------- -------------
Dividend yield....................................... 0.00 percent 0.00 percent
Expected volatility.................................. 242.26 percent 184.53 percent
Risk-free interest rate.............................. 3.02 percent 4.98 percent
Expected life........................................ 7 years 7 years
The weighted average fair value of options granted during the six-month period
ended June 30, 2003 and 2002 was $0.25 and $3.35, respectively.
In November 2002, the Company approved a voluntary stock option exchange program
for eligible employee option holders under the 1998 Employee Stock Option Plan.
Options granted on or before January 2, 2002 were eligible for the exchange
program, except for the performance-based options issued on January 1, 2002. To
participate in the exchange program, employees must have been continually
employed by the Company throughout the tender offer period and until the grant
of new options. Employee participation in the program was strictly voluntary and
options issued under the Company's 1999 Director Stock Incentive Plan were
excluded from the stock option exchange program. The number of new options
issued varied depending on the exercise price of the options tendered according
to the following exchange ratios:
NUMBER OF NEW OPTIONS
GRANTED AS A PERCENT OF SHARES
FOR OPTIONS WITH EXERCISE PRICES: COVERED BY TENDERED OPTIONS
- --------------------------------- ---------------------------
$4.00 and under 80%
$4.01 to $8.00 65%
$8.01 to $20.00 40%
Over $20.00 25%
The tender offer period commenced on December 19, 2002, with 4,482,021 options
eligible for exchange, and ended on January 21, 2003. Pursuant to the terms of
the tender offer, the outstanding current options properly tendered for exchange
by employees was 4,119,524, or approximately 92% of the options eligible for
exchange. On January 21, 2003, the Company granted to those eligible employees
new options to purchase 2,582,986 shares of common stock with an exercise price
of $0.26 per share. All tendered options that were fully vested on January 21,
2003 were replaced with new options that were fully vested. For tendered options
that had not yet vested, the vesting schedule for replacement options was
extended by one year.
The Company had options and warrants to purchase 6,780,066 and 8,953,956 shares
outstanding at June 30, 2003 and 2002, respectively, that were not included in
the calculation of diluted loss per share because the effect would be
anti-dilutive.
-14-
NOTE 11. RESTRUCTURING COSTS
In September 2002, the Company identified opportunities to optimize the use of
capital and company assets and committed to a plan of workforce reductions,
closing operations in its Ann Arbor and Lansing, Michigan market and reducing
reliance on certain collocation sites.
On September 5, 2002, the Company announced it had reduced its workforce by 102
operational and administrative positions. All positions were terminated by
September 30, 2002 and termination benefits for these positions were included in
the restructuring costs.
On October 9, 2002, the Company notified its customers in the communities of Ann
Arbor and Lansing, Michigan that the Company would be closing that market. The
Company stopped selling services to new customers in this market and notified
existing customers of the decision and the approximate time remaining until
services were terminated, which was in December 2002. The Company has and will
continue to redeploy certain equipment from this market to other markets to
optimize its network assets. Revenue and operating results of the Ann Arbor and
Lansing, Michigan market were not significant to the Company's consolidated
results of operations.
In connection with the above activities, the Company recorded restructuring
costs of $5.3 million, comprised of employee termination benefits of $0.6
million, contractual lease obligations of $3.4 million and network facility
costs of $1.3 million.
During February 2003, the Company modified a portion of its restructuring plan
related to reduced reliance on certain collocation sites. As the Company engaged
in its restructuring actions in the first quarter of 2003, the Company was
informed that additional costs would be charged to it by the established
telephone companies in connection with the restructuring. Based on this new
information, the Company reduced the number of collocation sites that would be
affected. As a result of this plan modification, the Company reversed
approximately $0.7 million in restructuring costs related to the collocation
sites. At the same time, the Company increased the restructuring accrual for
$0.1 million in termination benefits and other network facility costs that
became known during the first quarter of 2003.
At June 30, 2003, approximately $1.1 million of the total restructuring costs
recognized had been paid and it is anticipated that the remaining charges will
be liquidated within the next calendar year, except for contractual lease
obligations of $2.8 million that extend beyond one year and are included in
other long-term liabilities. The following table highlights the cumulative
restructuring activities through June 30, 2003:
TERMINATION LEASE NETWORK
BENEFITS OBLIGATIONS FACILITY COSTS TOTAL
-------- ----------- -------------- -----
Initial restructuring charge....................... $ 559 $ 3,441 $ 1,283 $ 5,283
Payment of benefits and other obligations.......... (537) (25) - (562)
-------- --------- --------- -------
Balance at December 31, 2002....................... 22 3,416 1,283 4,721
Payment of benefits and other obligations.......... (72) (191) (311) (574)
Adjustments due to plan modifications.............. 50 - (585) (535)
-------- --------- --------- -------
Balance at June 30, 2003........................... $ - $ 3,225 $ 387 $ 3,612
======== ========= ========= =======
-15-
NOTE 12. SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING ACTIVITIES
AND CASH FLOW INFORMATION
Supplemental disclosures of cash flow information for the six months ended:
JUNE 30, 2003 JUNE 30, 2002
------------- -------------
Interest paid....................................................... $ 15,080 $ 14,584
Capital lease obligations for IRUs.................................. $ 1,923 $ 679
Issuance of common stock for employer 401(k) contribution........... $ 409 $ 314
NOTE 13. COMMITMENTS AND CONTINGENCIES
On January 26, 2002, the Company and its wholly owned subsidiary US Xchange Inc.
(referred to collectively for purposes of this paragraph as the Company), filed
suit against AT&T Corp ("AT&T") in the United States District Court for the
Western District of New York (02-CV-6090L). The Company sought damages from AT&T
for breach of contract, based upon AT&T's failure to pay, either on time or in
full, the Company's invoices for access services provided to AT&T. On June 13,
2003, the Company settled this matter by entering into a Settlement and Switched
Access Service Agreement ("Agreement") with AT&T. Among other things, the
Agreement provided for a settlement payment by AT&T to Choice One to resolve
charges for access service provided prior to May 1, 2003. The Agreement also
established rates that the Company will charge AT&T for access service during
the term of the agreement.
On November 20, 2001, the Company and three of its officers were named in a
complaint filed in the United States District Court of the southern District of
New York on behalf of a class of persons consisting of certain purchasers of the
Company's common stock in its initial public offering which was completed on
February 23, 2000. The complaint seeks damages based on allegations that the
Company's Registration Statement and Prospectus relating to the offering
contained material misstatements and/or omissions regarding the compensation
received by the underwriters of the offering and certain transactions engaged in
by the underwriters. This case, which has been consolidated with more than 300
other cases against other companies involving similar allegations, also names
six underwriters of the Company's offering and the offerings of other issuers,
and alleges that the underwriters engaged in a pattern of conduct to extract
inflated commissions in excess of the amounts disclosed in offering materials
and manipulated the post-offering markets in connection with hundreds of
offerings by engaging in stabilizing transactions and issuing misleading and
fraudulent analyst and research reports. The complaint alleges that the Company
is strictly liable under Section 11 of the Securities Act of 1933 because Item
508 of Regulation S-K allegedly required the disclosure of commissions to be
paid to underwriters and of stabilizing transactions, and that the Company and
its officers acted with scienter, or recklessness, in failing to disclose these
facts, in violation of Section 10(b) of the Securities Exchange Act and Rule
10b-5 promulgated thereunder. The claims against the individual defendants were
dismissed without prejudice by an agreement with the plaintiffs. After the court
denied motions to dismiss the cases, the parties entered into a mediation which
has resulted in the execution of a Memorandum of Understanding by the Company
and approximately 300 other issuers who are the subject of similar litigation.
The settlement contemplated by the Memorandum of Understanding will not involve
any payments by the Company and would terminate only the claims by the
plaintiffs against issuers. The claims against the underwriters will continue,
and the Company will be required to participate in limited discovery related to
those claims. It is expected that the finalization of the settlement, including
the certification of a class and obtaining court approval of the settlement,
will continue through at least the end of the year. There are a number of
conditions to the finalization of the settlement and it is not possible to
predict whether all of those conditions will be satisfied.
-16-
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
CAUTIONARY STATEMENT ON FORWARD-LOOKING STATEMENTS
From time to time, we make oral and written statements that may constitute
"forward-looking statements" within the meaning of the Private Securities
Litigation Reform Act of 1995. We desire to take advantage of the "safe harbor"
provisions in the Private Securities Litigation Reform Act of 1995 for
forward-looking statements made by us from time to time, including, but not
limited to, the forward-looking information contained in "Management's
Discussion and Analysis of Financial Condition and Results of Operations", and
elsewhere in this Form 10-Q and in other filings with the Securities and
Exchange Commission ("SEC"). The words or phrases "believes", "expects",
"estimates", "anticipates", "will", "will be", "could", "may" and "plans" and
the negative or other similar words or expressions identify forward-looking
statements made by or on behalf of the Company.
Forward-looking statements may discuss our future expectations, as well as
certain projections of our results of operations and financial condition. We
caution readers that any such forward-looking statements made by or on behalf of
us involve risks, uncertainties and other unknown factors. Actual results,
levels of activity and performance could differ materially from those expressed
or implied in the forward-looking statements.
Factors that could impact our performance include, but are not limited to:
- - Successful marketing of our services to current and new customers;
- - The ability to generate positive working capital by timely collections from
customers and obtaining favorable payment terms from our vendors;
- - The availability of additional financing;
- - Compliance with covenants for borrowing under our bank credit facility;
- - Technological, regulatory or other developments in our business; and
- - Shifts in market demand and other changes in the competitive
telecommunications sector.
These and other applicable risks are summarized under the caption "Risk Factors"
and elsewhere in the Company's Annual Report on Form 10-K, filed on March 31,
2003. You should consider all of our written and oral forward-looking statements
only in light of such cautionary statements. You should not place undue reliance
on these forward-looking statements and you should understand that they
represent management's view only as of the dates we make them.
OVERVIEW
We are an integrated communications provider offering facilities-based voice and
data telecommunications services primarily to small and medium-sized businesses
in 29 second and third tier markets in 12 states in the northeastern and
midwestern United States. Our services include:
- local exchange and long distance service; and
- high-speed data and Internet services.
Our principal competitors are incumbent local exchange carriers, such as the
regional Bell operating companies, as well as other integrated communications
providers.
-17-
We seek to become the leading integrated communications provider in each of our
markets by offering a single source for competitively priced, high quality,
customized telecommunications services. A key element of our strategy has been
to be one of the first integrated communications providers to provide
comprehensive network coverage in each of the markets we serve. We are achieving
this market coverage by installing both voice and data equipment in multiple
established telephone company central offices. As of June 30, 2003, we have
connected approximately 94% of our clients directly to our own switches, which
allows us to more efficiently route traffic, ensure a high quality of service
and control costs.
We evaluate the growth of our business by focusing on various operational data
in addition to financial data. Lines in service represent the lines sold that
are now being used by our clients subscribing to our services. Although the
number of lines we service for each client may vary, our primary focus is on the
small- to medium-sized business customer. On average, our clients have 5 lines.
We plan to continue to focus primarily on small- to medium-sized business
clients.
The table below provides selected key operational data as of:
June 30, 2003 June 30, 2002
------------- -------------
Markets served 29 30
Number of switches-voice 25 26
Number of switches-data 63 63
Total central office collocations 505 530
Markets with operational fiber 19 16
Estimated addressable market (Business lines) 5.7 million 5.7 million
Lines in service-total 513,547 468,272
Lines in service-voice 495,365 452,593
Lines in service-data 18,182 15,679
Total employees 1,323 1,801
Direct sales employees 248 483
In this filing, we include references to and analyses of adjusted earnings
before income taxes, depreciation, amortization and other non-cash charges
("Adjusted EBITDA") amounts. Adjusted EBITDA is used by management and certain
investors as an indicator of a company's liquidity and should not be substituted
for cash flow provided by/(used in) operations determined in accordance with
accounting principles generally accepted in the United States of America
("GAAP"), the most directly comparable financial measure under GAAP. Management
believes that the presentation of adjusted EBITDA is meaningful because it is an
indicator of our ability to service existing debt, to sustain potential
increases in debt, and to satisfy capital requirements. Adjusted EBITDA is also
used as a factor in the calculation of management's variable compensation.
Adjusted EBITDA as presented may not be comparable to other similarly titled
measures used by other companies. We expect to continue to generate positive
adjusted EBITDA during the remainder of 2003.
-18-
The following table shows the differences between our cash flow from operations
as determined in accordance with GAAP and our adjusted EBITDA for the three and
six-month periods ending:
(in thousands)
THREE MONTHS ENDING SIX MONTHS ENDING
JUNE 30, MARCH 31, JUNE 30, JUNE 30, JUNE 30,
2003 2003 2002 2003 2002
---- ---- ---- ---- ----
Net cash used in operating activities. $ (3,763) $(8,123) $(12,105) $ (11,886) $ (39,270)
Adjustments to reconcile:
Changes in assets and liabilities.... 6,587 8,954 (11,964) 15,541 (1,286)
Net interest expense currently
payable
Other expense, net................. 16,746 16,409 14,897 33,155 29,007
Amortization of deferred financing
costs........................... (1,110) (1,141) (1,029) (2,251) (2,045)
Amortization of discount on
long-term debt.................. (275) (268) (126) (543) (249)
Interest payable in-kind on
long-term debt.................. (7,844) (7,583) (6,085) (15,427) (11,879)
-------- ------- -------- --------- ---------
Net interest expense currently
payable............................ 7,517 7,417 7,657 14,934 14,834
-------- ------- -------- --------- ---------
Adjusted EBITDA......................... $ 10,341 $ 8,248 $(16,412) $ 18,589 $ (25,722)
======== ======= ======== ========= =========
In September 2002, we identified opportunities to optimize the use of capital
and company assets and committed to a plan of workforce reductions, closing
operations in our Ann Arbor and Lansing, Michigan market and reducing reliance
on certain collocation sites.
On September 5, 2002, we announced we had reduced our workforce by 102
operational and administrative positions. All positions were terminated by
September 30, 2002 and termination benefits for these positions were included in
the restructuring costs.
On October 9, 2002, we notified our customers in the communities of Ann Arbor
and Lansing, Michigan that we would be closing that market. We stopped selling
services to new customers in this market and notified existing customers of the
decision and the approximate time remaining until services were terminated,
which was in December 2002. We have and will continue to redeploy certain
equipment from this market to other markets to optimize our network assets.
Revenue and operating results of the Ann Arbor and Lansing, Michigan market were
not significant to our consolidated results of operations.
In connection with the above activities, we recorded restructuring costs of $5.3
million in the three-month period ended September 30, 2002, comprised of
employee termination benefits of $0.6 million, contractual lease obligations of
$3.4 million and network facility costs of $1.3 million.
During February 2003, we modified a portion of our restructuring plan related to
reduced reliance on certain collocation sites. As we engaged in our
restructuring actions in the first quarter of 2003, we were informed that
additional costs would be charged to us by the established telephone companies
in connection with the restructuring. Based on this new information, we reduced
the number of collocation sites that would be affected. As a result of this plan
modification, we reversed approximately $0.7 million in restructuring costs
related to the collocation sites. At the same time, we increased the
restructuring accrual for $0.1 million in termination benefits and other network
facility costs that became known during the three months ended March 31, 2003.
-19-
RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED JUNE 30, 2003 AS COMPARED TO
JUNE 30, 2002
REVENUE
We generated $82.2 million in revenue during the three months ended June 30,
2003. This represents a 12.3% increase compared to revenue for the three months
ended June 30, 2002, and a 2.6% increase compared to the revenue for three
months ended March 31, 2003. Of our total revenue increase from the three months
ended June 30, 2002 , approximately $6.8 million was attributable to increases
in voice revenue, $1.4 million in data revenue, and $0.8 million in access
revenue. The increase in revenue for the three months ended June 30, 2003 versus
the three months ended June 30, 2002 is primarily attributable to an increase in
the average number of lines in service. Between June 30, 2002 and June 30, 2003,
the average number of voice lines increased by approximately 51,000 lines while
the average number of data lines increased by approximately 3,100 lines. Our
total lines in service increased by 9.7% to 513,547 lines at June 30, 2003.
Our churn for the three months ended June 30, 2003, of our facilities-based
business clients, was 1.4% per month. This compares to 1.4% per month for the
three months ended June 30, 2002 and 1.5% per month for the three months ended
March 31, 2003. Our churn levels continue to compare favorably to the churn of
clients experienced by other similar companies within the telecommunications
industry. We seek to minimize churn by providing superior client care, by
offering a competitively priced portfolio of local, long distance and Internet
services, by signing a significant number of clients to multi-year service
agreements, and by focusing on offering our own facilities-based services.
NETWORK COSTS
Network costs for the three months ended June 30, 2003 were $41.3 million,
representing a 2.2% increase compared to network costs for the three months
ended June 30, 2002 and a 1.9% increase compared to network costs for the three
months ended March 31, 2003. This increase is primarily attributable to a
greater number of lines in service. Network costs as a percentage of total
revenues were 50.3% at June 30, 2003, a decrease compared to 55.2% at June 30,
2002 and 50.6% at March 31, 2003. Network costs continue to increase at a slower
rate than revenue, which reflects the benefits of our fiber network
implementation and other network efficiencies realized from the increased number
of installed lines. We believe that network costs as a percentage of revenue
should continue to decline in 2003. We have continued with initiatives
introduced in 2002 to optimize our existing network. During the three months
ended June 30, 2003, our average cost per line declined approximately 8.6% as
compared to the three months ended June 30, 2002, which highlights the
effectiveness of our network optimization initiatives, the impact of economies
of scale from having a greater number of lines in service, and the benefits of
leasing fiber. The cost of leasing fiber is included in depreciation and
amortization expense. The benefits derived from our network optimization
initiatives were somewhat offset by increases in variable network costs related
to higher in-service line volume and minutes of use as compared to the three
months ended March 31, 2003.
Our network costs include:
- - Leases of high-capacity digital lines that interconnect our network with
established telephone company networks;
- - Leases of our inter-city network;
- - Leases of local loop lines which connect our clients to our network;
- - Leased space in established telephone company central offices for
collocating our transmission equipment;
-20-
- - Completion of local calls originated by our clients,
- - Completion of originating (1+ calling) and terminating (inbound 800 calling)
long distance calls by our clients, and
- - Non-recurring costs for installing and disconnecting lines.
We lease fiber capacity in certain markets when economically justified by
traffic volume growth in order to reduce the overall cost of local transport and
reduce our reliance on the established telephone company. Fiber deployment
provides the bandwidth necessary to support substantial incremental growth and
allows us to reduce network costs and enhance the quality and reliability of our
network, which strengthens our competitive position in our markets.
We currently have 19 markets where we have intra-city fiber connecting our
collocations. We plan to activate fiber in an additional 3 markets across our
footprint. Our fiber network now consists of 2,483 route miles of intra- and
inter-city fiber, of which 2,215 miles is operational. Once complete, our fiber
network will consist of approximately 3,420 fiber miles.
Our revenues exceeded our network costs by $40.9 million, or 49.7% of revenue,
for the three months ended June 30, 2003, compared to $32.8 million, or 44.8% of
revenue, for the three months ended June 30, 2002, and $39.6 million or 49.4% of
revenue for the three months ended March 31, 2003. We expect that our revenue in
excess of network costs, as a percentage of revenue will improve as our revenue
increases and we continue to realize cost efficiencies in our network costs
during 2003.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
Selling, general and administrative expenses for the three months ended June 30,
2003 were $30.7 million compared to selling, general and administrative expenses
of $56.6 million and $32.4 million during the three months ended June 30, 2002
and March 31, 2003, respectively. Excluding the non-cash deferred compensation
and management ownership allocation charges, the selling, general and
administrative expenses decreased 37.9% from $49.2 million during the three
months ended June 30, 2002 to $30.5 million during the three months ended June
30, 2003. For the three months ended March 31, 2003 selling, general and
administrative expenses excluding non-cash deferred compensation and management
allocation were $31.9 million.
Selling, general and administrative expenses, excluding non-cash deferred
compensation and management ownership allocation charges, as a percentage of
revenue were 37.2% for the three months ended June 30, 2003 as compared to 67.2%
for the three months ended June 30, 2002 and 39.8% for the three months ended
March 31, 2003. The changes in selling, general and administrative expenses from
the three months ended March 31, 2003 to the three months ended June 30, 2003
resulted primarily from changes in the number of employees, cost reductions
associated with restructuring efforts and other back office enhancements, and a
decrease in bad debt expense related to distressed telecommunication carrier
accounts.
During the three months ended June 30, 2003, salary, commissions and benefits
decreased approximately $5.3 million, directly related to headcount decreases as
compared to the three months ended June 30, 2002. The number of individuals we
employed decreased to 1,323 during the three months ending June 30, 2003. At
June 30, 2002, we employed 1,801 individuals and at March 31, 2003, we employed
1,410 individuals.
Bad debt expense decreased $12.2 million as compared to bad debt expense for the
three months r ended June 30, 2002. Of this change, $11.8 million in bad debt
expense for the three months ended June 30, 2002 was associated with distressed
telecommunications carriers, including Global Crossing and
-21-
WorldCom. The acquisition of assets from Fairpoint Communications Solutions
Corp. ("Fairpoint") also resulted in incremental expenses of $3.3 million during
the three months ended June 30, 2002.
Our selling, general and administrative expenses include:
- - Costs associated with sales and marketing, client care, billing, corporate
administration, personnel and network maintenance;
- - Administrative overhead and office lease expense; and
- - Bad debt expense.
Also included in selling, general and administrative expenses for the three
months ended June 30, 2003, are compensation amortization of $0.2 million. This
compares to the non-cash charges of $7.4 million for the three months ended June
30, 2002, which included a non-cash charge of $5.3 million for management
ownership allocation. Compensation expense for the three months ended June 30,
2003 includes the expense associated with our adoption of SFAS No. 148.
Prospectively, beginning on January 1, 2003, we changed from the intrinsic value
method under APB No. 25 to the fair value method under SFAS No. 123. Non-cash
compensation was recorded in connection with membership units of Choice One
Communications L.L.C. sold to certain management employees, grants to employees
under our 1998 Employee Stock Option Plan, and the issuance of restricted shares
to the former employees of US Xchange, which we acquired in 2000. The management
ownership allocation charge was fully amortized at December 31, 2002.
RESTRUCTURING COSTS
The following table highlights cumulative restructuring activities through June
30, 2003:
TERMINATION LEASE NETWORK
BENEFITS OBLIGATIONS FACILITY COSTS TOTAL
-------- ----------- -------------- ------
Initial restructuring charge....................... $ 559 $ 3,441 $ 1,283 $ 5,283
Payment of benefits and other obligations.......... (537) (25) - (562)
------- --------- --------- -------
Balance at December 31, 2002....................... 22 3,416 1,283 4,721
Payment of benefits and other obligations.......... (72) (191) (311) (574)
Adjustments due to plan modifications.............. 50 - (585) (535)
------- --------- --------- -------
Balance at June 30, 2003........................... $ - $ 3,225 $ 387 $ 3,612
======= ========= ========= =======
For the three months ended June 30, 2003, approximately $0.1 million of the
restructuring costs were paid and it is anticipated that the remaining charges
will be liquidated within the next calendar year, except for contractual lease
obligations of $2.8 million that extend beyond one year and are included in
other long-term liabilities.
IMPAIRMENT LOSS ON LONG-LIVED ASSETS
During June 2002, we noted a significant adverse change in the business climate
of the company and the telecommunications industry in general. These
circumstances required us to perform an interim goodwill impairment test. As a
result, we recorded an impairment charge of $283.0 million. The amount of the
impairment charge was determined utilizing a combination of market-based methods
to estimate the fair value of our goodwill in accordance with SFAS No. 142
"Goodwill and Other Intangible Assets." In addition, we recorded a $0.3 million
charge to write-down the value of acquired customer relationships related to the
our web hosting and design services in accordance with the provisions of SFAS
No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets.
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DEPRECIATION AND AMORTIZATION
Depreciation and amortization for the three months ended June 30, 2003 was $17.2
million. This represents a 3.8% increase compared to the three months ended June
30, 2002 and a 2.4% decrease from the three months ended March 31, 2003. The
increase in depreciation expense as compared to the three months ended June 30,
2002 was related to the deployment of network assets and other general business
assets. Our depreciation and amortization expense includes depreciation of
switch related equipment, non-recurring charges and equipment collocated in
established telephone company central offices, network infrastructure equipment,
information systems, furniture and fixtures, indefeasible rights to use fiber
and amortization of customer relationships.
INTEREST EXPENSE AND INCOME
Interest expense for the three months ended June 30, 2003 and 2002 was
approximately $16.8 million and $15.0 million, respectively. Interest expense
for the three months ended March 31, 2003 was approximately $16.5 million.
Interest expense includes interest payments on borrowings under our senior
credit facility, non-cash interest on the subordinated notes, amortization of
deferred financing costs related to these facilities, amortization of the
discount on the subordinated notes and Term C loan under the senior credit
facility, commitment fees on the unused senior credit facility, and interest
expense related to IRUs. Interest expense on the subordinated notes is payable
in-kind (PIK) through November 2006.
Interest expense increased from the same quarter a year ago due to an increase
in the amount of borrowings, offset by favorable declines in LIBOR rates that
impacted our borrowing rates. We expect interest expense to remain stable over
the next two quarters as increases in the amount of borrowings under the Term D
loan that may be drawn down on September 30, 2003 and December 31, 2003, will be
offset by lower effective interest rates resulting from the expiration of the
$62.5 million notional amount interest rate swap agreement in May 2003. Interest
expense, currently payable in cash, was $7.5 million and $7.7 million for the
three months ended June 30, 2003 and June 30, 2002, respectively, and $7.4
million for the three months ended March 31, 2003.
Interest income for the three months ended June 30, 2003 and 2002 was
approximately $0.1 million, and $0.1 million, respectively. Interest income for
the three months ended March 31, 2003 was approximately $0.1 million. Interest
income results from the investment of cash and cash equivalents, mainly from the
cash proceeds generated from the borrowings under our senior credit and
subordinated debt facilities. We expect interest income to decrease slightly in
the remaining two quarters of 2003.
INCOME TAXES
We have not generated any taxable income to date, and did not incur any income
tax liability as a result. Further, we do not expect to generate taxable income
during the remainder of 2003.
NET LOSS
The net loss was $23.8 million and $339.0 million for the three months ended
June 30, 2003 and 2002, respectively. The improvement in net loss was
attributable to the factors previously discussed.
The net loss applicable to common stockholders was $36.6 million and $349.8
million for the three months ended June 30, 2003 and 2002, respectively. The
decrease in net loss applicable to common stockholders was attributable to the
factors previously discussed, offset by non-cash accretion and dividends on
preferred stock. The non-cash accretion and dividends on our preferred stock
increased $2.0 million, or 18.8%, to $12.8 million for the three months ended
June 30, 2003 as compared to $10.8 million for the three months ended June 30,
2002. This change was primarily driven by the increase in dividends on preferred
stock, which result from the compounding of dividends that accrete to principal.
-23-
RESULTS OF OPERATIONS FOR THE SIX MONTHS ENDED JUNE 30, 2003 AS COMPARED TO JUNE
30, 2002
REVENUE
We generated $162.3 million in revenue during the six months ended June 30, 2003
as compared to $143.8 million for the six months ended June 30, 2002, an
increase of $18.5 million or 12.9%. Of our total revenue increase from the six
months ended June 30, 2002, approximately $16.5 million was attributable to
increases in voice revenue and $2.9 million in data revenue. These increases
were offset by a decrease in access revenue of $0.9 million. The increase in
voice and data revenue from the same period a year ago is primarily attributable
to an increase in the average number of lines in service. The average number of
voice lines increased by approximately 79,000 and the average number of data
lines increased by approximately 2,400 lines. Our total lines in service
increased by 9.7% to 513,547 lines at June 30, 2003.
Our churn for the six months ended June 30, 2003, of our facilities-based
business clients, decreased slightly to an average of 1.5% per month. Our churn
levels continue to compare favorably to the churn of clients experienced by
similar companies within the telecommunications industry. We seek to minimize
churn by providing superior client care, by offering a competitively priced
portfolio of local, long distance and Internet services, by signing a
significant number of clients to multi-year service agreements, and by focusing
on offering our own facilities-based services.
NETWORK COSTS
Network costs for the six months ended June 30, 2003 were $81.8 million
representing a $0.8 million or 0.9% decrease compared to network costs for the
six months ended June 30. Network costs as a percentage of total revenues were
50.4% at June 30, 2003, down from 57.5% for the six-months ended June 30, 2002.
Network costs continue to increase at a slower rate than revenue, which reflects
the benefits of our fiber network implementation and other network efficiencies
realized from the increased number of installed lines. We believe that network
costs as a percentage of revenue should continue to decline in 2003.
Additionally, we have continued with initiatives introduced in 2002 to optimize
our existing network. During the six month period ended June 30, 2003, our
average cost per line declined approximately 16.6% as compared to the six month
period ended June 30, 2002, which highlights the effectiveness of our network
optimization initiatives, the impact of economies of scale from having a greater
number of lines in service, and the benefits of leasing fiber. The cost of
leasing fiber is included in depreciation and amortization expense. The benefits
derived from our network optimization initiatives were somewhat offset by
increases in variable network costs related to higher in-service line volume and
minutes of use as compared to the six month period ended June 30, 2002.
Our revenues exceeded our network costs by $80.5 million, or 49.6% of revenue,
for the six month period ended June 30, 2003, compared to $61.2 million, or
42.5% of revenue, for the six month period ended June 30, 2002. We expect that
our revenue in excess of network costs, as a percentage of revenue will improve
as our revenue increases and we continue to realize cost efficiencies in our
network costs during 2003.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
Selling, general and administrative expenses for the six months ended June 30,
2003 were $63.1 million compared to selling, general and administrative expenses
of $101.8 million during the six months ended June 30, 2002. Excluding the
non-cash deferred compensation and management ownership allocation charges, the
selling, general and administrative expenses decreased 28.1% from $86.9 million
during the six months ended June 30, 2002 to $62.4 million during the six months
ended June 30, 2003.
-24-
Selling, general and administrative expenses, excluding non-cash deferred
compensation and management ownership allocation charges, as a percentage of
revenue was 38.5% for the six month period ended June 30, 2003 as compared to
60.4% for the six month period ended June 30, 2002. The changes in selling,
general and administrative expenses resulted primarily from changes in the
number of employees, cost reductions associated with restructuring efforts and
other back office enhancements, and a decrease in bad debt expense related to
distressed telecommunication carrier accounts.
During the six month period ended June 30, 2003, salary, commissions and
benefits decreased approximately $10.3 million, directly related to headcount
decreases as compared to the six month period ended June 30, 2002. The number of
individuals we employed decreased to 1,323 at June 30, 2003. At June 30, 2002,
we employed 1,801 individuals and at March 31, 2003, we employed 1,410
individuals.
Bad debt expense decreased $11.6 million as compared to the six-month period
ended June 30, 2002. Bad debt expense of $11.8 million for the six months ended
June 30, 2002 was associated with distressed telecommunications carriers,
including Global Crossing and World Com. The acquisition of assets from
Fairpoint also resulted in incremental expenses of $3.3 million for the six
months ended June 30, 2002.
Also included in selling, general and administrative expenses for the six months
ended June 30, 2003, is compensation amortization of $0.7 million. This compares
to the non-cash charges of $14.9 million for the six months ended June 30, 2002,
which included a non-cash charge of $10.7 million for management ownership
allocation. Compensation expense for the six month period ended June 30, 2003
includes the expense associated with our adoption of SFAS No. 148.
Prospectively, beginning on January 1, 2003, we changed from the intrinsic value
method under APB No. 25 to the fair value method under SFAS No. 123. Non-cash
compensation was recorded in connection with membership units of Choice One
Communications L.L.C. sold to certain management employees, grants to employees
under our 1998 Employee Stock Option Plan, and the issuance of restricted shares
to the former employees of US Xchange, which we acquired in 2000. The management
ownership allocation charge was fully amortized at December 31, 2002.
RESTRUCTURING COSTS
During February 2003, we modified a portion of our restructuring plan related to
reduce reliance on certain collocation sites. As we engaged in our restructuring
actions in the first quarter of 2003, we were informed that additional costs
would be charged to us by the established telephone companies in connection with
the restructuring. Based on this new information, we reduced the number of
collocation sites that would be affected. As a result of this plan modification,
we reversed approximately $0.7 million in restructuring costs related to the
collocation sites. At the same time, we increased the restructuring accrual for
$0.1 million in termination benefits and other network facility costs that
became known during the three months ended March 31, 2003.
For the six month period ended June 30, 2003, approximately $ 0.6 million of the
restructuring costs were paid and it is anticipated that the remaining charges
will be liquidated within the next calendar year, except for contractual lease
obligations of $2.8 million that extend beyond one year and are included in
other long-term liabilities. Refer to the table that highlights our cumulative
restructuring activities through June 30, 2003 in the results of operations for
the three months ended June 30, 2003 as compared to June 30, 2002 section of
this discussion.
IMPAIRMENT LOSS ON LONG-LIVED ASSETS
During June 2002, we noted a significant adverse change in the business climate
of the company and the telecommunications industry in general. These
circumstances required us to perform an interim goodwill impairment test. As a
result, we recorded an impairment charge of $283.0 million. The amount of the
impairment charge was determined utilizing a combination of market-based methods
to estimate the fair
-25-
value of our goodwill in accordance with SFAS No. 142 "Goodwill and Other
Intangible Assets." In addition, we recorded a $0.3 million charge to write-down
the value of acquired customer relationships related to the our web hosting and
design services in accordance with the provisions of SFAS No. 144, "Accounting
for the Impairment or Disposal of Long-Lived Assets.
DEPRECIATION AND AMORTIZATION
Depreciation and amortization for the six months ended June 30, 2003 was $34.7
million. This represents a 6.2% increase compared to the six months ended June
30. The increase in depreciation expense as compared to the six months ended
June 30, 2002 was related to the deployment of network assets, including fiber,
and other general business assets.
INTEREST EXPENSE AND INCOME
Interest expense for the six months ended June 30, 2003 and 2002 was
approximately $33.3 million and $29.1 million, respectively. Interest expense on
the subordinated notes is payable in-kind (PIK) through November 2006.
Interest expense increased from the same six month period a year ago due to an
increase in the amount of borrowings, offset by favorable declines in LIBOR
rates that impacted our borrowing rates. We expect interest expense to remain
stable over the next six months as increases in the amount of borrowings under
the Term D loan that may be drawn down on September 30, 2003 and December 31,
2003 will be offset by the expiration of the $62.5 million notional amount
interest rate swap agreement in May 2003. Interest expense, currently payable in
cash, was $14.9 million for the six-month period ended June 30, 2003 and 2002,
respectively.
Interest income for the six months ended June 30, 2003 and 2002 was
approximately $0.1 million, respectively. Interest income results from the
investment of cash and cash equivalents, mainly from the cash proceeds generated
from the borrowings under our senior credit and subordinated debt facilities. We
expect interest income to decrease slightly in the remaining six months of 2003.
INCOME TAXES
We have not generated any taxable income to date, and did not incur any income
tax liability as a result. Further, we do not expect to generate taxable income
during the remainder of 2003.
NET LOSS
The net loss was $50.0 million and $386.3 million for the six-month periods
ended June 30, 2003 and 2002, respectively. The improvement in net loss was
attributable to the factors previously discussed.
The net loss applicable to common stockholders was $75.2 million and $407.6
million for the six-month period ended June 30, 2003 and 2002, respectively. The
decrease in net loss applicable to common stockholders was attributable to the
factors previously discussed, offset by non-cash accretion and dividends on
preferred stock. The non-cash accretion and dividends on our preferred stock
increased $3.9 million, or 18.3%, to $25.2 million for the six months ended June
30, 2003 as compared to the six months ended June 30, 2002. This change was
primarily driven by the increase in dividends on preferred stock, which result
from the compounding of dividends that accrete to principal.
LIQUIDITY AND CAPITAL RESOURCES
The accompanying financial statements of the Company have been prepared on a
going concern basis, which contemplates the realization of assets and the
satisfaction of liabilities in the normal course of business. Our independent
accountants have noted in their report dated March 27, 2003 concerning our
financial statements for the year ended December 31, 2002, included in our
annual report filed on Form
-26-
10-K, that we had suffered recurring losses from operations and had a net
capital deficiency that raised substantial doubt about our ability to continue
as a going concern.
We have experienced net losses applicable to common stockholders of $36.6
million, $38.6 million, and $349.8 million for the quarters ended June 30, 2003,
March 31, 2003 and June 30, 2002, respectively. Adjusted EBITDA was positive
$10.3 million for the three months ended June 30, 2003, positive $8.2 million
for the three months ended March 31, 2003 and negative $16.4 million for the
three months ended June 30, 2002. Net cash used for operating activities was
approximately $3.8 million, $8.1 million and $12.1 million for the three months
ended June 30, 2003, March 31, 2003 and June 30, 2002, respectively. We
generated positive cash flow from operations for the month of June 2003.
Although not necessarily indicative of future cash flow results, this was the
first time we experienced positive monthly cash flow. Assuming we substantially
meet our 2003 plan, we expect our operating losses and net losses to decline as
our operations mature and we achieve greater operating efficiencies. Our
viability is dependent upon our ability to continue to execute under our
business strategy and to generate positive cash flows from operations. The
success of our business strategy includes obtaining and retaining a significant
number of customers, generating significant and sustained growth in our
operating cash flows, and managing our costs and capital expenditures to be able
to meet our debt service obligations.
We have completed several steps intended to increase our liquidity and better
position our company to compete under current conditions and anticipated changes
in the telecommunications industry. These include:
- - Completing an additional financing of $48.9 million in September 2002,
- - Maintaining a high client retention rate,
- - Completing operational initiatives to optimize our network and lower its
cost structure,
- - Reducing general and administrative expenses through automation and
reductions in workforce,
- - Exiting one market that was found to be unprofitable,
- - Introducing new products to improve revenue growth and profitability, and
- - Redeploying assets held for use to reduce the requirement for capital
expenditures.
Our 2003 plan is predicated upon the following assumptions:
- - sustained growth due to increased penetration for data and voice offerings
in our operational markets,
- - continued improvement in operational efficiencies through economies of scale
that translates into lower network costs and lower selling, general and
administrative expenses as a percentage of revenue; and
- - decreased capital expenditures.
Our revenue and costs may be dependent upon factors that are not within our
control, including regulatory changes, changes in technology, and increased
competition. Due to the uncertainty of these factors, actual revenue and costs
may vary from expected amounts, possibly to a material degree, and such
variations could affect our future funding requirements. Additional financing
may also be required in response to changing conditions within the industry or
unanticipated competitive pressures. We can make no assurances that we would be
successful in raising additional capital, if needed, on favorable terms or at
all. Due to current adverse conditions in the general economy and specifically
the telecommunications industry, it likely will be difficult to obtain
public/private financing, bank financing or vendor financing to continue our
business. Failure to raise sufficient funds may require us to engage in asset
sales or pursue other alternatives designed to enhance liquidity or obtain
relief from our obligations, as to which success cannot be assured.
-27-
There are conditions to our ability to borrow under the senior credit facility,
including the continued satisfaction of covenants. These covenants require us to
maintain minimum cash and committed financing of $10.0 million through July 1,
2004 and impose limits on our capital expenditures that vary annually as
described in the Third Amended and Restated Credit Agreement (the "Credit
Agreement"). A default in observance of these covenants, if unremedied in three
business days, could cause the lenders to declare the principal and interest
outstanding at that time to be payable immediately and terminate any
commitments. If that event should occur, we can make no assurance that we will
not be required to engage in asset sales or pursue other alternatives designed
to enhance liquidity or obtain relief from our obligations, or that we will be
successful in these efforts. As of June 30 2003, we were in compliance with
these covenants and if we are able to substantially execute our 2003 plan, then
we expect to be in compliance with these covenants for the remainder of 2003.
At June 30, 2003, we had $15.0 million in cash and cash equivalents and $1.8
million available under our senior credit facility which is available in two
equal quarterly installments on September 31, 2003 and December 31, 2003, and
subject to no "material adverse change" in the business, as defined in our
Credit Agreement. The 2003 plan assumes that we will have positive cash and cash
equivalents, in excess of the $10.0 million minimum cash and committed financing
covenant established pursuant to the Credit Agreement, at December 31, 2003. The
amount of cash available as of December 31, 2003 is dependent upon factors that
could differ materially from the estimates. Should factors assumed in the 2003
plan differ materially, management may delay some of its future capital
expenditures, reduce selling, general and administrative expenses, or seek
alternative financing for future capital expenditures.
Our projections of future positive cash flows from operations may be inaccurate
due to a variety of factors including:
- - delays in the timely collection of amounts owed to us;
- - shorter payment terms given to us by our vendors;
- - changes in number of customers and penetration of new services;
- - changes in cost of our networks in each of our markets;
- - regulatory changes;
- - changes in technology;
- - changing conditions within the industry and the general economy; and
- - increased competition.
Due to the uncertainty of all of these factors, actual funding available from
operations and other sources may vary from expected amounts, possibly to a
material degree, and such variations could affect our funding needs and could
result in a default under our credit facilities. Our collection from
interexchange carriers and established telephone companies has historically been
longer than those from end-users, but has decreased in the first six months of
2003.
Our failure to comply with the covenants and restrictions contained in our
senior credit facility and subordinated note agreements could lead to default
under those agreements. If such default were to occur, our lenders could declare
all amounts owed to them immediately due and payable. If that event should
occur, we can make no assurances that we would be able to make payments on our
indebtedness, meet our working capital or capital expenditure requirements, or
that we would be able to obtain additional financing, any of which would have a
material adverse effect on our business, financial condition and results of
operations.
-28-
Our continuation as a going concern is dependent on our ability to substantially
achieve the 2003 plan. While our 2003 plan assumes we will have positive cash
and cash equivalents, in excess of the $10.0 million minimum cash and committed
financing covenant established pursuant to the Credit Agreement, at December 31,
2003, there can be no assurance that we will be successful in executing our
business strategy or in obtaining additional debt or equity financing, if
needed, on terms acceptable to us, or at all, or that management's estimate of
additional funds required is accurate. The financial statements do not include
any adjustments relating to the recoverability and classification of assets and
the satisfaction and classification of liabilities that might be necessary
should we be unable to continue as a going concern.
FINANCING FACILITIES
Our Bridge Agreement, as amended, permits us to incur up to $425.0 million in
borrowings under the senior credit facility, subject to approval from a majority
of our lenders. We have $398.9 million that has been committed, subject to
various conditions, covenants and restrictions, including those described in
Note 8 to the condensed consolidated financial statements. As of June 30, 2003,
there was $125.0 million outstanding under the term B loan, $125.0 million
outstanding under the term A loan, $100.0 million outstanding under the
revolving credit facility, $44.5 million outstanding under the term C loan, and
$2.6 million outstanding under the term D loan. There was $1.8 million available
under the senior credit facility at June 30, 2003, which is subject to no
"material adverse change" in the business, as defined in our Credit Agreement.
The senior credit facility, which is secured by liens on substantially all of
our and our subsidiaries' assets and a pledge of our subsidiaries' common stock,
contains covenants and events of default that are customary for credit
facilities of this nature.
Our senior credit facility requires us to notify our lenders of a material
adverse change in our business. Failure to timely notify our lenders of a
material adverse change would be an event of default under the Credit Agreement
permitting our lenders to accelerate the loan; however, notice to our lenders of
a material adverse change does not itself create an event of default under the
Credit Agreement. However, our lenders are not required to advance further funds
under such circumstances. As of June 30, 2003, we were in compliance with these
covenants.
We also have $216.0 million of subordinated notes outstanding, excluding the
discount of $2.5 million and accrued PIK interest of $3.9 million, which are
subordinate to the senior credit facility. The interest expense on the
subordinated notes is PIK at a fixed rate of 13.0%, accreting to principal
semi-annually until November 2006. Thereafter, until maturity on November 9,
2010, interest will be payable in cash quarterly. The subordinated notes contain
covenants related to capital expenditures and events of default that are similar
to those in our senior credit facility. As of June 30, 2003, we were in
compliance with these covenants.
CASH FLOWS
We have incurred significant operating and net losses since our inception.
However, we generated positive cash flow from operations for the month of June
2003 and positive adjusted EBITDA during the quarter ended June 30, 2003.
Although not necessarily indicative of future cash flow results, this was the
first time we experienced positive monthly cash flow. Also, this was the second
straight quarter in which we generated positive adjusted EBITDA. While we expect
to continue to generate positive adjusted EBITDA, we also expect to continue to
have operating losses as we penetrate our markets. As of June 30, 2003, we had
an accumulated deficit of $1.0 billion. Net cash used for operating activities
was approximately $11.9 million and $39.3 million for the six months ended June
30, 2003 and 2002, respectively. The net cash used for operating activities
during the six months ended June 30, 2003 was primarily due to net losses from
operations, negative net working capital changes of $15.5 million, of which $0.6
million was related to payments of restructuring obligations, and interest
expense payable in cash of $14.9 million. Net cash used for operating activities
was also impacted by settlement payments received by us and offset by payments
made by us upon resolution of disputes with other phone
-29-
companies. Net cash paid for interest for the six months ended June 30, 2003
versus June 30, 2002 increased $0.1 million, or 0.7%, as a result of additional
borrowings, offset by lower LIBOR rates. The net cash used for operating
activities during the six months ended June 30, 2002 was primarily due to net
losses incurred while we grew our client base and operations.
Net cash used in investing activities was $4.0 million and $11.2 million for the
six months ended June 30, 2003 and 2002, respectively. Net cash used in
investing activities for the six months ended June 30, 2003 related to capital
expenditures in support of growth in existing markets. Net cash used in
investing activities for the six months ended June 30, 2002, also related to
capital expenditures, offset by the proceeds from the sale of non-essential
corporate assets.
Net cash provided by financing activities was $1.4 million and $54.8 million for
the six months ended June 30, 2003 and 2002, respectively. Net cash provided by
financing activities for the six months ended June 30, 2003 was related to
borrowings under the Term D loan of the senior credit facility. Net cash
provided by financing activities for the six months ended June 30, 2002 was also
related to borrowings under the senior credit facility. Funds received were used
for capital expenditures and general corporate purposes.
CAPITAL REQUIREMENTS
Capital expenditures were $4.0 million and $12.2 million for the six months
ended June 30, 2003 and 2002, respectively. We expect that our capital
expenditures for 2003 will continue to remain below the level of 2002. The
actual amount and timing of our future capital requirements may differ
materially from our estimates as a result of the demand for our services and
regulatory, technological and competitive developments, including new
opportunities in the industry.
CRITICAL ACCOUNTING POLICIES
Our critical accounting policies are described in Item 7 of our Form 10-K for
the year ended December 31, 2002.
RECENT ACCOUNTING PRONOUNCEMENTS
In June 2001, the Financial Accounting Standards Board ("FASB") issued Statement
of Financial Accounting Standards ("SFAS") No. 143, "Accounting for Asset
Retirement Obligations". This standard addresses the financial accounting and
reporting for obligations associated with the retirement of tangible long-lived
assets and the associated asset retirement costs. The standard is effective for
fiscal years beginning after June 15, 2002. We adopted this standard on January
1, 2003. The adoption did not have a material impact on our financial condition
or results of operations.
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated
with Exit or Disposal Activities". This standard amends Emerging Issue Task
Force (EITF) Issue No. 94-3, "Liability Recognition for Certain Employee
Termination Benefits and Other Costs to Exit an Activity". This statement
requires that a liability for costs associated with an exit or disposal activity
be recognized when the liability is incurred, rather than when an entity commits
to an exit plan. The standard also established the use of fair value for the
measurement of exit liabilities. The standard is effective for exit or disposal
activities initiated after December 31, 2002, with early application encouraged.
We adopted this standard on January 1, 2003. The adoption of this standard did
not have an impact on our financial condition or results of operations as it
will only impact the Company's future exit or disposal activities, if any.
-30-
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure, an amendment of FASB Statement No.
123". This standard amends SFAS No. 123, "Accounting for Stock-Based
Compensation". This statement permits two additional transition methods for
entities to apply when implementing the fair value recognition provisions of
SFAS No. 123. The standard also establishes new disclosure requirements and
requires prominent display of such disclosures. The standard is effective for
financial statements for fiscal years ending after December 31, 2002, with early
application permitted. We adopted this standard effective January 1, 2003. On a
prospective basis, we changed from the intrinsic value method under APB No. 25
to the fair value method under SFAS No. 123, and the impact of the adoption is
included in our results of operations for the three and six months ended June
30, 2003. The adoption of SFAS Nos. 123 and 148 during the three and six months
ended June 30, 2003 resulted in us recording $0.1 million and $0.5 million of
compensation expense for the fair value of options granted during the period and
deferring $0.6 million and $0.5 million to be recognized over the remaining
vesting period, respectively.
In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133 on
Derivative Instruments and Hedging Activities". This standard amends SFAS No.
133, "Accounting for Derivative Instruments and Hedging Activities". This
standard clarifies the accounting guidance on derivative instruments, including
certain derivative instruments embedded in other contracts, and hedging
activities. The standard is effective for contracts entered into or modified
after June 30, 2003. We do not expect the adoption of this standard to have a
material impact on our financial condition or results of operations.
In May 2003, the FASB issued SFAS No. 150, "Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity." This statement
establishes standards for how an issuer classifies and measures in its statement
of financial position certain financial instruments with characteristics of both
liabilities and equity. It requires that an issuer classify a financial
instrument that is within its scope as a liability (or an asset in some
circumstances) because that financial instrument embodies an obligation of the
issuer. This statement is effective for financial instruments entered into or
modified after May 31, 2003 and otherwise is effective at the beginning of the
first interim period beginning after June 15, 2003, except for mandatorily
redeemable financial instruments of nonpublic entities. We will adopt this
Standard on July 1, 2003. Upon adoption, we will reclassify our mandatorily
redeemable preferred stock to long-term liabilities. We will also begin to
recognize dividends declared and accretion related to this preferred stock as
interest expense. We are currently assessing the impact of the adoption of SFAS
No. 150 on our financial condition and results of operations.
In November 2002, the FASB issued Financial Interpretation ("FIN") No. 45,
"Guarantor's Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others". FIN No. 45 elaborates on the
existing disclosure requirements for most guarantees, and clarifies that at the
time a company issues a guarantee, the company must recognize an initial
liability for the fair value of the obligation it assumes under that guarantee
and must disclose that information in its interim and annual financial
statements. The initial recognition and measurement provisions apply on a
prospective basis to guarantees issued or modified after December 31, 2002. The
adoption of FIN No. 45 did not have a material impact on our financial condition
or results of operations.
On January 17, 2003 the FASB issued FIN No. 46, "Consolidation of Variable
Interest Entities." The objective of FIN No. 46 is to improve financial
reporting by companies involved with variable interest entities. FIN No. 46
changes certain consolidation requirements by requiring a variable interest
entity to be consolidated by a company if that company is subject to a majority
of the risk of loss from the variable interest entity's activities or entitled
to receive a majority of the entity's residual returns or both. The
consolidation requirements apply to entities created before February 1, 2003, no
later than the beginning of the first fiscal year or interim period beginning
after June 15, 2003. We do not expect the adoption of this standard to have a
material impact on our financial condition or results of operations.
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
At June 30, 2003 and December 31, 2002, the carrying value of our debt
obligations, excluding capital lease obligations, was $613.4 million and $595.9
million, respectively. The fair value of those obligations was $623.3 million
and $602.4 million, respectively. The weighted average interest rate of our debt
obligations at June 30, 2003 and December 31, 2002 was 7.46% and 8.21%,
respectively. A hypothetical decrease of approximately 100 basis points from
prevailing interest rates at June 30, 2003 would have resulted in an increase in
fair value of long-term debt of approximately $10.7 million.
Also, a hypothetical increase of approximately 100 basis points from prevailing
interest rates at June 30, 2003 would have resulted in an approximate increase
in cash required for interest on variable rate debt during the remaining fiscal
year of $1.1 million, increasing to $2.1 million in the next fiscal year, and
then declining to $2.0 million, $1.7 million, and 1.2 million, in the third,
fourth and fifth years, respectively.
As a result of our operating and financing activities, we are exposed to changes
in interest rates that may adversely affect our results of operations and
financial position. In seeking to minimize the risks and/or costs associated
with such activities, we may enter into derivative contracts. However, we do not
use derivative financial instruments for speculative purposes. Interest rate
swaps were employed as a requirement under the Company's Second Amended and
Restated Credit Agreement. The Third Amended and Restated Credit Agreement does
not have such a requirement. This agreement does prohibit the Company from
entering into any new interest rate swap, collar, cap, floor or forward rate
agreements without the prior written consent of the lenders. Interest rate swap
agreements are used to reduce our exposure to risks associated with interest
rate fluctuations. By their nature, these instruments would involve risk,
including the risk of nonperformance by counterparties, and our maximum
potential loss may exceed the amount recognized in our balance sheet. We attempt
to control our exposure to counterparty credit risk through monitoring
procedures and by entering into multiple contracts. At June 30, 2003, the
weighted average pay rate for the interest rate swap agreement was 6.94% and the
average receive rate was 1.29%.
At June 30, 2003, we had an interest rate swap agreement for a notional amount
of $125.0 million. Based on the fair value of the interest rate swap at June 30,
2003, it would have cost us $17.9 million to terminate the agreement. A
hypothetical decrease of 100 basis points in the swap rate would have increased
the cost to terminate this agreement by approximately $3.4 million.
In a declining interest rate market, the benefits of the hedge position are
minimized, however, we continue to monitor market conditions.
ITEM 4. CONTROLS AND PROCEDURES
Based on their evaluation as of the end of the period covered by this Quarterly
Report on Form 10-Q, the principal executive officer and principal financial
officer of Choice One Communications Inc., with the participation and assistance
of the Company's management, concluded that the Company's disclosure controls
and procedures as defined in Rules 13a- 15(e) and 15d- 15(e) promulgated under
the Securities Exchange Act of 1934, were effective in design and operation.
There have been no significant changes in the Company's system of internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of their evaluation.
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PART II OTHER INFORMATION
Item 1. Legal Proceedings
On January 26, 2002, the Company and its wholly owned
subsidiary US Xchange Inc. (referred to collectively for
purposes of this paragraph as the Company), filed suit against
AT&T Corp ("AT&T") in the United States District Court for the
Western District of New York (02-CV-6090L). The Company sought
damages from AT&T for breach of contract, based upon AT&T's
failure to pay, either on time or in full, the Company's
invoices for access services provided to AT&T. On June 13,
2003, the Company settled this matter by entering into a
Settlement and Switched Access Service Agreement ("Agreement")
with AT&T. Among other things, the Agreement provided for a
settlement payment by AT&T to Choice One to resolve charges
for access service provided prior to May 1, 2003. The
Agreement also established rates that the Company will charge
AT&T for access service during the term of the agreement.
On November 20, 2001, the Company and three of its officers
were named in a complaint filed in the United States District
Court of the southern District of New York on behalf of a
class of persons consisting of certain purchasers of the
Company's common stock in its initial public offering which
was completed on February 23, 2000. The complaint seeks
damages based on allegations that the Company's Registration
Statement and Prospectus relating to the offering contained
material misstatements and/or omissions regarding the
compensation received by the underwriters of the offering and
certain transactions engaged in by the underwriters. This
case, which has been consolidated with more than 300 other
cases against other companies involving similar allegations,
also names six underwriters of the Company's offering and the
offerings of other issuers, and alleges that the underwriters
engaged in a pattern of conduct to extract inflated
commissions in excess of the amounts disclosed in offering
materials and manipulated the post-offering markets in
connection with hundreds of offerings by engaging in
stabilizing transactions and issuing misleading and fraudulent
analyst and research reports. The complaint alleges that the
Company is strictly liable under Section 11 of the Securities
Act of 1933 because Item 508 of Regulation S-K allegedly
required the disclosure of commissions to be paid to
underwriters and of stabilizing transactions, and that the
Company and its officers acted with scienter, or recklessness,
in failing to disclose these facts, in violation of Section
10(b) of the Securities Exchange Act and Rule 10b-5
promulgated thereunder. The claims against the individual
defendants were dismissed without prejudice by an agreement
with the plaintiffs. After the court denied motions to dismiss
the cases, the parties entered into a mediation which has
resulted in the execution of a Memorandum of Understanding by
the Company and approximately 300 other issuers who are the
subject of similar litigation. The settlement contemplated by
the Memorandum of Understanding will not involve any payments
by the Company and would terminate only the claims by the
plaintiffs against issuers. The claims against the
underwriters will continue, and the Company will be required
to participate in limited discovery related to those claims.
It is expected that the finalization of the settlement,
including the certification of a class and obtaining court
approval of the settlement, will continue through at least the
end of the year. There are a number of conditions to the
finalization of the settlement and it is not possible to
predict whether all of those conditions will be satisfied.
Item 2. Changes in Securities and Use of Proceeds
Not applicable.
Item 3. Defaults Upon Senior Securities
Not applicable.
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Item 4. Submission of Matters to a Vote of Security Holders
Election of Directors - At the Annual Meeting of Stockholders
held on May 29, 2003, stockholders re-elected current
directors Leigh J. Abramson and Louis Massaro.
Votes Cast
----------
For Against Abstain Broker Non-Votes
--- ------- ------- ----------------
Leigh J. Abramson 31,956,826 0 58,259 0
Louis Massaro 31,873,901 0 141,184 0
Stockholders ratified the appointment of
PricewaterhouseCoopers LLP as independent accountants for the
year ended December 31, 2003.
Item 5. Other Information
Not applicable.
Item 6. Exhibits and Reports for Form 8-K
A. Exhibits
See Exhibit Index
B. Reports on Form 8-K
On May 5, 2003, the Company filed a report on Form
8-K to report on a press release announcing the
activation of an intra-city fiber ring network in
Columbus, Ohio , and a press release reporting our
first quarter results for the three months ended
March 31, 2003.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
CHOICE ONE COMMUNICATIONS INC.
Registrant
DATE: August 12, 2003 By: /s/ Steve M. Dubnik
------------------------------------------
Steve M. Dubnik, Chairman and Chief
Executive Officer
(Principal Executive Officer)
By: /s/ Ajay Sabherwal
--------------------------------------------
Ajay Sabherwal, Executive Vice President,
Finance and Chief Financial Officer
(Principal Financial Officer)
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EXHIBIT INDEX
EXHIBIT
NUMBER DESCRIPTION LOCATION
- ------- ----------- --------
3.1 Amended and Restated Certificate of Incorporation. Incorporated by reference from Exhibit 3.1 to
Choice One Communication Inc.'s Registration
Statement on Form S-1 declared effective on
February 16, 2000 located under Securities and
Exchange Commission File No. 333-91321
("February 2000 Registration Statement").
3.2 Amended and Restated Bylaws. Incorporated by reference from Exhibit 3.2 to
the February 2000 Registration Statement.
3.3 Certificate of Designations for Series A Senior Incorporated by reference from Exhibit 3.1 to
Cumulative Preferred Stock. the August 10, 2000 8-K filing located under
the Securities and Exchange Commission File
No. 29279.
3.4 Certificate of Amendment of Certificate of Incorporated by reference from Exhibit 10.25
Designations for Series A Senior Cumulative to the Company's 10-K filed on April 1, 2002.
Preferred Stock of Choice One Communications Inc.
3.5 Certificate of Amendment of Certificate of Incorporated by reference from Exhibit 3.4 to
Incorporation with Certificate of Designations, the Company's 10-Q filed on May 15, 2002.
Preferences and Rights of Series A Senior
Cumulative Preferred Stock dated March 30, 2002.
3.6 Certificate of Amendment of Certificate of Incorporated by reference from Exhibit 4.6 to
Designations for Series A Senior Cumulative the Company's 8-K filed on September 27, 2002.
Preferred Stock.
10.40 Master Facilities Agreement between Fiber Incorporated by reference from Exhibit 10.1 to
Technologies Operating Company, LLC and Choice the Company's 10-Q for the quarter ended June
One Communications Inc. dated as of May 31, 30, 2000.
2000.*
10.45 Amendment No. 1 dated as of December 7, 2001 to Filed herewith
Master Facilities Agreement and Assignment and
Assumption among Choice One Communications Inc.,
Fiber Technologies Construction Company, LLC and
Fiber Technologies Networks, LLC dated as of May
31, 2000.**
10.46 Amendment No. 2 dated as of May 2, 2002 to Master Filed herewith
Facilities Agreement and Assignment and
Assumption among Choice One Communications Inc.,
Fiber Technologies Construction Company, LLC and
Fiber Technologies Networks, LLC dated as of May
31, 2000.**
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EXHIBIT
NUMBER DESCRIPTION LOCATION
- ------- ----------- --------
10.47 Amendment No. 3 dated as of June 13, 2002 to Filed herewith
Master Facilities Agreement and Assignment and
Assumption among Choice One Communications Inc.,
Fiber Technologies Construction Company, LLC and
Fiber Technologies Networks, LLC dated as of May
31, 2000.
10.48 Amendment No. 4 dated as of August 15, 2002 to Filed herewith
Master Facilities Agreement and Assignment and
Assumption among Choice One Communications Inc.,
Fiber Technologies Construction Company, LLC and
Fiber Technologies Networks, LLC dated as of May
31, 2000.**
10.49 Amendment No. 5 dated as of September 23, 2002 to Filed herewith
Master Facilities Agreement and Assignment and
Assumption among Choice One Communications Inc.,
Fiber Technologies Construction Company, LLC and
Fiber Technologies Networks, LLC dated as of May
31, 2000.**
10.50 Amendment No. 6 dated as of October 29, 2002 to Filed herewith
Master Facilities Agreement and Assignment and
Assumption among Choice One Communications Inc.,
Fiber Technologies Construction Company, LLC and
Fiber Technologies Networks, LLC dated as of May
31, 2000.**
31.1 Certification by Chief Executive Officer filed Filed herewith
herewith pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
31.2 Certification Chief Financial Officer filed Filed herewith
herewith pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
32.1 Certification by Chief Executive Officer and Chief Filed herewith
Financial Officer filed herewith pursuant to 18
U.S.C. Section 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.
* Portions of this agreement have been omitted and filed separately with the
Commission pursuant to an application for confidential treatment under Rule
24b-2, which was granted by the Commission until May 31, 2003. A request
for an extension of confidential treatment was filed with the Commission on
May 30, 2003.
** Portions of this agreement have been omitted and filed separately with the
Commission pursuant to an application for confidential treatment under Rule
24b-2.
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