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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 SEPTEMBER 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 November 1, 2003, there were outstanding 44,098,354 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. Condensed Consolidated Financial Statements (Unaudited)
Condensed Consolidated Balance Sheets as of September 30, 2003 and
December 31, 2002................................................................................ 2
Condensed Consolidated Statements of Operations for the three months ended
September 30, 2003 and September 30, 2002........................................................ 3
Condensed Consolidated Statements of Operations for the nine months ended
September 30, 2003 and September 30, 2002........................................................ 4
Condensed Consolidated Statements of Cash Flow for the nine months ended
September 30, 2003 and September 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.......................................................................... 33
PART II. OTHER INFORMATION
Item 1. Legal Proceedings................................................................................ 34
Item 2. Changes in Securities and Use of Proceeds........................................................ 34
Item 3. Defaults Upon Senior Securities.................................................................. 34
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 SHEETS
(AMOUNTS IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
(UNAUDITED)
SEPTEMBER 30, DECEMBER 31,
2003 2002
---- ----
ASSETS
Current Assets:
Cash and cash equivalents ................................................. $ 17,434 $ 29,434
Accounts receivable, net .................................................. 33,265 43,215
Prepaid expenses and other current assets ................................. 4,176 2,298
----------- -----------
Total current assets .................................................. 54,875 74,947
Property and equipment, net of accumulated depreciation ........................ 303,003 336,711
Intangible assets, net of accumulated amortization ............................. 36,282 47,479
Other assets, net .............................................................. 5,037 4,813
----------- -----------
Total assets ................................................................... $ 399,197 $ 463,950
=========== ===========
LIABILITIES AND STOCKHOLDERS' DEFICIT
Current Liabilities:
Current portion of capital leases for indefeasible rights to use fiber .... $ 572 $ 461
Accounts payable .......................................................... 5,307 14,717
Accrued expenses .......................................................... 45,374 58,381
----------- -----------
Total current liabilities ............................................. 51,253 73,559
Long-term debt, net ............................................................ 622,528 595,941
Redeemable series A preferred stock, $0.01 par value, 340,000 shares authorized;
251,588 shares issued and outstanding, at September 30, 2003, ($326,877
liquidation value at September 30, 2003) ....................................... 282,094 --
Long-term portion of capital leases for indefeasible rights to use fiber ....... 33,551 31,968
Interest rate swaps ............................................................ 15,734 19,308
Other long-term liabilities .................................................... 3,646 3,581
----------- -----------
Total long-term debt and other liabilities ............................ 957,553 650,798
Commitments and Contingencies (Note 13)
Redeemable Series A Preferred stock, $0.01 par value, 340,000 shares authorized;
251,588 shares issued and outstanding at December 31, 2002 ..................... -- 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; 44,191,360 and
42,478,396 shares issued as of September 30, 2003 and
December 31, 2002, respectively ....................................... 442 425
Treasury stock, 135,415 shares, at cost, at September 30, 2003 and
December 31, 2002, respectively ....................................... (473) (473)
Additional paid-in capital ................................................ 474,510 498,439
Deferred compensation ..................................................... (457) (391)
Accumulated other comprehensive loss ...................................... (15,734) (19,308)
Accumulated deficit ....................................................... (1,067,897) (982,631)
----------- -----------
Total stockholders' deficit ............................................... (609,609) (503,939)
----------- -----------
Total liabilities and stockholders' deficit ............................... $ 399,197 $ 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)
(UNAUDITED)
THREE MONTHS ENDED
SEPTEMBER 30,
2003 2002
------------ ------------
Revenue ........................................................................ $ 80,822 $ 74,439
Operating expenses:
Network costs, excluding depreciation expense of $7,521 and $10,067 in
2003 and 2002, respectively.............................................. 38,846 40,304
Selling, general and administrative, excluding depreciation and
amortization expense of $7,859 and $8,360 in 2003 and 2002, respectively,
and including non-cash compensation of $145 and $962 in 2003 and 2002,
respectively, and non-cash management ownership allocation charge of $200
in 2002 ................................................................. 31,714 38,469
Loss on disposition of assets ............................................. 154 36
Restructuring costs ....................................................... -- 5,283
Impairment loss on long-lived assets ...................................... -- 11,273
Depreciation and amortization ............................................. 15,380 18,427
------------ ------------
Total operating expenses .............................................. 86,094 113,792
------------ ------------
Loss from operations ........................................................... (5,272) (39,353)
Interest income/(expense):
Interest income ........................................................... 29 108
Interest expense .......................................................... (16,625) (15,473)
Accretion of preferred stock .............................................. (2,902) --
Accrued dividends on preferred stock ...................................... (10,458) --
------------ ------------
Total interest income/(expense), net .................................. (29,956) (15,365)
------------ ------------
Net loss ....................................................................... (35,228) (54,718)
Accretion of preferred stock .............................................. -- 2,125
Accrued dividends on preferred stock ...................................... -- 9,114
------------ ------------
Net loss applicable to common stockholders ..................................... $ (35,228) $ (65,957)
============ ============
Net loss per share, basic and diluted .......................................... $ (0.65) $ (1.47)
============ ============
Weighted average number of shares outstanding, basic and diluted ............... 54,006,877 44,974,102
============ ============
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)
(UNAUDITED)
NINE MONTHS ENDED
SEPTEMBER 30,
2003 2002
------------ ------------
Revenue ......................................................................... $ 243,111 $ 218,225
Operating expenses:
Network costs, excluding depreciation expense of $25,425 and $26,473 in 2003
and 2002, respectively ................................................... 120,684 122,923
Selling, general and administrative, excluding depreciation and amortization
expense of $24,678 and $24,662 in 2003 and 2002, respectively, and
including non-cash compensation of $806 and $4,909 in 2003 and 2002,
respectively, and non-cash management ownership allocation charge of
$10,915 in 2002 .......................................................... 94,808 140,218
Loss on disposition of assets .............................................. 242 814
Restructuring (credits)/costs .............................................. (535) 5,283
Impairment loss on long-lived assets ....................................... -- 294,524
Depreciation and amortization .............................................. 50,103 51,135
------------ ------------
Total operating expenses ............................................... 265,302 614,897
------------ ------------
Loss from operations ............................................................ (22,191) (396,672)
Interest income/(expense):
Interest income ............................................................ 139 239
Interest expense ........................................................... (49,891) (44,611)
Accretion of preferred stock ............................................... (2,902) --
Accrued dividends on preferred stock ....................................... (10,458) --
------------ ------------
Total interest income/(expense), net ................................... (63,112) (44,372)
Other income .................................................................... 36 --
------------ ------------
Net loss ........................................................................ (85,267) (441,044)
Accretion of preferred stock ............................................... 5,334 6,122
Accrued dividends on preferred stock ....................................... 19,867 26,427
------------ ------------
Net loss applicable to common stockholders ...................................... $ (110,468) $ (473,593)
============ ============
Net loss per share, basic and diluted ........................................... $ (2.05) $ (10.94)
============ ============
Weighted average number of shares outstanding, basic and diluted ................ 53,839,007 43,305,779
============ ============
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)
(UNAUDITED)
NINE MONTHS ENDED
SEPTEMBER 30,
2003 2002
--------- ---------
Cash flows from operating activities:
Net loss .................................................................. $ (85,267) $(441,044)
Adjustments to reconcile net loss to net cash used in operating activities:
Loss on disposition of assets ......................................... 242 814
Depreciation and amortization ......................................... 50,103 51,135
Interest payable in-kind on long-term debt ............................ 23,454 18,188
Amortization of deferred financing costs .............................. 3,331 3,096
Amortization of discount on long-term debt ............................ 828 422
Accretion of preferred stock .......................................... 2,902 --
Dividends on preferred stock .......................................... 10,458 --
Non-cash compensation and management ownership allocation charge ...... 806 15,824
Impairment loss on long-lived assets .................................. -- 294,524
Changes in assets and liabilities:
Decrease/(increase) in accounts receivable, net .................... 9,950 (675)
Increase in prepaid expenses and other assets ...................... (2,376) (538)
(Decrease)/increase in accrued restructuring costs ................. (1,223) 5,283
(Decrease)/increase in accounts payable and accrued expenses ....... (20,334) 2,953
--------- ---------
Net cash used in operating activities ........................... (7,126) (50,019)
Cash flows from investing activities:
Capital expenditures .................................................. (7,026) (19,958)
Proceeds from sale of assets .......................................... 112 1,002
--------- ---------
Net cash used in investing activities .............................. (6,914) (18,956)
Cash flows from financing activities:
Additions to long-term debt ........................................ 2,625 198,200
Principal payments of long-term debt ............................... -- (98,700)
Payments of financing costs ........................................ -- (2,382)
Payments under long-term capital leases for indefeasible rights to
use fiber .......................................................... (585) (231)
--------- ---------
Net cash provided by financing activities ................................. 2,040 96,887
--------- ---------
Net (decrease)/increase in cash and cash equivalents ...................... (12,000) 27,912
--------- ---------
Cash and cash equivalents, beginning of period ............................ 29,434 14,415
--------- ---------
Cash and cash equivalents, end of period .................................. $ 17,434 $ 42,327
========= =========
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 NINE MONTH PERIOD ENDED SEPTEMBER 30, 2003
(Unaudited)
(Amounts in thousands, except share and per share data)
NOTE 1. DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION
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 operates in one segment
and its 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.
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 nine month periods ended September 30,
2003 are not necessarily indicative of the results to be expected for other
interim periods or for the year ended December 31, 2003.
NOTE 2. 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
$35.2 million, $36.6 million and $66.0 million for the three months ended
September 30, 2003, June 30, 2003 and September 30, 2002, respectively. At
September 30, 2003, the Company had $17.4 million in cash and cash equivalents
and $0.9 million available under its senior credit facility. The $0.9 million is
available in one remaining quarterly installment on 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 nine
months ended September 30, 2003. The Company has a total stockholders' deficit
of $609.6 million as of September 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"). The Company's viability is dependent upon its ability to continue
to execute under its business strategy and to generate positive cash flows from
operations. For the three months ended September 30, 2003, the Company generated
$4.8 million in positive cash flows from operations. Although not necessarily
indicative of future cash flow from operations, this was the first time the
Company generated positive quarterly cash flows from operations. 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 through July 1, 2004, the
covenant measurement period, 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 $0.9
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, the covenant
measurement period, 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 September 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 3. 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 nine month periods ended September 30,
2003 resulted in the Company recording $0.1 million and $0.6 million of
compensation expense for the fair value of options granted during the period and
deferring $0.1 million and $0.4 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 NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30,
2003 2002 2003 2002
---- ---- ---- ----
Net loss as reported ........................... $ (35,228) $ (54,718) $ (85,267) $(441,044)
Stock-based employee compensation expense
included in reported net loss, net of related
tax effects .................................... 145 230 806 972
Total stock-based employee compensation expense
determined under fair value based method for all
awards, net of related tax effects ............. (502) (3,395) (1,326) (10,341)
--------- --------- --------- ---------
Additional expense ............................. (357) (3,165) (520) (9,369)
--------- --------- --------- ---------
Net loss pro forma ............................. $ (35,585) $ (57,883) $ (85,787) $(450,413)
========= ========= ========= =========
Net loss per share, basic and diluted:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30,
2003 2002 2003 2002
---- ---- ---- ----
As reported .................................... $ (0.65) $ (1.47) $ (2.05) $ (10.94)
Pro forma ...................................... $ (0.66) $ (1.54) $ (2.06) $ (11.17)
-8-
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:
SEPTEMBER 30, SEPTEMBER 30,
2003 2002
---- ----
Dividend yield ................... 0.00 percent 0.00 percent
Expected volatility .............. 222.94 percent 215.07 percent
Risk-free interest rate .......... 3.04 percent 4.92 percent
Expected life .................... 7 years 7 years
The weighted average fair value of options granted during the nine-month period
ended September 30, 2003 and 2002 was $0.25 and $3.20, 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.
Basic and diluted loss per common share for all periods presented was computed
by dividing the net loss attributable to common stockholders by the weighted
average outstanding common shares for the period. The Company had options and
warrants to purchase 6,969,643 and 8,605,215 shares outstanding at September 30,
2003 and 2002, respectively, that were not included in the calculation of
diluted loss per share because the effect would be anti-dilutive.
-9-
NOTE 4. NEW ACCOUNTING PRONOUNCEMENTS
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 adoption of this standard has not had a material impact
on the Company's condensed consolidated financial statements.
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 the scope of SFAS No. 150 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
adopted this Standard on July 1, 2003. Upon adoption, the Company reclassified
its mandatorily redeemable preferred stock, previously given mezzanine
presentation, to long-term liabilities. The Company also now recognizes
dividends declared and accretion related to this preferred stock as a component
of interest expense. Restatement of prior period classifications is not
permitted upon adoption of SFAS No. 150.
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 December 15, 2003, as amended by FASB Staff Position FIN 46-6. The Company
does not expect the adoption of this standard to have a material impact on its
condensed consolidated financial statements.
NOTE 5. PROPERTY AND EQUIPMENT
Property and equipment, at cost, consisted of the following:
SEPTEMBER 30, 2003 DECEMBER 31, 2002
------------------ -----------------
Switch equipment ..................... $ 304,649 $ 300,506
Computer equipment and software ...... 59,598 55,598
Office furniture and equipment ....... 9,891 9,950
Leasehold improvement ................ 23,120 22,815
Indefeasible right to use fiber (IRU) 69,475 67,548
Assets held for use .................. 6,045 5,132
Construction in progress ............. 2,482 5,665
--------- ---------
Total property and equipment 475,260 467,214
Less: accumulated amortization on IRUs (8,048) (5,452)
accumulated depreciation ....... (164,209) (125,051)
--------- ---------
Property and equipment, net . $ 303,003 $ 336,711
========= =========
-10-
Depreciation expense, including amortization of IRUs, amounted to $12.7 million
and $15.7 million for the three months ended September 30, 2003 and September
30, 2002, respectively, and $42.0 million and $43.2 million for the nine months
ended September 30, 2003 and September 30, 2002, respectively.
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:
SEPTEMBER 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 . (33,832) (25,787)
Deferred financing costs (13,336) (10,154)
-------- --------
Intangible assets, net .......... $ 36,282 $ 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:
October to December, 2003.................................... 2,681
2004......................................................... 10,616
2005......................................................... 6,027
2006......................................................... 370
2007......................................................... 109
Amortization expense was $2.7 million for the three months ended September 30,
2003 and 2002, respectively, and $8.1 million and $8.0 million for the nine
months ended September 30, 2003 and 2002, respectively.
NOTE 7. ACCRUED EXPENSES
Accrued expenses consisted of the following:
SEPTEMBER 30, 2003 DECEMBER 31, 2002
------------------ -----------------
Accrued network costs.............................. $ 24,724 $ 33,936
Accrued payroll and payroll related benefits....... 4,685 2,883
Accrued collocation costs.......................... 2,864 5,723
Accrued interest................................... 1,107 1,222
Accrued restructuring costs........................ 764 1,695
Deferred revenue................................... 5,320 4,990
Other.............................................. 5,910 7,932
------------ --------------
Total accrued expenses $ 45,374 $ 58,381
============ ==============
-11-
NOTE 8. DEBT
Long-term debt outstanding consists of the following:
SEPTEMBER 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 ............. 44,243 41,389
Term D loan ............. 3,500 875
Revolver ................ 100,000 100,000
Subordinated notes .......... 224,785 203,677
-------- --------
$622,528 $595,941
======== ========
Included in the subordinated notes is a discount on the notes of $2.3 million
and $2.8 million as of September 30, 2003 and December 31, 2002, respectively.
Included in the Term C loan is a discount of $3.7 million and $4.1 million as of
September 30, 2003 and December 31, 2002, respectively, and payable-in-kind
("PIK") interest which accreted to principal of $3.5 million and $1.0 million as
of September 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 September 30, 2003 and 2002, $0.2 million and
$0.1 million of the discount was amortized, respectively. For the nine months
ended September 30, 2003 and 2002, $0.4 million and $0.4 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 each of the three months
ended September 30, 2003 and 2002, $0.1 million of the discount on the Term C
loan was amortized. For the nine months ended September 30, 2003 and 2002, $0.1
million and $0.4 million, respectively, of the discount 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.
-12-
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 September 30, 2003.
As of September 30, 2003, the Company had principal borrowings of $216.0 million
in subordinated notes, excluding the discount of $2.3 million and PIK interest
of $11.1 million that had accrued but not accreted to principal. 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. In May 2003, $13.3 million in PIK interest accreted
to principal. The subordinated notes mature on November 9, 2010.
As of September 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 $3.5
million outstanding under the Term D loan at September 30, 2003 and an
additional $0.9 million was available subject to certain conditions. The maximum
borrowing under the subordinated notes was outstanding. At September 30, 2003,
$276.5 million was variable rate debt and $341.0 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 September 30, 2003 were 5.53% and 11.37%, 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 September 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
$15.7 million and $19.3 million liability as of September 30, 2003 and December
31, 2002, respectively. The fair value of the interest rate swap agreement is
estimated based on quotes from a broker and represents the estimated amount that
the Company would expect to pay to terminate the agreement at the reporting
date.
-13-
The Company also had an interest rate swap agreement with a notional principal
amount of $62.5 million that expired in May 2003.
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 agreements is the only
component of the other comprehensive loss. Comprehensive loss for the three
months ended September 30, 2003 and September 30, 2002 was $33.1 million and
$59.7 million, respectively. Comprehensive loss for the nine months ended
September 30, 2003 and September 30, 2002 was $81.7 million and $447.6 million,
respectively.
NOTE 10. 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 redeployed
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 September 30, 2003, approximately $1.3 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 $2.7 million that extend beyond one year and are included in
other long-term liabilities.
-14-
The following table highlights the cumulative restructuring activities through
September 30, 2003:
NETWORK
TERMINATION LEASE FACILITY
BENEFITS OBLIGATIONS 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) (289) (327) (688)
Adjustments due to plan modifications ... 50 -- (585) (535)
------- ------- ------- -------
Balance at September 30, 2003 ........... $ -- $ 3,127 $ 371 $ 3,498
======= ======= ======= =======
NOTE 11. SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING ACTIVITIES
AND CASH FLOW INFORMATION
Supplemental disclosures of cash flow information for the nine months ended:
SEPTEMBER 30, SEPTEMBER 30,
2003 2002
---- ----
Interest paid ........................................... $22,369 $24,713
Capital lease obligations for IRUs ...................... $ -- $ 9,435
Issuance of common stock for employer 401(k) contribution $ -- $ 414
NOTE 12. BARTER TRANSACTIONS
The Company engages in non-monetary trades of facilities-based voice and data
telecommunications services for goods or services. These barter transactions are
recorded at the estimated fair value of the asset or services received in
accordance with SFAS No. 29, "Accounting for Non-monetary Transactions". During
the three months ended September 30, 2003, the Company entered into one
non-monetary agreement. For the nine months ended September 30, 2003,
non-monetary barter transactions were not material to the financial statements.
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 for 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
-15-
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 September 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:
September 30, 2003 September 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 18
Estimated addressable market (Business lines) 5.7 million 5.7 million
Lines in service-total 514,314 492,879
Lines in service-voice 495,667 475,930
Lines in service-data 18,647 16,949
Total employees 1,373 1,615
Direct sales employees 296 436
GOING CONCERN MATTERS
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. The report of
independent accountants dated March 27, 2003 concerning our financial statements
for the year ended December 31, 2002, included in our annual report filed on
Form 10-K, noted 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 $35.2
million, $36.6 million, and $66.0 million for the quarters ended September 30,
2003, June 30, 2003 and September 30, 2002, respectively. Adjusted EBITDA was
positive $10.5 million for the three months ended September 30, 2003, positive
$10.3 million for the three months ended June 30, 2003 and negative $8.7 million
for the three months ended September 30, 2002. Net cash provided by operating
activities was $4.8 million for the three months ended September 30, 2003. Net
cash used in operating activities was approximately $3.8 million, and $10.7
million for the three months ended June 30, 2003, and September 30, 2002,
-18-
respectively. Although not necessarily indicative of future cash flow results,
the three months ended September 30, 2003 was the first time we generated
positive quarterly cash flow from operations. 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 future
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.
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
-19-
obligations, or that we will be successful in these efforts. As of September 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 September 30, 2003, we had $17.4 million in cash and cash equivalents and
$0.9 million available under our senior credit facility which is available in
one quarterly installment on December 31, 2003 and subject to no "material
adverse change" in the business, as defined in our Credit Agreement. We expect
to 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, through July 1, 2004, the covenant measurement period. The amount of
cash available through July 1, 2004 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 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.
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, through July 1,
2004, the covenant measurement period, 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.
-20-
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 generated positive adjusted EBITDA during
each of the quarters in 2003. We expect to continue to generate positive
adjusted EBITDA during the remainder of 2003.
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
nine-month periods ended:
(in thousands)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, JUNE 30, SEPTEMBER 30, SEPTEMBER 30, SEPTEMBER 30,
2003 2003 2002 2003 2002
Net cash provided by/(used in) operating
activities .............................. $ 4,760 $ (3,763) $(10,749) $ (7,126) $(50,019)
Adjustments to reconcile:
Changes in assets and liabilities ...... (1,558) 6,587 (5,736) 13,448 (7,022)
Net interest expense currently payable
Other expense, net .................. 29,956 16,746 15,365 63,076 44,372
Amortization of deferred financing
costs ............................ (1,080) (1,110) (1,051) (3,331) (3,096)
Amortization of discount on
long-term debt .................. (285) (275) (173) (828) (422)
Interest payable in-kind on
long-term debt .................. (8,027) (7,844) (6,309) (23,454) (18,188)
Accretion of preferred stock ........ (2,902) -- -- (2,902) --
Dividends on preferred stock ........ (10,458) -- -- (10,458) --
-------- -------- -------- -------- --------
Net interest expense currently payable . 7,204 7,517 7,832 22,103 22,666
-------- -------- -------- -------- --------
Adjusted EBITDA ............................ $ 10,406 $ 10,341 $ (8,653) $ 28,425 $(34,375)
======== ======== ======== ======== ========
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.
-21-
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 redeployed 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 be nefits 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.
Refer to the table that highlights our cumulative restructuring activities
through September 30, 2003 in the Results of Operations section below.
RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2003 AS COMPARED
TO SEPTEMBER 30, 2002
REVENUE
We generated $80.8 million in revenue during the three months ended September
30, 2003. This represents an 8.6% increase compared to revenue for the three
months ended September 30, 2002, and a 1.7% decrease compared to the revenue for
the three months ended June 30, 2003.
Of our total revenue increase from the three months ended September 30, 2002,
approximately $4.0 million was attributable to increases in voice revenue, $1.0
million in data revenue, and $0.9 million in access revenue. The increase in
revenue for the three months ended September 30, 2003 versus the three months
ended September 30, 2002 is primarily attributable to an increase in the average
number of lines in service. For the three months ended September 30, 2003 as
compared to the three months ended September 30, 2002, the average number of
voice lines increased by approximately 22,250 lines while the average number of
data lines increased by approximately 2,100 lines. Our total lines in service
increased from September 30, 2002 by 4.4% to 514,314 lines at September 30,
2003. The decrease in revenue for the three months ended September 30, 2003
versus the three months ended June 30, 2003 was primarily due to lower access
revenue resulting from FCC mandated per minute access rate reductions.
Our churn for the three months ended September 30, 2003, of our facilities-based
business clients, was 1.3% per month. This compares to 1.6% per month for the
three months ended September 30, 2002 and 1.4% per month for the three months
ended June 30, 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.
-22-
NETWORK COSTS
Network costs for the three months ended September 30, 2003 were $38.8 million,
representing a 3.6% decrease compared to network costs for the three months
ended September 30, 2002 and a 6.0% decrease compared to network costs for the
three months ended June 30, 2003. Network costs as a percentage of total
revenues were 48.1% at September 30, 2003, a decrease compared to 54.1% at
September 30, 2002 and 50.3% June 30, 2003. Network cost changes in relation to
revenue changes reflect the benefits of our fiber network implementation and
other network efficiencies. We believe that network costs as a percentage of
revenue should continue to decline in 2003. During the three months ended
September 30, 2003, our average cost per line declined approximately 8.2% as
compared to the three months ended September 30, 2002, and 6.2% as compared to
the three months ended June 30, 2003. These decreases highlight the
effectiveness of our network optimization initiatives and the benefits of
leasing fiber. The cost of leasing fiber is included in depreciation expense.
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;
- - 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 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. While we do not lay
our own fiber, we do incur future cash obligations in the form of lease payments
when we take possession of the fiber. Such obligations extend over the 20 year
life of the lease for the indefeasible right to use the fiber. Our future
obligations have been included in the five year cash obligation table previously
disclosed in our Annual Report on Form 10-K: Item 7, filed on March 31, 2003.
We currently have 19 markets where we have intra-city fiber connecting our
collocations. We plan to activate fiber in an additional 2 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 $42.0 million, or 51.9% of revenue,
for the three months ended September 30, 2003, compared to $34.1 million, or
45.9% of revenue, for the three months ended September 30, 2002, and $40.9
million, or 49.7% of revenue for the three months ended June 30, 2003. We expect
that our revenue in excess of network costs, as a percentage of revenue, will
continue to improve as our revenue increases and network costs decrease through
optimization.
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SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
Selling, general and administrative expenses for the three months ended
September 30, 2003 were $31.7 million compared to selling, general and
administrative expenses of $38.5 million and $30.7 million during the three
months ended September 30, 2002 and June 30, 2003, respectively. Excluding the
non-cash deferred compensation and management ownership allocation charges, the
selling, general and administrative expenses decreased 15.8% from $37.5 million
during the three months ended September 30, 2002 to $31.6 million during the
three months ended September 30, 2003. For the three months ended June 30, 2003
selling, general and administrative expenses excluding non-cash deferred
compensation and management allocation were $30.5 million.
Selling, general and administrative expenses, excluding non-cash deferred
compensation and management ownership allocation charges, as a percentage of
revenue, were 39.1% for the three months ended September 30, 2003, as compared
to 50.4% for the three months ended September 30, 2002 and 37.2% for the three
months ended June 30, 2003. The increase in selling, general and administrative
expenses from the three months ended June 30, 2003 to the three months ended
September 30, 2003 resulted primarily from increased salaries, commissions and
advertising expenses.
During the three months ended September 30, 2003, salary, commissions and
benefits decreased approximately $3.6 million, directly related to headcount
decreases as compared to the three months ended September 30, 2002. The number
of individuals we employed decreased to 1,373 during the three months ended
September 30, 2003. At September 30, 2002, we employed 1,615 individuals and at
June 30, 2003, we employed 1,323 individuals.
Bad debt expense decreased $3.3 million as compared to bad debt expense for the
three months ended September 30, 2002. Of this change, $2.8 million in bad debt
expense for the three months ended September 30, 2002 was associated with
distressed telecommunications carriers, including Global Crossing and WorldCom
(now known as MCI).
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 September 30, 2003, is compensation amortization of $0.1 million.
This compares to the non-cash charges of $1.0 million for the three months ended
September 30, 2002, which included a non-cash charge of $0.2 million for
management ownership allocation. Compensation expense for the three months ended
September 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.
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RESTRUCTURING COSTS
During the three months ended September 30, 2002, we 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.
The following table highlights cumulative restructuring activities through
September 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) (289) (327) (688)
Adjustments due to plan modifications ... 50 -- (585) (535)
------- ------- ------- -------
Balance at September 30, 2003 ........... $ -- $ 3,127 $ 371 $ 3,498
======= ======= ======= =======
For the three months ended September 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 $2.7 million that extend beyond one year and are included in
other long-term liabilities.
IMPAIRMENT LOSS ON LONG-LIVED ASSETS
In conjunction with the previously described restructuring plan, we also
evaluated the related long-lived assets for impairment. During the three months
ended September 30, 2002, we recorded an impairment charge of approximately $7.3
million for the value of unrecoverable leasehold improvements and other general
equipment that was abandoned, which is reported in impairment loss on long-lived
assets on the Consolidated Statement of Operations. The restructuring plan and
related asset impairment required us to evaluate for impairment our equipment
held for use. It was also determined during the three months ended September 30,
2002 that a portion of this equipment would not be used. We recorded an
impairment charge of $4.0 million related to this equipment that was abandoned,
which is reported in impairment loss on long-lived assets on the Consolidated
Statement of Operations.
DEPRECIATION AND AMORTIZATION
Depreciation and amortization for the three months ended September 30, 2003 was
$15.4 million. This represents a 16.5% decrease compared to the three months
ended September 30, 2002 and a 10.3% decrease from the three months ended June
30, 2003. The decrease in depreciation expense as compared to the three months
ended September 30, 2002 and June 30, 2003 was related to certain switch
software assets acquired in the acquisition of US Xchange, Inc. ("US Xchange")
becoming fully depreciated during the three months ended September 30, 2003. 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 the value of acquired customer relationships.
INTEREST EXPENSE AND INCOME
Interest expense, net, for the three months ended September 30, 2003 and 2002
was approximately $30.0 million and $15.4 million, respectively. The increase in
interest expense, net, was attributable to an aggregate of $13.4 million of
accretion and dividends on our preferred stock being characterized as
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interest expense in accordance with the adoption of SFAS No. 150 where
corresponding amounts in prior periods were not included in interest expense,
net.
Interest expense for the three months ended June 30, 2003 was approximately
$16.8 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. As of July 1, 2003, interest expense, net,
also includes the accretion and dividends on preferred stock in accordance with
the adoption of SFAS No. 150.
Interest expense increased from $15.5 million to $16.6 million from the same
quarter a year ago due to an increase in the amount of our borrowings, offset by
favorable declines in LIBOR rates that impacted our borrowing rates. We expect
interest expense to remain stable over the next three months. Interest expense,
currently payable in cash, was $7.2 million and $7.8 million for the three
months ended September 30, 2003 and September 30, 2002, respectively, and $7.5
million for the three months ended June 30, 2003.
Interest income for the three months ended September 30, 2003 and 2002 was
approximately $29,000 and $0.1 million, respectively. Interest income for the
three months ended June 30, 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.
The non-cash accretion of and dividends on our preferred stock increased $2.2
million, or 18.9%, to $13.4 million for the three months ended September 30,
2003 as compared to $11.2 million for the three months ended September 30, 2002.
This change was primarily driven by the increase in dividends on preferred
stock, which result from the compounding effect of dividends that have accreted.
On July 1, 2003, we adopted Statement of Financial Accounting Standards ("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 and
statement of operations 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. As a result, we now classify accretion and dividends related to our
redeemable preferred stock as a component of interest expense and include these
amounts in the calculation of net loss. Restatement of prior period
classifications is not permitted upon adoption of SFAS No. 150.
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 AND NET LOSS APPLICABLE TO COMMON STOCKHOLDERS
Our net loss was $35.2 million and $54.7 million for the three months ended
September 30, 2003 and 2002, respectively. The net loss applicable to common
stockholders was $35.2 million and $66.0 million for the three months ended
September 30, 2003 and 2002, respectively. The improvement in net loss and net
loss applicable to common stockholders was attributable to the factors
previously discussed.
-26-
RESULTS OF OPERATIONS FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2003 AS COMPARED
TO SEPTEMBER 30, 2002
REVENUE
We generated $243.1 million in revenue during the nine months ended September
30, 2003 as compared to $218.2 million for the nine months ended September 30,
2002, an increase of $24.9 million or 11.4%. Of our total revenue increase from
the nine months ended September 30, 2002, approximately $21.0 million was
attributable to increases in voice revenue and $3.9 million was attributable to
increases in data revenue. Access revenue remained essentially unchanged from
the nine-month period ended September 30, 2002.
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.
For the nine months ended September 30, 2003 as compared to the nine months
ended September 30, 2002 the average number of voice lines increased by
approximately 60,300 and the average number of data lines increased by
approximately 4,000 lines. Our total lines in service increased from September
30, 2002 by 4.4% to 514,314 lines at September 30, 2003. Access revenue for the
nine months ended September 30, 2003 versus the nine months ended September 30,
2002 remained relatively unchanged as a result of FCC mandated per minute access
rate reductions offset by the increase in access lines in service and total
access minutes.
Our churn for the nine months ended September 30, 2003, of our facilities-based
business clients, decreased slightly to an average of 1.4% per month. Our churn
levels continue to compare favorably to the churn of clients experienced by
similar companies within the telecommunications industry.
NETWORK COSTS
Network costs for the nine months ended September 30, 2003 were $120.7 million,
representing a $2.2 million or 1.8% decrease compared to network costs for the
nine months ended September 30, 2002. Network costs as a percentage of total
revenues were 49.6% at September 30, 2003, down from 56.3% for the nine-months
ended September 30, 2002. Network cost changes in relation to revenue changes
primarily reflect the benefits of our fiber network implementation and other
network efficiencies realized from the increased number of installed lines. We
have continued with initiatives introduced in 2002 to optimize our existing
network. During the nine months ended September 30, 2003, our average cost per
line declined approximately 14.1% as compared to the nine months ended September
30, 2002. This decrease 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 expense.
Our revenues exceeded our network costs by $122.4 million, or 50.4% of revenue,
for the nine month period ended September 30, 2003, compared to $95.3 million,
or 43.7% of revenue, for the nine month period ended September 30, 2002.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
Selling, general and administrative expenses for the nine months ended September
30, 2003 were $94.8 million compared to selling, general and administrative
expenses of $140.2 million during the nine months ended September 30, 2002.
Excluding the non-cash deferred compensation and management ownership allocation
charges, the selling, general and administrative expenses decreased 24.4% from
$124.4 million during the nine months ended September 30, 2002 to $94.0 million
during the nine months ended September 30, 2003.
Selling, general and administrative expenses, excluding non-cash deferred
compensation and management ownership allocation charges, as a percentage of
revenue was 38.7% for the nine month period ended
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September 30, 2003 as compared to 57.0% for the nine month period ended
September 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 nine month period ended September 30, 2003, salary, commissions and
benefits decreased approximately $14.0 million, directly related to headcount
decreases as compared to the nine month period ended September 30, 2002. The
number of individuals we employed decreased to 1,373 at September 30, 2003. At
September 30, 2002, we employed 1,615 individuals.
Bad debt expense decreased $14.9 million as compared to the nine-month period
ended September 30, 2002. A significant portion of the bad debt expense for the
nine months ended September 30, 2002 was directly associated with distressed
telecommunications carriers, including Global Crossing and World Com (now known
as MCI).
Also included in selling, general and administrative expenses for the nine
months ended September 30, 2003, is compensation amortization of $0.8 million.
This compares to the non-cash charges of $15.8 million for the nine months ended
September 30, 2002, which included a non-cash charge of $10.9 million for
management ownership allocation. Compensation expense for the nine month period
ended September 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 (CREDITS)/COSTS
During the three months ended September 30, 2002, we 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, 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 nine month period ended September 30, 2003, approximately $ 0.7 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 September 30, 2003 in the results of
operations for the three months ended September 30, 2003 as compared to
September 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
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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".
In conjunction with the previously described restructuring plan, we also
evaluated the related long-lived assets for impairment. We recorded an
impairment charge of approximately $7.3 million for the value of unrecoverable
leasehold improvements and other general equipment that was abandoned, which is
reported in impairment loss on long-lived assets on the Consolidated Statement
of Operations. The restructuring plan and related asset impairment required us
to evaluate for impairment our equipment held for use. It was also determined
that a portion of this equipment would not be used. We recorded an impairment
charge of $4.0 million related to this equipment that was abandoned, which is
reported in impairment loss on long-lived assets on the Consolidated Statement
of Operations.
DEPRECIATION AND AMORTIZATION
Depreciation and amortization for the nine months ended September 30, 2003 was
$50.1 million. This represents a 2.0% decrease compared to the nine months ended
September 30, 2002. The decrease in depreciation expense as compared to the nine
months ended September 30, 2002 was primarily related to certain switch software
assets acquired in the acquisition of US Xchange becoming fully depreciated
during the nine months ended September 30, 2003.
INTEREST EXPENSE AND INCOME
Interest expense, net, for the nine months ended September 30, 2003 and 2002 was
approximately $63.1 million and $44.5 million, respectively. The increase in
interest expense, net, was attributable to an aggregate of $13.4 million of
accretion and dividends on our preferred stock being characterized as interest
expense in accordance with the adoption of SFAS No. 150 where corresponding
amounts in prior periods were not included in interest expense, net. Interest
expense increased from $44.6 million to $49.9 million from the same nine 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. Interest
expense, currently payable in cash, was $22.1 million and $22.7 million for the
nine-month period ended September 30, 2003 and 2002, respectively.
Interest income for the nine months ended September 30, 2003 and 2002 was
approximately $0.1 million and $0.2 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.
The non-cash accretion of and dividends on our preferred stock increased $6.0
million, or 18.5%, to $38.6 million for the nine months ended September 30, 2003
as compared to $32.6 million for the nine months ended September 30, 2002. This
change was primarily driven by the increase in dividends on preferred stock,
which result from the compounding effect of dividends that have accreted.
As a result of our adoption of SFAS No. 150, we now classify accretion and
dividends related to our redeemable preferred stock as a component of interest
expense and include these amounts in the calculation of net loss. Restatement of
prior period classifications is not permitted upon adoption of SFAS No. 150.
INCOME TAXES
We have not generated any taxable income to date, and did not incur any income
tax liability as a result.
-29-
NET LOSS AND NET LOSS APPLICABLE TO COMMON STOCKHOLDERS
Our net loss was $85.3 million and $441.0 million for the nine months ended
September 30, 2003 and 2002, respectively. The net loss applicable to common
stockholders was $110.5 million and $473.6 million for the nine months ended
September 30, 2003 and 2002, respectively. The improvement in net loss and net
loss applicable to common stockholders was attributable to the factors
previously discussed.
LIQUIDITY AND CAPITAL RESOURCES
Refer to the discussion of going concern matters earlier in this section of
management's discussion and analysis of financial condition and results of
operations.
FINANCING FACILITIES
Our Bridge Financing 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
September 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 $3.5 million outstanding under the term D loan. There was $0.9 million
available under the senior credit facility at September 30, 2003, which is
subject to no "material adverse change" in our 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 September 30, 2003, we were in compliance with
these covenants.
We also have $216.0 million of subordinated notes outstanding, excluding the
discount of $2.3 million and payable-in-kind ("PIK") interest of $11.1 million
that has accrued as of September 30, 2003 but not accreted to principal. These
notes 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 September 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 three months
ended September 30, 2003 and positive adjusted EBITDA during each of the fiscal
quarters in 2003. Although not necessarily indicative of future cash flow
results, the three months ended September 30, 2003 was the first quarter in our
history that we generated positive quarterly cash flow from operations. While we
expect to continue to generate positive adjusted EBITDA, we also expect to
continue to have operating losses as we further penetrate our markets. As of
September 30, 2003, we had an accumulated deficit of $1.1 billion.
Net cash used in operating activities was approximately $7.1 million and $50.0
million for the nine months ended September 30, 2003 and September 30, 2002,
respectively. The net cash used in operating
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activities during the nine months ended September 30, 2003 was primarily due to
net losses from operations, negative net working capital changes of $14.0
million, of which $0.7 million was related to payments of restructuring
obligations, and interest expense payable in cash of $22.1 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
telecommunication companies. Net cash paid for interest for the nine months
ended September 30, 2003 as compared to September 30, 2002 decreased $2.3
million, or 9.5%, due to payments to bring us current in September 2002 under an
amendment to our senior credit facility that requires interest be paid monthly
on the Term A, Term B, and Revolver loans. The net cash used for operating
activities during the nine months ended September 30, 2002 was primarily due to
net losses incurred while we grew our client base and operations.
Net cash used in investing activities was $6.9 million and $19.0 million for the
nine months ended September 30, 2003 and 2002, respectively. Net cash used in
investing activities for the nine months ended September 30, 2003 related to
capital expenditures in support of growth in existing markets. Net cash used in
investing activities for the nine months ended September 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 $2.0 million and $96.9 million for
the nine months ended September 30, 2003 and 2002, respectively. Net cash
provided by financing activities for the nine months ended September 30, 2003
was related to borrowings under the Term D loan of the senior credit facility.
Net cash provided by financing activities for the nine months ended September
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 $7.0 million and $20.0 million for the nine months
ended September 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 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 condensed consolidated financial statements.
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 the scope of SFAS No. 150 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
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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 adopted
this Standard on July 1, 2003. Upon adoption, we reclassified our mandatorily
redeemable preferred stock to long-term liabilities. We also now recognize
dividends declared and accretion related to this preferred stock as a component
of interest expense. Restatement of prior period classifications is not
permitted upon adoption of SFAS No. 150.
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 December 15, 2003, as amended by FASB Staff Position FIN 46-6. We do not
expect the adoption of this standard to have a material impact on our condensed
consolidated financial statements.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
At September 30, 2003 and December 31, 2002, the carrying value of our debt
obligations, excluding capital lease obligations, was $622.5 million and $595.9
million, respectively. The fair value of those obligations was $633.0 million
and $602.4 million, respectively. The weighted average interest rate of our debt
obligations at September 30, 2003 and December 31, 2002 was 7.38% and 8.21%,
respectively. A hypothetical decrease of approximately 100 basis points from
prevailing interest rates at September 30, 2003 would have resulted in an
increase in fair value of long-term debt of approximately $10.5 million.
Also, a hypothetical increase of approximately 100 basis points from prevailing
interest rates at September 30, 2003 would have resulted in an approximate
increase in cash required for interest on variable rate debt during the
remaining fiscal year of $0.5 million, increasing to $2.1 million in the next
fiscal year, and then declining to $2.0 million, $1.7 million, 1.2 million, and
$0.7 million in the second, 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 September 30, 2003, the
weighted average pay rate for the interest rate swap agreement was 6.94% and the
average receive rate was 1.14%.
At September 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
September 30, 2003, it would have cost us $15.7 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 $2.5
million.
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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
Not applicable.
Item 2. Changes in Securities and Use of Proceeds
Not applicable.
Item 3. Defaults Upon Senior Securities
Not applicable.
Item 4. Submission of Matters to a Vote of Security Holders
Not applicable.
Item 5. Other Information
In October 2003, the Company's Audit Committee dismissed
PricewaterhouseCoopers LLP as the Company's independent accountants
and engaged Deloitte & Touche LLP to serve in that capacity
effective October 15, 2003. The company has filed reports with the
Securities and Exchange Commission on Form 8-K reporting this
change.
Item 6. Exhibits and Reports for Form 8-K
A. Exhibits
See Exhibit Index
B. Reports on Form 8-K
On August 11, 2003, the Company filed a report on Form 8-K to
report on a press release announcing our second quarter
results for the three months ended June 30, 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: November 13, 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
XHIBIT
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 the
August 10, 2000 Stock. 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 to the
Designations for Series A Senior Cumulative 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 the
Incorporation with Certificate of Designations, 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 the
Designations for Series A Senior Cumulative Company's 8-K filed on September 27, 2002.
Preferred Stock.
10.51 Amendment No. 8 to the Master Facilities Agreement Filed herewith
and Assignment and Assumption among Choice One
Communications Inc., Fiber Technologies Networks,
LLC and Fiber Technologies Construction Company, LLC
and 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 herewith Filed 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.