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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
QUARTERLY REPORT ON FORM 10-Q
(MARK ONE)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2004
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM ______ TO ______
COMMISSION FILE NUMBER: 0-29279
----------------------------
CHOICE ONE COMMUNICATIONS INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
STATE OF DELAWARE 16-1550742
(STATE OR OTHER JURISDICTION (I.R.S. EMPLOYER
OF INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
100 CHESTNUT STREET, SUITE 600, ROCHESTER, NEW YORK 14604-2417
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
(585) 246-4231
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
----------------------------
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to the filing
requirements for the past 90 days. Yes X No
--- ---
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). Yes No X
--- ---
As of August 1, 2004, there were outstanding 44,146,570 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 June 30, 2004 and
December 31, 2003.................................................................................2
Condensed Consolidated Statements of Operations for the three months ended
June 30, 2004 and June 30, 2003...................................................................3
Condensed Consolidated Statements of Operations for the six months ended
June 30, 2004 and June 30, 2003...................................................................4
Condensed Consolidated Statements of Cash Flow for the six months ended
June 30, 2004 and June 30, 2003...................................................................5
Notes to Condensed Consolidated Financial Statements..............................................6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations............16
Item 3. Quantitative and Qualitative Disclosures about Market Risk.......................................31
Item 4. Controls and Procedures..........................................................................32
PART II. OTHER INFORMATION
Item 1. Legal Proceedings................................................................................33
Item 2. Changes in Securities, Use of Proceeds, and Issuer Purchases of Equity Securities................33
Item 3. Defaults Upon Senior Securities..................................................................33
Item 4. Submission of Matters to a Vote of Security Holders..............................................33
Item 5. Other Information................................................................................33
Item 6. Exhibits and Reports on Form 8-K.................................................................33
Signatures.....................................................................................................34
(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)
ASSETS
JUNE 30, DECEMBER 31,
2004 2003
---- ----
Current Assets:
Cash and cash equivalents .................................................. $ 10,112 $ 16,238
Accounts receivable, net ................................................... 30,754 30,859
Prepaid expenses and other current assets .................................. 4,168 3,251
----------- -----------
Total current assets ................................................... 45,034 50,348
Property and equipment, net of accumulated depreciation ......................... 278,905 295,423
Intangible assets, net of accumulated amortization .............................. 25,322 32,601
Other assets, net ............................................................... 5,550 5,096
----------- -----------
Total assets .................................................................... $ 354,811 $ 383,468
=========== ===========
LIABILITIES AND STOCKHOLDERS' DEFICIT
Current Liabilities:
Current portion of capital leases for indefeasible rights to use fiber ..... $ 1,068 $ 962
Current portion of long-term debt (net of unamortized discount of $5,172
at June 30, 2004) ........................................................ 648,854 12,220
Interest rate swap ......................................................... 9,304 --
Accounts payable ........................................................... 18,646 7,762
Accrued expenses ........................................................... 36,941 42,627
----------- -----------
Total current liabilities .............................................. 714,813 63,571
Long-Term Liabilities:
Long-term debt (net of unamortized discount of $5,781 at December 31,
2003) .................................................................... -- 619,756
Redeemable Series A preferred stock, $0.01 par value, 340,000 shares
authorized; 251,588 shares issued and outstanding, at June 30, 2004,
($360,499 liquidation value at June 30, 2004, inclusive of accrued
dividends of $91,300) .................................................... 325,478 295,990
Interest rate swap ......................................................... -- 13,500
Long-term portion of capital leases for indefeasible rights to use fiber ... 34,142 32,037
Other long-term liabilities ................................................ 4,045 3,609
----------- -----------
Total long-term debt and other long-term liabilities ................... 363,665 964,892
Commitments and Contingencies (Note 13)
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; 44,281,985 and
44,261,052 shares issued as of June 30, 2004 and December 31, 2003,
respectively ............................................................. 443 443
Treasury stock, 135,415 shares, at cost, at June 30, 2004 and December 31,
2003, respectively ....................................................... (473) (473)
Additional paid-in capital ................................................. 477,611 475,179
Deferred compensation ...................................................... (989) (962)
Accumulated other comprehensive loss ....................................... (9,304) (13,500)
Accumulated deficit ........................................................ (1,190,955) (1,105,682)
----------- -----------
Total stockholders' deficit ............................................ (723,667) (644,995)
----------- -----------
Total liabilities and stockholders' deficit ..................................... $ 354,811 $ 383,468
=========== ===========
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
JUNE 30,
2004 2003
---- ----
Revenue ......................................................................... $ 82,194 $ 82,189
Operating expenses:
Network costs, excluding depreciation expense of $9,177 and $9,716 in 2004
and 2003, respectively ................................................... 38,272 41,311
Selling, general and administrative, excluding depreciation and amortization
expense of $6,347 and $7,438 in 2004 and 2003, respectively, and
including non-cash compensation of $95 and $186 in 2004 and 2003,
respectively ............................................................. 40,587 30,723
Loss on disposition of assets .............................................. 610 29
Depreciation and amortization .............................................. 15,524 17,154
------------ ------------
Total operating expenses ............................................... 94,993 89,217
------------ ------------
Loss from operations ............................................................ (12,799) (7,028)
Interest income/(expense):
Interest income ............................................................ 12 43
Interest expense ........................................................... (17,480) (16,789)
Accretion of preferred stock ............................................... (3,440) --
Accrued dividends on preferred stock ....................................... (11,595) --
------------ ------------
Total interest expense, net ............................................ (32,503) (16,746)
------------ ------------
Net loss ........................................................................ (45,302) (23,774)
Accretion of preferred stock ............................................... -- 2,742
Accrued dividends on preferred stock ....................................... -- 10,105
------------ ------------
Net loss applicable to common stockholders ...................................... $ (45,302) $ (36,621)
============ ============
Net loss per share, basic and diluted ........................................... $ (0.84) $ (0.68)
============ ============
Weighted average number of shares outstanding, basic and diluted ................ 54,098,171 53,994,804
============ ============
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)
SIX MONTHS ENDED
JUNE 30,
2004 2003
---- ----
Revenue ......................................................................... $ 163,350 $ 162,289
Operating expenses:
Network costs, excluding depreciation expense of $18,725 and $19,631 in 2004
and 2003, respectively ................................................... 75,894 81,838
Selling, general and administrative, excluding depreciation and amortization
expense of $12,478 and $15,092 in 2004 and 2003, respectively, and
including non-cash compensation of $201 and $661 in 2004 and 2003,
respectively ............................................................. 76,955 63,094
Loss on disposition of assets .............................................. 623 88
Restructuring credits ...................................................... -- (535)
Depreciation and amortization .............................................. 31,203 34,723
------------ ------------
Total operating expenses ............................................... 184,675 179,208
------------ ------------
Loss from operations ............................................................ (21,325) (16,919)
Interest income/(expense):
Interest income ............................................................ 30 146
Interest expense ........................................................... (34,490) (33,266)
Accretion of preferred stock ............................................... (6,690) --
Accrued dividends on preferred stock ....................................... (22,798) --
------------ ------------
Total interest expense, net ............................................ (63,948) (33,120)
------------ ------------
Net loss ........................................................................ (85,273) (50,039)
Accretion of preferred stock ............................................... -- 5,334
Accrued dividends on preferred stock ....................................... -- 19,867
------------ ------------
Net loss applicable to common stockholders ...................................... $ (85,273) $ (75,240)
============ ============
Net loss per share, basic and diluted ........................................... $ (1.58) $ (1.40)
============ ============
Weighted average number of shares outstanding, basic and diluted ................ 54,091,667 53,753,681
============ ============
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)
SIX MONTHS ENDED
JUNE 30,
2004 2003
---- ----
Cash flows from operating activities:
Net loss .................................................................. $(85,273) $(50,039)
Adjustments to reconcile net loss to net cash used in operating activities:
Loss on disposition of assets ........................................ 623 88
Impairment of executive loans ........................................ 2,200 --
Depreciation and amortization ........................................ 31,203 34,723
Interest payable in-kind on long-term debt ........................... 16,270 15,427
Amortization of deferred financing costs ............................. 2,066 2,251
Amortization of discount on long-term debt ........................... 609 543
Accretion of preferred stock ......................................... 6,690 --
Accrued dividends on preferred stock ................................. 22,798 --
Non-cash compensation ................................................ 201 661
Changes in assets and liabilities:
Decrease in accounts receivable, net ............................... 105 8,248
Increase in prepaid expenses and other assets ...................... (1,523) (2,277)
Increase/(decrease) in accounts payable and accrued expenses ....... 7,772 (20,402)
Decrease in accrued restructuring costs ............................ (198) (1,109)
-------- --------
Net cash provided by/(used in) operating activities .............. 3,543 (11,886)
Cash flows from investing activities:
Capital expenditures ................................................. (9,299) (4,022)
Proceeds from sale of assets ......................................... 123 52
-------- --------
Net cash used in investing activities ............................ (9,176) (3,970)
Cash flows from financing activities:
Additions to long-term debt .......................................... -- 1,750
Payments under long-term capital leases for indefeasible rights to use
fiber .............................................................. (498) (349)
Proceeds from exercise of stock options .............................. 5 --
-------- --------
Net cash (used in)/provided by financing activities .............. (493) 1,401
-------- --------
Net decrease in cash and cash equivalents ................................. (6,126) (14,455)
Cash and cash equivalents, beginning of period ............................ 16,238 29,434
-------- --------
Cash and cash equivalents, end of period .................................. $ 10,112 $ 14,979
======== ========
The accompanying notes to condensed consolidated financial statements
are an integral part of these financial statements.
-5-
CHOICE ONE COMMUNICATIONS INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE SIX MONTH PERIOD ENDED JUNE 30, 2004
(unaudited)
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, 2003. The
results of operations for the three and six month periods ended June 30, 2004
are not necessarily indicative of the results to be expected for other interim
periods or for the year ended December 31, 2004.
Certain amounts in the December 31, 2003 consolidated financial statements have
been reclassified to conform to the current period presentation.
NOTE 2. GOING CONCERN MATTER
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 had net losses applicable to common stockholders of $45.3 million,
$40.0 million, and $36.6 million for the three months ended June 30, 2004, March
31, 2004 and June 30, 2003, respectively. The Company had net losses applicable
to common stockholders of $148.3 million and $524.1 million for the years ended
December 31, 2003 and 2002, respectively. At June 30, 2004, the Company had
$10.1 million in cash and cash equivalents and had drawn all available funding
under its senior credit facility. The Company generated negative cash flows from
both operating and investing activities during the years ended December 31, 2003
and 2002. The Company had a total stockholders' deficit of $723.7 million as of
June 30, 2004. These factors raise substantial doubt about the Company's ability
to continue as a going concern.
On July 30, 2004, the Company failed to make certain payments in the aggregate
amount of $5.1 million that were then due under its senior credit facility. Such
failure constituted an event of default under the senior credit facility and the
Company's subordinated notes and would permit the Company's obligations under
its senior credit facility and subordinated notes to be declared to be
immediately payable. The requisite majority of both the lenders under the senior
credit facility and the holders of the subordinated notes have entered into
standstill and, in the case of the subordinated notes, waiver agreements on July
30,
-6-
2004, subject to certain conditions, pursuant to which they have agreed not to
take any action before August 30, 2004 with respect to such default so as to
provide the Company with additional time to facilitate the negotiation and
initiation of the Financial Restructuring (as defined below) which is
anticipated to be in the form of a "prepackaged" or prearranged proceeding under
Chapter 11 of the United States Bankruptcy Code. As a result of the event of
default, the Company's long-term debt has been classified as current in the
consolidated balance sheet as of June 30, 2004. The Company does not expect to
be in a position on August 30, 2004 to make the payments due under the senior
credit facility, and the Company does not expect to be able to satisfy the
covenants relating to the senior credit facility throughout the remainder of
2004. If the lenders under the senior credit facility and the holders of the
Company's subordinated notes do not extend such standstill and waiver agreements
or otherwise continue to cooperate with the Company in connection with the
Financial Restructuring, the Company could be forced to seek relief through a
different bankruptcy process than the contemplated Financial Restructuring that
might have a greater impact on the Company's ability to operate its business in
the ordinary course.
On August 2, 2004, the Company announced that it had reached an agreement in
principle with ad hoc committees of the lenders under its senior credit facility
and the holders of its subordinated notes to restructure and substantially
reduce the Company's outstanding indebtedness (the "Financial Restructuring").
The Financial Restructuring is expected to consist of: (i) the conversion of the
Company's approximately $404.0 million of outstanding debt under its senior
credit facility into $175.0 million of new senior secured term notes payable
over six years and 90% of the Company's outstanding common stock following the
Financial Restructuring; (ii) the conversion of the Company's approximately
$252.0 million of outstanding subordinated notes into the remaining 10% of such
common stock and into two series of seven-year warrants to purchase additional
shares of common stock following the Financial Restructuring; and (iii) the
establishment of a new revolving credit facility of up to $25.0 million from a
subset of the lenders under the senior credit facility to provide for ongoing
working capital requirements. Upon completion of the Financial Restructuring,
certain restricted stock and/or stock option grants are expected to be made to
the Company's management in amounts and subject to conditions to be determined.
There can be no assurances that the Company will be able to effect the Financial
Restructuring as contemplated or at all.
The Company anticipates implementing the Financial Restructuring through a
"prepackaged" or prearranged proceeding under Chapter 11 of the United States
Bankruptcy Code. The Company's goal in using this process is to permit its
normal operations and client services to continue without interruption through
the Financial Restructuring process. The Company's goal is to complete the
Financial Restructuring process by the end of 2004. The Company expects that the
rights of its existing preferred and common stockholders and the existing
holders of options and warrants to purchase the Company's common stock would be
extinguished in connection with the Financial Restructuring and that the holders
of such securities would not receive any recovery.
If the Financial Restructuring is implemented as currently contemplated, the
Company's debt will be significantly reduced and its liquidity will be improved.
The Company's ability to function as a going concern after the implementation of
the Financial Restructuring will depend on it obtaining and retaining a
significant number of customers, generating significant and sustained growth in
its cash flows from operating activities, and managing its costs and capital
expenditures to be able to meet its reduced debt service obligations. The
Company's revenue and costs are dependent upon some factors that are not
entirely 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. Based on its current financial condition, the Company will need to
raise additional capital or obtain additional financing in order to continue to
operate its business. Additional financing may also be required in response to
changing conditions within the industry or unanticipated competitive pressures.
There can be no assurance that the Company would be successful in raising
additional capital or obtaining additional financing on favorable terms or at
all. The Company's ability to do so will depend on a number of uncertainties and
factors outside its control, including those described above.
-7-
NOTE 3. STOCK OPTION PLANS
In accordance with Statement of Financial Accounting Standards ("SFAS") No. 148,
"Accounting for Stock-Based Compensation - Transition and Disclosure," the
Company adopted the financial statement measurement and recognition provisions
of SFAS No. 123, "Accounting for Stock-Based Compensation," 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. 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."
During the three month periods ended June 30, 2004 and 2003, the Company
recorded $0.1 million and $0.1 million of compensation expense for the fair
value of options granted during each period, respectively. During the three
month periods ended June 30, 2004 and 2003, the Company deferred $0.1 million
and $0.1 million to be recognized over the remaining vesting period,
respectively. During the six month periods ended June 30, 2004 and 2003, the
Company recorded $0.2 million and $0.5 million of compensation expense for the
fair value of options granted during each period, respectively. During the six
month periods ended June 30, 2004 and 2003, the Company deferred $0.2 million
and $0.8 million to be recognized over the remaining vesting period,
respectively.
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 (in
thousands, except per share data):
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30, JUNE 30, JUNE 30,
2004 2003 2004 2003
---- ---- ---- ----
Net loss as reported ..................................... $(45,302) $(23,774) $(85,273) $(50,039)
Stock-based employee compensation expense included in
reported net loss, net of related tax effects ............ 95 186 201 661
Total stock-based employee compensation expense determined
under fair value based method for all awards, net of
related tax effects ...................................... (318) (520) (726) (825)
-------- -------- -------- --------
Additional expense ....................................... (223) (334) (525) (164)
-------- -------- -------- --------
Net loss pro forma ....................................... $(45,525) $(24,108) $(85,798) $(50,203)
======== ======== ======== ========
Net loss per share, basic and diluted:
As reported................................................. $ (0.84) $ (0.68) $ (1.58) $ (1.40)
Pro forma................................................... $ (0.84) $ (0.68) $ (1.59) $ (1.40)
-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:
JUNE 30, 2004 JUNE 30, 2003
------------- -------------
Dividend yield......................................... 0.00 percent 0.00 percent
Expected volatility.................................... 198.60 percent 242.26 percent
Risk-free interest rate................................ 3.21 percent 3.02 percent
Expected life.......................................... 7 years 7 years
The weighted average fair value of options granted during the six-month periods
ended June 30, 2004 and 2003 was $0.29 and $0.25, respectively.
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 8,801,657 and 6,780,066 shares outstanding at June 30, 2004
and 2003, respectively, that were not included in the calculation of diluted
loss per share because the effect would be anti-dilutive. It is expected that
the rights of the Company's existing holders of options and warrants to purchase
the Company's common stock would be extinguished in connection with the
Financial Restructuring and that the holders of such securities would not
receive any recovery. See Note 2.
NOTE 4. NEW ACCOUNTING PRONOUNCEMENTS
At its March 31, 2004 meeting, the Emerging Issues Task Force ratified its
consensus in EITF No. 03-16, "Accounting for Investments in Limited Liability
Companies" ("EITF 03-16"). EITF 03-16 requires companies to evaluate whether or
not their investments in limited liability companies (LLC) should be
accounted for on the equity method of accounting. The Task Force confirmed its
previous conclusion that LLCs that have separate ownership accounts for each
investor should be accounted for like investments in partnerships. This
conclusion is based on the fact that the investor's separate account is its
claim on the long-term appreciation in net assets of the LLC similar to a
partner's capital account. Investors in partnerships have used a lower threshold
for determining whether they should record an investment on the equity method
(under SOP No. 78-9, Accounting for Investments in Real Estate Ventures) than
allowed under SFAS No. 115. The consensus must be applied in the first period
beginning after June 15, 2004. The Company has an investment in a limited
liability company, and has not completed the process of evaluating the
impact that will result from adopting this consensus.
-9-
NOTE 5. PROPERTY AND EQUIPMENT
Property and equipment, at cost, consisted of the following (in thousands):
JUNE 30, 2004 DECEMBER 31, 2003
------------- -----------------
Switch equipment................................... $ 309,068 $ 305,046
Computer equipment and software.................... 67,040 61,161
Office furniture and equipment..................... 9,888 10,111
Leasehold improvement.............................. 23,274 23,253
Indefeasible rights to use fiber (IRU)............. 71,283 68,352
Assets held for future use......................... 1,973 7,295
Construction in progress........................... 6,304 4,338
----------- ----------
Total property and equipment 488,830 479,556
Less: accumulated amortization on IRUs............ (10,871) (8,896)
accumulated depreciation.................... (199,054) (175,237)
----------- ---------
Property and equipment, net............... $ 278,905 $ 295,423
=========== =========
Depreciation expense, including amortization of IRUs, amounted to $12.8 million
and $14.4 million for the three months ended June 30, 2004 and June 30, 2003,
respectively, and $25.8 million and $29.3 million for the six months ended June
30, 2004 and June 30, 2003, respectively.
Refer to Note 13 regarding the impact of the Financial Restructuring on the
Company's property and equipment.
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." (Refer to
Note 13 regarding the impact of the Financial Restructuring on the Company's
intangible assets.) The following schedule sets forth the major classes of
intangible assets held by the Company (in thousands):
JUNE 30, 2004 DECEMBER 31, 2003
------------- -----------------
Amortized intangibles:
Customer relationships.......................... $ 53,635 $ 53,635
Deferred financing costs........................ 29,815 29,815
Less: accumulated amortization
Customer relationships............. (41,877) (36,513)
Deferred financing costs........... (16,251) (14,336)
---------- -----------
Intangible assets, net ..................... $ 25,322 $ 32,601
========== ===========
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 (in thousands):
July to December, 2004......................................... $ 5,252
2005........................................................... 6,027
2006........................................................... 370
2007........................................................... 109
-10-
Amortization expense excluding amortization of IRUs, was $2.7 million for each
of the three month periods ended June 30, 2004 and 2003, respectively, and was
$5.4 million for each of the six month periods ended June 30, 2004 and 2003,
respectively. Amortization of deferred financing costs is classified as interest
expense and is not included in the above estimated amortization expense for the
years ended December 31, 2004 through 2007, nor is it included in the
amortization expense for the three and six months ended June 30, 2004 and 2003.
NOTE 7. ACCRUED EXPENSES
Accrued expenses consisted of the following (in thousands):
JUNE 30, 2004 DECEMBER 31, 2003
------------- -----------------
Accrued network costs.............................. $ 14,381 $ 19,438
Accrued payroll and payroll related benefits....... 3,268 4,354
Accrued collocation costs.......................... 1,597 2,986
Accrued interest................................... 1,060 1,062
Accrued restructuring costs........................ 761 761
Deferred revenue................................... 6,577 5,381
Other.............................................. 9,297 8,645
------------ --------------
Total accrued expenses.................... $ 36,941 $ 42,627
============ ==============
NOTE 8. DEBT
Long-term debt outstanding consists of the following (in thousands):
JUNE 30, 2004 DECEMBER 31, 2003
------------- -----------------
Senior credit facility:
Term A loan.................................... $ 125,000 $ 125,000
Term B loan.................................... 125,000 125,000
Term C loan.................................... 46,360 45,224
Term D loan.................................... 4,375 4,375
Revolver....................................... 100,000 100,000
Subordinated notes................................. 248,119 232,377
------------ -------------
Total debt.................................. 648,854 631,976
Less: current portion................... 648,854 12,220
------------ -------------
Long-term debt, net of current portion $ -- $ 619,756
============ =============
Included in the subordinated notes is a discount on the notes of $1.8 million
and $2.2 million as of June 30, 2004 and December 31, 2003, respectively.
Included in the Term C loan is a discount of $3.3 million and $3.6 million as of
June 30, 2004 and December 31, 2003, respectively, and payable in-kind ("PIK")
interest which accreted to principal of $5.2 million and $4.3 million as of June
30, 2004 and December 31, 2003, respectively.
The discount on the subordinated notes is being amortized over the nine-year
term of the subordinated notes. For the three months ended June 30, 2004 and
2003, $0.2 million and $0.1 million of the discount was amortized, respectively.
For each of the six month periods ended June 30, 2004 and 2003, $0.3 million of
the discount was amortized, respectively. The discount on the Term C loan is
being amortized over its seven and one-half year term. For each of the three
month periods ended June 30, 2004 and 2003,
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$0.1 million of the discount on the Term C loan was amortized, respectively. For
each of the six month periods ended June 30, 2004 and 2003, $0.3 million of the
discount on the Term C loan was amortized, respectively.
As of June 30, 2004, the Company had principal borrowings of $245.5 million in
subordinated notes, excluding the discount of $1.8 million and PIK interest of
$4.4 million that had accrued but not accreted to principal. Interest on the
subordinated notes is fixed at 13% and accretes to the principal semi-annually
until November 2006. Thereafter interest will be payable quarterly, in cash,
based on LIBOR plus an applicable margin. During the six months ended June 30,
2004, $15.1 million in PIK interest accreted to principal. The subordinated
notes mature on November 9, 2010.
As of June 30, 2004, the maximum borrowings under the Term A loan, Term B loan,
Term C loan, Term D loan, revolver loan, and the subordinated notes were all
outstanding. At June 30, 2004, $279.1 million was variable rate debt and $370.5
million was fixed rate debt, including variable rate debt fixed by an interest
rate swap agreement. At June 30, 2004, the weighted average floating interest
rate and the weighted average fixed swapped interest rate was 5.64% and 11.85%,
respectively.
The Company's Credit Agreement provides the Company with the following borrowing
limits, maturities and interest rates (in thousands):
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.
** Interest on the Term C loan accrued to principal through March 31,
2004, and thereafter is payable monthly.
Borrowings under the Credit Agreement are secured by substantially all of the
assets of the Company. 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 May 10,
2004 and $6.0 million from May 11, 2004 through November 15, 2004, impose limits
on its capital expenditures that vary annually, and require it to maintain
certain leverage, fixed charges and interest coverage ratios as described in the
Credit Agreement. A default in the observance of these covenants could cause the
lenders to declare the principal and interest outstanding at that time to be
payable immediately.
On May 12, 2004, the Company and the lenders under the Credit Agreement entered
into the Third Amendment. Pursuant to the Third Amendment, the covenant
previously obligating the Company to maintain an aggregate minimum amount of
cash and committed financing of $10.0 million during the period from May 11,
2004 through June 30, 2004 was amended to require the Company to maintain an
aggregate minimum amount of cash and committed financing of $6.0 million during
the period from May 11, 2004 through November 15, 2004. The Third Amendment does
not affect the Company's other
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financial covenants to maintain certain leverage, fixed charges and interest
coverage ratios, which become effective on September 30, 2004. The Third
Amendment also incorporated certain clarifying and ministerial changes into the
Credit Agreement.
On June 30, 2004, the Company and the lenders under the Credit Agreement entered
into another amendment to the Credit Agreement that deferred the Company's
obligation to make certain principal payments in the aggregate amount of $3.1
million from June 30, 2004 to July 30, 2004.
The Company was in compliance with all covenants under the Credit Agreement as
of June 30, 2004 but failed to make certain payments that were due on July 30,
2004. Such failure constituted an event of default under the senior credit
facility and the Company's subordinated debt and would permit the Company's
obligations under its senior credit facility and subordinated notes to be
declared to be immediately payable. As a result of this event, the Company's
long-term debt has been classified as current in the consolidated balance sheet
as of June 30, 2004. (Refer to Note 2 for further details.)
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. The Credit 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 interest rate swap agreement is
recognized over the life of the related debt and is included in interest expense
or income. The Company designates this interest rate swap contract as a cash
flow hedge. The fair value of the interest rate swap agreement, designated and
effective as a cash flow hedging instrument, is included in accumulated other
comprehensive loss. Credit risk associated with nonperformance by counterparties
is mitigated by using major financial institutions with high credit ratings.
At June 30, 2004, 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 senior credit facility debt is
being hedged with this interest rate swap agreement. The fair value of the
interest rate swap agreement was a $9.3 million and $13.5 million liability as
of June 30, 2004 and December 31, 2003, 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 each such date. (Refer to Note 14 regarding an
amendment and waiver to the interest rate swap agreement.)
NOTE 10. COMPREHENSIVE LOSS
The fair value of the interest rate swap agreement is included in accumulated
other comprehensive loss on the consolidated balance sheet and the change in the
fair value of the interest rate swap agreement is the only component of the
other comprehensive loss. Comprehensive loss for the three months ended June 30,
2004 and 2003 was $41.6 million and $23.4 million, respectively. Comprehensive
loss for the six months ended June 30, 2004 and 2003 was $81.1 million and $48.6
million, respectively.
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NOTE 11. RESTRUCTURING COSTS
The Company implemented an operational restructuring plan in September 2002 and
in conjunction with the plan 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. A
portion of the restructuring plan was modified in February 2003. At that time,
the Company revised the restructuring costs for $0.1 million in termination
benefits and other network facility costs that became known during the first
quarter of 2003 and reversed approximately $0.7 million in restructuring costs
related to certain collocation sites.
At June 30, 2004, approximately $1.5 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 $2.4 million that extend beyond one year and are included in
other long-term liabilities.
The following table highlights the cumulative restructuring activities through
June 30, 2004 (in thousands):
TERMINATION LEASE NETWORK
BENEFITS OBLIGATIONS FACILITY COSTS TOTAL
-------- ----------- -------------- -----
Initial restructuring charge....................... $ 559 $ 3,440 $ 1,283 $ 5,282
Adjustments due to plan modifications.............. 50 -- (585) (535)
Payment of benefits and other obligations.......... (609) (408) (332) (1,349)
--------- ----------- ----------- ----------
Balance at December 31, 2003....................... -- 3,032 366 3,398
Payment of benefits and other obligations.......... -- (188) (10) (198)
--------- ----------- ----------- ----------
Balance at June 30, 2004.......................... $ -- $ 2,844 $ 356 $ 3,200
========= =========== =========== ==========
NOTE 12. SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING ACTIVITIES
AND CASH FLOW INFORMATION
Supplemental disclosures of non-cash investing activities and cash flow
information for the six months ended June 30 (in thousands):
2004 2003
---- ----
Interest paid.......................................................... $ 15,364 $ 15,080
Capital lease obligations for IRUs..................................... $ 2,712 $ 1,923
Issuance of common stock for employer 401(k) contribution.............. $ -- $ 409
NOTE 13. COMMITMENTS AND CONTINGENCIES
In accordance with SFAS No. 144, "Accounting for the Impairment or Disposal of
Long-Lived Assets", the Company has evaluated all of their long-lived assets for
impairment as of June 30, 2004. When the carrying value of an asset exceeds the
undiscounted cash flows directly related to it, there is an impairment. The
impairment loss is recognized as the amount by which the asset's carrying value
exceeds its fair value. No such impairment losses under the SFAS No. 144
standard were recorded as of June 30, 2004. If the Financial Restructuring is
implemented as currently contemplated, the Company's balance sheet may be
materially impacted. The Company expects to implement fresh start accounting
upon emergence from their Financial Restructuring, requiring the Company to
record its balance sheet at fair value, which may vary materially from the
carrying value of assets and liabilities as of June 30, 2004.
-14-
The Company's net operating loss carryforwards, which were subject to annual use
limitations, may be significantly reduced as a result of the Financial
Restructuring. Furthermore, other tax attributes, including the tax basis of
certain assets, could also be reduced as a result of the cancellation of
indebtedness as part of the Financial Restructuring. In addition, Section 382 of
the Internal Revenue Code of 1986, which generally applies after a more than 50
percentage point ownership change has occurred, may impose other limitations on
the annual utilization of any remaining net operating losses. The Company
believes that it will experience such an ownership change as a result of the
implementation of its Financial Restructuring. However, because the Company will
be under the jurisdiction of a court in a case under Chapter 11 of the United
States Bankruptcy Code at the time of the ownership change, various alternatives
pertaining to the application of Section 382 are available. At this time, the
Company has not yet determined the full impact of all limitations.
From time to time, the Company is involved in legal proceedings arising in the
ordinary course of business. Other than as described in the Company's annual
report on Form 10-K filed on March 30, 2004, the Company believes there is no
litigation pending against it that could have, individually or in the aggregate,
a material adverse effect on its financial position, results of operations or
cash flows.
NOTE 14. SUBSEQUENT EVENTS
On August 9, 2004, the Company and the counterparty under its interest rate swap
agreement entered into an amendment and waiver to the interest rate swap
agreement pursuant to which a payment of approximately $1.8 million due to be
paid by the Company to the counterparty on August 9, 2004 was deferred until
September 30, 2004 or such earlier date on which the Company obtains
debtor-in-possession financing in connection with the proposed Financial
Restructuring. In the amendment and waiver the counterparty also waived certain
defaults under the interest rate swap agreement until September 30, 2004. As a
result of this event, the interest rate swap liability has been classified as
current in the consolidated balance sheet as of June 30, 2004.
-15-
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
CAUTIONARY STATEMENT ON FORWARD-LOOKING STATEMENTS
Certain statements contained in the "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")
constitute "forward-looking statements" within the meaning of the Private
Securities Litigation Reform Act of 1995, and we intend that such
forward-looking statements be subject to the "safe harbor" provisions created
thereby. The words "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.
These forward-looking statements are subject to many uncertainties and factors
that may cause our actual results to be materially different from any future
results expressed or implied by such forward-looking statements. Examples of
such uncertainties and factors include, but are not limited to:
o The ability to effect a Financial Restructuring described under the caption
"Going Concern Matter" below that will significantly reduce the amount of
our indebtedness,
o Compliance with covenants for borrowings under our senior credit facility
and subordinated notes and the willingness of the lenders under our senior
credit facility and the holders of our subordinated notes to cooperate with
us in connection with any non-compliance,
o The impact that the Financial Restructuring may have on our business,
o Availability of additional capital or financing,
o Availability of significant operating cash flows,
o Continued availability of regulatory approvals,
o The number of potential customers and average revenue for such customers in
a market,
o The existence or continuation of strategic alliances or relationships,
o Technological, regulatory or other developments in our business,
o Changes in the competitive climate in which we operate, and
o The emergence of future opportunities.
All of these could cause our actual results and experiences to vary
significantly from our current business plan and to differ materially from
anticipated results and expectations expressed in the forward-looking statements
contained herein. These and other applicable risks are summarized under the
caption "Risk Factors" and elsewhere in our Annual Report on Form 10-K, filed on
March 30, 2004. 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. We market and provide these services 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:
o local exchange and long distance service; and
-16-
o high-speed data and Internet services.
In January 2004, we began offering residential voice telecommunication services
in selected markets within our footprint.
Our principal competitors are incumbent local exchange carriers, such as the
regional Bell operating companies, other integrated communications providers,
and voice over internet protocol providers.
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 achieve
comprehensive coverage in the markets we serve by installing both voice and data
equipment in multiple established telephone company central offices, a process
known as collocation. All of our collocations also include equipment to provide
digital subscriber loop ("DSL") services.
We have connected approximately 95% of our clients directly to our own switches,
which allows us to more efficiently route traffic, ensure quality of service and
control costs. Our networks reach approximately 5.7 million business lines,
which constitute approximately 72% of the estimated business lines in the
markets we serve, and approximately 9.7 million residential lines constituting
approximately 70% of the estimated residential lines in these markets. While our
network allows us to reach this number of business and residential lines, the
number of business and residential lines that we actually service will depend on
our ability to sell telecommunications services to customers and our success in
winning market share from our competitors. We have no current plans to expand
into additional markets or close existing markets.
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. On average, our
business clients have 5 lines. We plan to continue to focus primarily on small-
to medium-sized business clients.
The table below provides selected key operational data as of:
June 30, 2004 June 30, 2003
------------- -------------
Lines in service..................................... 540,824 513,547
Total central office collocations.................... 505 505
Markets in operation................................. 29 29
Markets with operational intra-city fiber............ 19 19
Number of voice switches............................. 25 25
Number of data switches.............................. 63 63
GOING CONCERN MATTER
Our 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 report of independent accountants dated March
25, 2004 concerning our financial statements for the year ended December 31,
2003, 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.
-17-
On July 30, 2004, we failed to make certain payments in the aggregate amount of
$5.1 million that were then due under our senior credit facility. Such failure
constituted an event of default under our senior credit facility and our
subordinated notes and would permit our obligations under our senior credit
facility and subordinated notes to be declared to be immediately payable. The
requisite majority of both the lenders under our senior credit facility and the
holders of the subordinated notes have entered into standstill and, in the case
of our subordinated notes, waiver agreements on July 30, 2004, subject to
certain conditions, pursuant to which they have agreed not to take any action
before August 30, 2004 with respect to such default so as to provide us with
additional time to facilitate the negotiation and initiation of the Financial
Restructuring (as defined below) which is anticipated to be in the form of a
"prepackaged" or prearranged proceeding under Chapter 11 of the United States
Bankruptcy Code. As a result of the event of default, our long-term debt has
been reclassified to short-term in the consolidated balance sheet as of June 30,
2004. We do not expect to be in a position on August 30, 2004 to make the
payments due under our senior credit facility, and we do not expect to be able
to satisfy the covenants relating to our senior credit facility throughout the
remainder of 2004. If the lenders under our senior credit facility and the
holders of our subordinated notes do not extend such standstill and waiver
agreements or otherwise continue to cooperate with us in connection with the
Financial Restructuring, we could be forced to seek relief through a different
bankruptcy process than the contemplated Financial Restructuring that might have
a greater impact on our ability to operate our business in the ordinary course.
On August 2, 2004, we announced that we had reached an agreement in principle
with ad hoc committees of the lenders under our senior credit facility and the
holders of our subordinated notes to restructure and substantially reduce our
outstanding indebtedness (the "Financial Restructuring"). The Financial
Restructuring is expected to consist of: (i) the conversion of our approximately
$404.0 million of outstanding debt under our senior credit facility into $175.0
million of new senior secured term notes payable over six years and 90% of our
outstanding common stock following the Financial Restructuring; (ii) the
conversion of our approximately $252.0 million of outstanding subordinated notes
into the remaining 10% of such common stock and into two series of seven-year
warrants to purchase additional shares of common stock following the Financial
Restructuring; and (iii) the establishment of a new revolving credit facility of
up to $25.0 million from a subset of the lenders under our senior credit
facility to provide for ongoing working capital requirements. Upon completion of
the Financial Restructuring, certain restricted stock and/or stock option grants
are expected to be made to the Company's management in amounts and subject to
conditions to be determined. There can be no assurances that we will be able to
effect the Financial Restructuring as contemplated or at all.
We anticipate implementing the Financial Restructuring through a "prepackaged"
or prearranged proceeding under Chapter 11 of the United States Bankruptcy Code.
Our goal in using this process is to permit our normal operations and client
services to continue without interruption through the Financial Restructuring
process. Our goal is to complete the Financial Restructuring process by the end
of 2004. We expect that the rights of our existing preferred and common
stockholders and the existing holders of options and warrants to purchase our
common stock would be extinguished in connection with the Financial
Restructuring and that the holders of such securities would not receive any
recovery.
If the Financial Restructuring is implemented as currently contemplated, our
debt will be significantly reduced and our liquidity will be improved. Our
ability to function as a going concern after the implementation of the Financial
Restructuring will depend on our obtaining and retaining a significant number of
customers, generating significant and sustained growth in our cash flows from
operating activities, and managing our costs and capital expenditures to be able
to meet our reduced debt service obligations. Our ability to do so will depend
on a number of uncertainties and factors outside our control, including those
described above.
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RESULTS OF OPERATIONS FOR THE THREE MONTHS ENDED JUNE 30, 2004 AS
COMPARED TO THE THREE MONTHS ENDED JUNE 30, 2003
EBITDA
In this filing, we include references to and analyses of earnings before
interest, income taxes, depreciation and amortization ("EBITDA") amounts that
are not calculated and presented in accordance with accounting principles
generally accepted in the United States of America ("GAAP"). 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 GAAP, the most directly comparable financial
measure under GAAP. Regulation G, "Conditions for Use of Non-GAAP Financial
Measures," and other provisions of the Exchange Act define and prescribe the
conditions for use of certain non-GAAP financial information in SEC filings.
EBITDA highlights trends that may not otherwise be apparent when relying solely
on GAAP financial measures, because this non-GAAP financial measure eliminates
from net cash used in operating activities financial items that have less
bearing on our liquidity. Management believes that the presentation of 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.
EBITDA is also used as a factor in the calculation of management's variable
compensation.
Investors or potential investors are urged to read our consolidated financial
statements and notes thereto in conjunction with their consideration of our
EBITDA. They should not rely solely on a single financial measure to evaluate
our business. EBITDA information is presented for the limited purpose of
supplementing our GAAP results to provide a more complete understanding of the
factors and trends affecting our business. EBITDA as presented may not be
comparable to other similarly titled measures used by other companies.
The following table shows the differences between our net cash provided by/(used
in) operating activities, as determined in accordance with GAAP, and our EBITDA
for the three-month periods ended (in thousands):
JUNE 30, MARCH 31, JUNE 30,
2004 2004 2003
---- ---- ----
Net cash provided by/(used in) operating
activities........................................ $ 1,141 $ 2,402 $ (3,763)
Adjustments to reconcile:
Changes in assets and liabilities .............. (3,781) (2,375) 6,587
Non-cash compensation .......................... (95) (106) (186)
Impairment of executive loans .................. (2,200) -- --
Loss on disposition of assets .................. (610) (13) (29)
-------- -------- --------
Subtotal ....................................... (6,686) (2,494) 6,372
Net interest expense (net of other income) ... 32,503 31,446 16,746
Interest payable in-kind on long-term debt ... (7,845) (8,425) (7,844)
Amortization of deferred financing costs ..... (1,044) (1,022) (1,110)
Amortization of discount on long-term debt ... (309) (300) (275)
Accretion of preferred stock ................. (3,440) (3,250) --
Dividends on preferred stock ................. (11,595) (11,203) --
-------- -------- --------
Net cash interest expense ...................... 8,270 7,246 7,517
-------- -------- --------
EBITDA ............................................ $ 2,725 $ 7,154 $ 10,126
======== ======== ========
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REVENUE
We generated $82.2 million in revenue during the three months ended June 30,
2004 which was essentially unchanged as compared to revenue for the three months
ended June 30, 2003, and a 1.3% increase compared to the revenue for the three
months ended March 31, 2004.
Revenue for the three months ended June 30, 2004 was unchanged as compared to
the three months ended June 30, 2003 primarily as a result of the increase in
lines in service offset by reductions in access revenue and the loss of a large
wholesale customer. Our total lines in service increased from June 30, 2003 by
approximately 5.3% to 540,824 lines at June 30, 2004. This increase in revenues
from having more lines in service was offset by a decrease in access revenue
attributable to reduced interstate per minute rates that we charge other
carriers as FCC mandated per minute rate reductions took effect in June 2003.
The loss of the wholesale customer negatively impacted revenue by $3.5 million
for the three months ended June 30, 2004. Average revenue per line for the three
months ended June 30, 2004 decreased by approximately 4.1% as compared to the
three months ended June 30, 2003 and by approximately 1.1% as compared to the
three months ended March 31, 2004. We expect total revenue to be relatively
stable over the remainder of 2004. Revenue is expected to increase due to an
increase in lines in service, the introduction of residential services in
selected markets, and the introduction of new service offerings, including
Select Savings.free and other bundled voice and data offerings. However, the
increases from line growth and growth through new offerings are expected to be
offset by further access revenue decreases. We expect access revenue to
decrease, beginning in June 2004, as interstate per minute rates will decline
due to the FCC mandated per minute rate reductions.
Our churn rate for the three months ended June 30, 2004, of our facilities-based
business clients, was 1.4% per month. This compares to 1.4% per month each for
the three months ended June 30, 2003 and for the three months ended March 31,
2004, respectively. We seek to minimize churn by providing superior client care,
by offering a competitively priced portfolio of local, long distance and
Internet services, by signing a significant number of clients to multi-year
service agreements, and by focusing on offering our own facilities-based
services.
NETWORK COSTS
Network costs for the three months ended June 30, 2004 were $38.3 million,
representing a 7.4% decrease from network costs of $41.3 million for the three
months ended June 30, 2003 and a 1.7% increase from network costs of $37.6
million for the three months ended March 31, 2004. Network costs as a percentage
of total revenues were 46.6% at June 30, 2004, a decrease compared to 50.3% for
the three months ended June 30, 2003 and an increase compared to 46.4% for the
three months ended March 31, 2004.
Network cost changes, in relation to revenue changes, reflect the continuing
benefits of our fiber network implementation and other network optimization
initiatives. These initiatives included least cost routing, replacing leased
capacity with alternative technologies and grooming and capacity sizing of our
network facilities. As a result, during the three months ended June 30, 2004,
our average cost per line declined approximately 11.2% as compared to the three
months ended June 30, 2003. These changes highlight the effectiveness of our
network optimization initiatives and the benefits of leasing fiber. The average
cost per line as compared to the three months ended March 31, 2004 decreased
approximately 0.6%. Amortization of the cost of the capital leases for fiber is
included in depreciation and amortization expense which is not a component of
network costs.
Our network costs include:
o Leases of high-capacity digital lines that interconnect our network with
established telephone company networks;
-20-
o Leases of our inter-city network;
o Leases of local loop lines which connect our clients to our network;
o Leased space in established telephone company central offices for
collocating our transmission equipment;
o Completion of local calls originated by our clients,
o Completion of originating (1+ calling) and terminating (inbound 800
calling) long distance calls by our clients, and
o Non-recurring costs for installing and disconnecting lines.
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
the markets we serve. We currently have operational intra-city fiber in 19 of
the markets that we serve. We plan to activate fiber in an additional 3 markets
across our footprint during 2004. Our fiber network consists of 1,457 route
miles of operational intra-city fiber and 1,170 miles of operational inter-city
fiber.
Our revenues exceeded our network costs by $43.9 million, or 53.4% of revenue,
for the three months ended June 30, 2004, compared to $40.9 million, or 49.7% of
revenue for the three months ended June 30, 2003, and $43.5 million, or 53.6% of
revenue, for the three months ended March 31, 2004. We expect that our revenue
in excess of network costs, as a percentage of revenue, will remain unchanged as
our projected revenue increases will be offset by additional decreases in access
revenue.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
Selling, general and administrative expenses for the three months ended June 30,
2004 were $40.6 million compared to $30.7 million and $36.4 million during the
three months ended June 30, 2003 and March 31, 2004, respectively. Excluding
non-cash compensation expense described below, the selling, general and
administrative expenses increased 32.6% from $30.5 million during the three
months ended June 30, 2003 to $40.5 million during the three months ended June
30, 2004. For the three months ended March 31, 2004, selling, general and
administrative expenses, excluding non-cash deferred compensation expense, were
$36.3 million. Selling, general and administrative expenses are expected to
increase during the remaining fiscal quarters of 2004 due to professional
services expenses for consultants and other advisors engaged to guide and
facilitate our efforts with respect to our lenders.
Our selling, general and administrative expenses include:
o Costs associated with sales and marketing, client care, billing, corporate
administration, personnel and network maintenance;
o Administrative overhead and office lease expense; and
o Bad debt expense.
Selling, general and administrative expenses, excluding non-cash compensation
charges, as a percentage of revenue, were 49.3% for the three months ended June
30, 2004, as compared to 37.2% for the three months ended June 30, 2003 and
44.7% for the three months ended March 31, 2004. The increase in selling,
general and administrative expenses from the three months ended June 30, 2003
and from the three months ended March 31, 2004 resulted from increased salaries,
benefits, commissions, professional services, outside consulting, advertising
expenses and a $2.2 million impairment of executive loans. Professional services
increased $1.8 million during the three months ended June 30, 2004 as compared
to the three months ended June 30, 2003 and $1.7 million as compared to the
three months ended March 31, 2004 primarily due to the engagement of consultants
and other advisors to guide and facilitate our efforts
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with respect to our lenders. Advertising expense increased primarily as a result
of our new offering of residential voice service which began in selected markets
within our footprint in January 2004. The non-recourse executive loans made in
August 2001 have been deemed to be impaired, as the amounts due on the loans are
significantly greater than the value of the common stock pledged to secure the
loans.
During the three months ended June 30, 2004, salary and benefits expense
increased approximately $1.8 million as compared to the three months ended June
30, 2003, primarily as a result of headcount increases. Commission expense for
the same comparative period increased $1.6 million due to an increase in lines
sold and installed. At June 30, 2004, we employed 1,407 individuals. We employed
1,323 and 1,434 individuals at June 30, 2003 and March 31, 2004, respectively.
Also included in selling, general and administrative expenses for the three
months ended June 30, 2004, is non-cash compensation expense of $0.1 million.
This compares to $0.2 million for the three months ended June 30, 2003.
Compensation expense for the three months ended June 30, 2004 and 2003 includes
the expense associated with our adoption of Statement of Financial Accounting
Standards ("SFAS") No. 148, under which we adopted the financial statement
measurement and recognition provisions of SFAS No. 123. Under SFAS No. 123, on a
prospective basis, we recognize compensation expense for the fair value of all
stock options granted after December 31, 2002 over the vesting period of the
options.
RESTRUCTURING (CREDITS)/COSTS
We implemented an operational restructuring plan in September 2002 and modified
such plan in February 2003. The plan included restructuring costs for employee
termination benefits, contractual lease obligations and network facility costs.
The following table highlights cumulative restructuring activities through June
30, 2004 (in thousands):
TERMINATION LEASE NETWORK FACILITY
BENEFITS OBLIGATIONS COSTS TOTAL
------- ------- ------- -------
Initial restructuring charge ............ $ 559 $ 3,440 $ 1,283 $ 5,282
Adjustments due to plan modifications ... 50 -- (585) (535)
Payment of benefits and other obligations (609) (408) (332) (1,349)
------- ------- ------- -------
Balance at December 31, 2003 ............ -- 3,032 366 3,398
Payment of benefits and other obligations -- (188) (10) (198)
------- ------- ------- -------
Balance at June 30, 2004 ................ $ -- $ 2,844 $ 356 $ 3,200
======= ======= ======= =======
For the three months ended June 30, 2004, 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 $2.4 million that extend beyond one year and are included in
other long-term liabilities.
During February 2003, we modified a portion of our restructuring plan related to
reduced reliance on certain collocation sites. As we engaged in restructuring
activities 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, 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.
LOSS ON DISPOSITION OF ASSETS
For the three months ended June 30, 2004, loss on disposition of assets was
approximately $0.6 million as compared to $29,000 for the three month period
ended June 30, 2003. The increase in the loss on
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disposition of assets was primarily the result of efforts to minimize our
investment in certain switch equipment that we determined would no longer be
used in our collocation sites.
DEPRECIATION AND AMORTIZATION
Depreciation and amortization for the three months ended June 30, 2004 was $15.5
million. This represents a 9.5% decrease from the three months ended June 30,
2003. Depreciation expense remained relatively unchanged as compared to the
three months ended March 31, 2004. The decrease in depreciation expense as
compared to the three months ended June 30, 2003 was primarily related to
certain switch software assets acquired in the acquisition of US Xchange, Inc.
("US Xchange") which became fully depreciated during 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 ("IRUs") and amortization of the value of
acquired customer relationships. We expect our depreciation and amortization
expense to remain consistent with the three months ended June 30, 2004 for the
remaining fiscal quarters of 2004.
INTEREST EXPENSE AND INCOME
Interest expense includes interest payments on borrowings under our senior
credit facility, non-cash interest expense on our subordinated notes,
amortization of deferred financing costs related to these facilities,
amortization of the discount on the subordinated notes and the Term C loan under
the senior credit facility, and interest expense related to IRUs. Interest
expense on the subordinated notes is payable-in-kind ("PIK") through November
2006. As of July 1, 2003, interest expense, net, includes the accretion and
dividends on preferred stock in accordance with SFAS No. 150. Restatement of
prior period classifications was not permitted upon adoption of SFAS No. 150.
Interest expense, net, for the three months ended June 30, 2004 and June 30,
2003 was approximately $32.5 million and $16.7 million, respectively. Interest
expense, net for the three months ended March 31, 2004 was $31.4 million. The
increase in interest expense, net, from the three months ended June 30, 2003 was
attributable to an aggregate of $15.0 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 also increased $0.5 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 increase over the next three
months due to anticipated increases in LIBOR rates that will impact our
borrowing rates. If the Financial Restructuring is implemented we expect our
interest expense to decrease substantially because of the resulting substantial
reduction in our outstanding indebtedness and the extinguishment of our
outstanding preferred stock.
Cash interest expense is the interest expense that must be settled periodically
in cash as compared to the interest expense which accretes to principal. Cash
interest expense was $8.3 million for the three months ended June 30, 2004, and
$7.5 million and $7.2 million for the three months ended June 30, 2003 and March
31, 2004, respectively. The increase in cash interest expense was the result of
interest on the Term C loan of the senior credit facility being settled in cash
monthly beginning on April 30, 2004, offset by lower interest rates on our
senior credit facility borrowings. Subject to the impact from the Financial
Restructuring, if implemented, cash interest expense is expected to increase for
each of the three month periods remaining in 2004 due to anticipated increases
in LIBOR rates that will impact our borrowing rates.
The non-cash accretion of and dividends on our preferred stock was $15.0 million
for the three months ended June 30, 2004. Beginning on July 1, 2003, accretion
and dividends on our redeemable preferred stock is classified as a component of
interest expense in accordance with SFAS No. 150. Non-cash accretion and
dividends on our preferred stock for the three months ended March 31, 2004 were
$14.5
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million. This change from the three months ended March 31, 2004 was primarily
driven by the increase in dividends on preferred stock which result from the
compounding effect of dividends that have accreted.
INCOME TAXES
We did not generate any taxable income during the three months ended June 30,
2004 and 2003, and did not incur any income tax liability as a result. We do not
expect to generate taxable income during the remainder of 2004. As of December
31, 2003, we had approximately $598.1 million in net operating loss
carryforwards for federal income tax purposes. Our net operating loss
carryforwards, which were subject to annual use limitations, may be
significantly reduced as a result of the Financial Restructuring. Furthermore,
other tax attributes, including the tax basis of certain assets, could also be
reduced as a result of the cancellation of indebtedness as part of our Financial
Restructuring. In addition, Section 382 of the Internal Revenue Code of 1986,
which generally applies after a more than 50 percentage point ownership change
has occurred, may impose other limitations on the annual utilization of any
remaining net operating losses. We believe that we will experience such an
ownership change as a result of the implementation of our Financial
Restructuring. However, because we will be under the jurisdiction of a court in
a case under Chapter 11 of the United States Bankruptcy Code at the time of the
ownership change, various alternatives pertaining to the application of Section
382 are available. At this time, we have not yet determined the full impact of
all limitations.
NET LOSS AND NET LOSS APPLICABLE TO COMMON STOCKHOLDERS
Our net loss was $45.3 million, $23.8 million, and $40.0 million for the three
months ended June 30, 2004, June 30, 2003 and March 31, 2004, respectively. The
increase in net loss was attributable to an aggregate of $15.0 million of
accretion and dividends on our preferred stock being characterized as interest
expense in accordance with the adoption of SFAS No. 150 as of July 1, 2003, and
the other factors previously discussed. The net loss applicable to common
stockholders was $45.3 million, $36.6 million, and $40.0 million for the three
months ended June 30, 2004, June 30, 2003, and March 31, 2004, respectively. The
change in net loss applicable to common stockholders was attributable to the
factors previously discussed.
RESULTS OF OPERATIONS FOR THE SIX MONTHS ENDED JUNE 30, 2004 AS COMPARED TO THE
SIX MONTHS ENDED JUNE 30, 2003
EBITDA
In this filing, we include references to and analyses of EBITDA amounts that are
not calculated and presented in accordance with GAAP. EBITDA as used by
management and certain investors is described in detail in the results of
operations for the three months ended June 30, 2004 as compared to the three
months ended June 30, 2003 section of this filing.
-24-
The following table shows the differences between our net cash provided by/(used
in) operating activities, as determined in accordance with GAAP, and our EBITDA
for the six month periods ended (in thousands):
JUNE 30, JUNE 30,
2004 2003
-------- --------
Net cash provided by/(used in) operating activities $ 3,543 $(11,886)
Adjustments to reconcile:
Changes in assets and liabilities .............. (6,156) 15,541
Non-cash compensation .......................... (201) (661)
Impairment of executive loans .................. (2,200) --
Loss on disposition of assets .................. (623) (88)
-------- --------
Subtotal ....................................... (9,180) 14,792
Net interest expense (net of other income) ... 63,948 33,155
Interest payable in-kind on long-term debt ... (16,270) (15,427)
Amortization of deferred financing costs ..... (2,066) (2,251)
Amortization of discount on long-term debt ... (609) (543)
Accretion of preferred stock ................. (6,690) --
Dividends on preferred stock ................. (22,798) --
-------- --------
Net cash interest expense ...................... 15,515 14,934
-------- --------
EBITDA ............................................ $ 9,878 $ 17,840
======== ========
REVENUE
We generated $163.4 million in revenue during the six months ended June 30, 2004
which was a 0.7% increase compared to revenue of $162.3 million for the six
months ended June 30, 2003 and was attributable to an increase in the number of
lines in service offset by a decline in access revenue and the loss of a large
wholesale customer. Our total lines in service increased from June 30, 2003 by
approximately 5.3% to 540,824 lines at June 30, 2004. Access revenue was
negatively impacted by reduced interstate per minute rates that we charge other
carriers as FCC mandated per minute rate reductions took effect in June 2003.
The loss of the wholesale customer negatively impacted revenue by $5.8 million
for the six months ended June 30, 2004.Average revenue per line for the six
months ended June 30, 2004 decreased approximately 1.9% as compared to the six
months ended June 30, 2003.
Our churn rate for the six months ended June 30, 2004, of our facilities-based
business clients, was 1.4% per month. This compares to 1.5% per month for the
six months ended June 30, 2003.
NETWORK COSTS
Network costs for the six months ended June 30, 2004 were $75.9 million,
representing a 7.3% decrease from network costs of $81.8 million for the six
months ended June 30, 2003. Network costs as a percentage of total revenues were
46.5% at June 30, 2004, a decrease compared to 50.4% for the six months ended
June 30, 2003.
Network cost changes, in relation to revenue changes, reflect the continuing
benefits of our fiber network implementation and other network optimization
initiatives. These initiatives include least cost routing, replacing leased
capacity with alternative technologies and grooming and capacity sizing of our
network facilities. As a result, during the six months ended June 30, 2004, our
average cost per line declined approximately 9.7% as compared to the six months
ended June 30, 2003. These changes highlight the effectiveness of our network
optimization initiatives and the benefits of leasing fiber. Amortization of the
-25-
cost of the capital leases for fiber is included in depreciation and
amortization expense which is not a component of network costs.
Our revenues exceeded our network costs by $87.5 million, or 53.5% of revenue,
for the six months ended June 30, 2004, compared to $80.5 million, or 49.6% of
revenue for the six months ended June 30, 2003.
Refer to the results of operations for the three months ended June 30, 2004 as
compared to the three months ended June 30, 2003 section of this filing for a
discussion of the components included in our network costs.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
Selling, general and administrative expenses for the six months ended June 30,
2004 were $77.0 million compared to $63.1 million during the six months ended
June 30, 2003. Excluding non-cash compensation expense described below, the
selling, general and administrative expenses increased 22.9% from $62.4 million
during the six months ended June 30, 2003 to $76.8 million during the six months
ended June 30, 2004.
Selling, general and administrative expenses, excluding non-cash compensation
charges, as a percentage of revenue, were 47.0% for the six months ended June
30, 2004, as compared to 38.5% for the six months ended June 30, 2003. The
increase in selling, general and administrative expenses from the six months
ended June 30, 2003 resulted from increased salaries, benefits, commissions,
temporary services, professional services, advertising expenses and a $2.2
million impairment of loans made to executives in August 2001. Professional
services increased $1.8 million during the six months ended June 30, 2004 as
compared to June 30, 2003 due to the engagement of consultants and other
advisors to guide and facilitate our efforts with respect to our lenders.
Advertising expense increased primarily as a result of our new offering of
residential voice service which began in selected markets within our footprint
in January 2004. The non-recourse executive loans made in August 2001 have been
deemed to be impaired, as the amounts due on the loans are significantly greater
than the value of the common stock pledged to secure the loans.
During the six months ended June 30, 2004, salary and benefits expense increased
approximately $3.3 million as compared to the six months ended June 30, 2003,
primarily as a result of headcount increases. Commission expense for the same
comparative period increased $3.4 million due to an increase in lines sold and
installed. Also during the six months ended June 30, 2004, temporary services
increased $1.2 million as compared to the six months ended June 30, 2003. We
employed 1,407 and 1,323 individuals at June 30, 2004 and June 30, 2003,
respectively.
Also included in selling, general and administrative expenses for the six months
ended June 30, 2004 is non-cash compensation expense of $0.2 million. This
compares to $0.7 million for the six months ended June 30, 2003. Compensation
expense for the six months ended June 30, 2004 and 2003 includes the expense
associated with our adoption of Statement of Financial Accounting Standards
("SFAS") No. 148, under which we adopted the financial statement measurement and
recognition provisions of SFAS No. 123. Under SFAS No. 123, on a prospective
basis, we recognize compensation expense for the fair value of all stock options
granted after December 31, 2002, over the vesting period of the options.
RESTRUCTURING (CREDITS)/COSTS
We implemented an operational restructuring plan in September 2002 and modified
such plan in February 2003. The plan included restructuring costs for employee
termination benefits, contractual lease obligations and network facility costs.
For the six months ended June 30, 2004, approximately $0.2 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
-26-
contractual lease obligations of $2.4 million that extend beyond one year and
are included in other long-term liabilities.
During February 2003, we modified a portion of our restructuring plan related to
reduced reliance on certain collocation sites. As we engaged in restructuring
activities 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, 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.
LOSS ON DISPOSITION OF ASSETS
For the six months ended June 30, 2004, loss on disposition of assets was
approximately $0.6 million as compared to approximately $0.1 million for the six
month period ended June 30, 2003. The increase in the loss on disposition of
assets was primarily the result of efforts to minimize our investment in certain
switch equipment that we determined would no longer be used in our collocation
sites.
DEPRECIATION AND AMORTIZATION
Depreciation and amortization for the six months ended June 30, 2004 was $31.2
million. This represents a 10.1% decrease from the six months ended June 30,
2003. The decrease in depreciation expense as compared to the six months ended
June 30, 2003 was primarily related to certain switch software assets acquired
in the acquisition of US Xchange which became fully depreciated during three
months ended September 30, 2003.
INTEREST EXPENSE AND INCOME
Interest expense, net, for the six months ended June 30, 2004 and June 30, 2003
was approximately $63.9 million and $33.1 million, respectively. The increase in
interest expense, net, from the six months ended June 30, 2003 was attributable
to an aggregate of $29.5 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 also increased $1.1 million from the
comparable period 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.
Cash interest expense is the interest expense that must be settled periodically
in cash as compared to the interest expense which accretes to principal. Cash
interest expense was $15.5 million for the six months ended June 30, 2004, and
$14.9 million for the six months ended June 30, 2003. The increase in cash
interest expense was the result of interest on the Term C loan of the senior
credit facility being settled in cash monthly beginning on April 30, 2004 offset
by lower interest rates on our senior credit facility borrowings.
The non-cash accretion of and dividends on our preferred stock was $29.5 million
for the six months ended June 30, 2004. Beginning on July 1, 2003, accretion and
dividends on our redeemable preferred stock is classified as a component of
interest expense in accordance with SFAS No. 150. Non-cash accretion and
dividends on our preferred stock for the six months ended June 30, 2003 were
$25.2 million. This change from the six months ended June 30, 2003 was primarily
driven by the increase in dividends on preferred stock which result from the
compounding effect of dividends that have accreted.
-27-
INCOME TAXES
We did not generate any taxable income during the six months ended June 30, 2004
and 2003, and did not incur any income tax liability as a result. As of December
31, 2003, we had approximately $598.1 million in net operating loss
carryforwards for federal income tax purposes. Our net operating loss
carryforwards, which were subject to annual use limitations, may be
significantly reduced as a result of the Financial Restructuring. Furthermore,
other tax attributes, including the tax basis of certain assets, could also be
reduced as a result of the cancellation of indebtedness as part of our Financial
Restructuring. In addition, Section 382 of the Internal Revenue Code of 1986,
which generally applies after a more than 50 percentage point ownership change
has occurred, may impose other limitations on the annual utilization of any
remaining net operating losses. We believe that we will experience such an
ownership change as a result of the implementation of our Financial
Restructuring. However, because we will be under the jurisdiction of a court in
a case under Chapter 11 of the United States Bankruptcy Code at the time of the
ownership change, various alternatives pertaining to the application of Section
382 are available. At this time, we have not yet determined the full impact of
all limitations.
NET LOSS AND NET LOSS APPLICABLE TO COMMON STOCKHOLDERS
Our net loss was $85.3 million and $50.0 million for the six months ended June
30, 2004 and June 30, 2003, respectively. The change in net loss was
attributable to an aggregate of $29.5 million of accretion and dividends on our
preferred stock being characterized as interest expense in accordance with the
adoption of SFAS No. 150 as of July 1, 2003, and the other factors previously
discussed. The net loss applicable to common stockholders was $85.3 million and
$75.2 million for the six months ended June 30, 2004 and June 30, 2003,
respectively. The change in net loss applicable to common stockholders was
attributable to the factors previously discussed.
LIQUIDITY AND CAPITAL RESOURCES
Refer to the discussion of the going concern matter earlier in this section of
management's discussion and analysis of financial condition and results of
operations.
CREDIT FACILITIES
We have $398.9 million that has been committed under our senior credit facility,
subject to various conditions, covenants and restrictions, including those
described in Note 8 to the financial statements. At June 30, 2004, the maximum
available funding under our senior credit facility was outstanding. 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.
We also have $245.5 million of subordinated notes outstanding, excluding the
discount of $1.8 million and PIK interest of $4.4 million that has accrued as of
June 30, 2004 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.
We are required to make periodic payments on our senior credit facility to
reduce outstanding balances in 2004 of $12.2 million. On July 30, 2004, we
failed to make certain payments in the aggregate amount of $5.1 million that
were then due under our senior credit facility. Such failure constituted an
event of default under our senior credit facility and our subordinated notes and
would permit our obligations under our senior credit facility and subordinated
notes to be declared to be immediately payable. The requisite majority of both
the lenders under our senior credit facility and the holders of our subordinated
notes have
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entered into standstill and, in the case of the subordinated notes, waiver
agreements on July 30, 2004, subject to certain conditions, pursuant to which
they have agreed not to take any action before August 30, 2004 with respect to
such default so as to provide us with additional time to facilitate the
negotiation and initiation of the Financial Restructuring. As a result of the
event of default, our long-term debt has been reclassified to short-term in the
consolidated balance sheet as of June 30, 2004.
On August 9, 2004, we and the counterparty under our interest rate swap
agreement entered into an amendment and waiver to the interest rate swap
agreement pursuant to which a payment of approximately $1.8 million due to be
paid by us to the counterparty on August 9, 2004 was deferred until September
30, 2004 or such earlier date on which we obtain debtor-in-possession financing
in connection with the proposed Financial Restructuring. In the amendment and
waiver the counterparty also waived certain defaults under the interest rate
swap agreement until September 30, 2004. As a result of this event, the interest
rate swap liability has been classified as current in the consolidated balance
sheet as of June 30, 2004.
In connection with the proposed Financial Restructuring, we intend to obtain
debtor-in-possession financing to meet our liquidity needs during the Financial
Restructuring process. Upon completion of the Financial Restructuring, we expect
this financing to be replaced with a new revolving credit facility of up to
$25.0 million from a subset of the lenders under our senior credit facility to
provide for our ongoing working capital requirements. There can be no assurance
that we will be able to obtain such financing or that the terms of any such
financing that is available will be acceptable to us. Assuming that we do not
make principal or interest payments due under our senior credit facility or the
payment due under the interest rate swap agreement, we expect that our cash
reserves and our cash flow from operations will be sufficient to satisfy our
operating cash needs until we obtain debtor-in-possession financing.
In accordance with SFAS No. 144, "Accounting for the Impairment or Disposal of
Long-Lived Assets", we have evaluated all of our long-lived assets for
impairment as of June 30, 2004. When the carrying value of an asset exceeds the
undiscounted cash flows directly related to it, there is an impairment. The
impairment loss is recognized as the amount by which the asset's carrying value
exceeds its fair value. No such impairment losses under the SFAS No. 144
Standard were recorded as of June 30, 2004. If the Financial Restructuring is
implemented as currently contemplated, our balance sheet may be materially
impacted. We expect to implement fresh start accounting upon our emergence from
Financial Restructuring, requiring us to record our balance sheet at fair value,
which may vary materially from the carrying value of assets and liabilities as
of June 30, 2004.
CASH FLOWS
We have incurred significant operating and net losses since our inception.
Although not necessarily indicative of future cash flow results, we have
generated positive cash flow from operations for the six months ended June 30,
2004, as well as for the six months ended December 31, 2003. While we expect our
cash flows from operations to remain positive for the remaining fiscal quarters
of 2004, changes in interest rates and working capital make it difficult to
predict whether cash flows from operations will increase or decrease during
those periods. If the Financial Restructuring is implemented, we would expect
our cash flow from operations to increase primarily due to a reduction in
interest expense. We also generated positive EBITDA during the first two fiscal
quarters of 2004 and each of the fiscal quarters in 2003. While we expect to
continue to generate positive EBITDA and expect our EBITDA to grow, we also
expect to continue to have operating losses. As of June 30, 2004, we had an
accumulated deficit of $1.2 billion.
Net cash provided by operating activities was approximately $3.5 million for the
six months ended June 30, 2004 while net cash used in operating activities for
the six months ended June 30, 2003 was approximately $11.9 million. Net cash
provided by operating activities for the six months ended June 30, 2004 was
primarily due to positive net working capital changes of $6.2 million, of which
$0.2 million was related to payments of our operational restructuring
obligations. Net cash used in operating activities
-29-
for the six months ended June 30, 2003 was primarily due to net losses from
operations, negative net working capital changes of $15.5 million, of which $0.6
million was related to payments of our operational restructuring obligations,
and interest expense payable in cash of $14.9 million. The change in net working
capital for the six months ended June 30, 2004 compared to the six months ended
June 30, 2003 was primarily due to the timing of vendor invoice payments and
collections and settlements of amounts owed to us since June 30, 2003.
Net cash used in investing activities was $9.2 million and $4.0 million for the
six months ended June 30, 2004 and 2003, respectively. Net cash used in
investing activities for the six months ended June 30, 2004 primarily related to
capital expenditures for technology to support the growth in newer service
offerings, including Select Savings.free and other bundled voice and data
offerings. Net cash used in investing activities for the six months ended June
30, 2003 related to capital expenditures in support of growth in our existing
markets.
Net cash used in financing activities was $0.5 million for the six months ended
June 30, 2004 compared to net cash provided by financing activities of $1.4
million for the six months ended June 30, 2003. Net cash used in financing
activities for the six months ended June 30, 2004 was primarily related to
payments under capital lease obligations. Net cash provided by financing
activities for the six months ended June 30, 2003 was related to borrowings
under the senior credit facility offset by payments under capital lease
obligations. Funds received from senior credit facility borrowings were used for
capital expenditures and general corporate purposes. We do not expect to receive
additional cash from financing activities as a result of borrowings under our
existing senior credit facility as all of the existing financing commitments
have been used.
CAPITAL REQUIREMENTS
Capital expenditures were $9.3 million and $4.0 million for the six months ended
June 30, 2004 and 2003, respectively. We expect that our capital expenditures
will be between $15.0 million and $25.0 million for 2004 as we continue to
penetrate our existing markets. The actual amount and timing of our future
capital requirements may differ materially from our estimates as a result of the
availability of financial resources, the demand for our services and regulatory,
technological and competitive developments, including new opportunities in the
industry and other factors.
CRITICAL ACCOUNTING POLICIES
Our critical accounting policies are described in Item 7 of our Form 10-K for
the year ended December 31, 2003.
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RECENT ACCOUNTING PRONOUNCEMENTS
At its March 31, 2004 meeting, the Emerging Issues Task Force ratified its
consensus in EITF No. 03-16, "Accounting for Investments in Limited Liability
Companies" ("EITF 03-16"). EITF 03-16 requires companies to evaluate whether or
not their investments in limited liability companies (LLC) should be
accounted for on the equity method of accounting. The Task Force confirmed its
previous conclusion that LLCs that have separate ownership accounts for each
investor should be accounted for like investments in partnerships. This
conclusion is based on the fact that the investor's separate account is its
claim on the long-term appreciation in net assets of the LLC similar to a
partner's capital account. Investors in partnerships have used a lower threshold
for determining whether they should record an investment on the equity method
(under SOP No. 78-9, Accounting for Investments in Real Estate Ventures) than
allowed under SFAS No. 115. The consensus must be applied in the first period
beginning after June 15, 2004. We have an investment in a limited liability
company, and have not completed the process of evaluating the impact that
will result from adopting this consensus.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
At June 30, 2004 and December 31, 2003, the carrying value of our debt
obligations, excluding capital lease obligations, was $648.9 million and $632.0
million, respectively. The fair value of these debt obligations at June 30, 2004
is not determinable though it is recognized to be less than the carrying value
due to the contemplated Financial Restructuring. The fair value of these
obligations at December 31, 2003 was $643.3 million. The changes in value are
due to non-cash amortization of debt discount of $0.6 million, interest payable
in-kind that accreted to principal of $15.1 million, and changes in related
interest rates. The weighted average interest rate of our debt obligations at
June 30, 2004 and December 31, 2003 was 7.56% and 7.41%, respectively.
Also, a hypothetical increase of 100 basis points from prevailing interest rates
at June 30, 2004 would have resulted in an approximate increase in cash required
for interest on variable rate debt during the remaining fiscal year of $1.3
million, increasing to $2.5 million in the next fiscal year, and then declining
to $2.1 million, $1.5 million, 0.8 million, and $0.1 million in the second,
third, fourth and fifth years, respectively. At June 30, 2004, $279.1 million of
our debt was variable rate debt.
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 our Second Amended and Restated
Credit Agreement. The Third Amended and Restated Credit Agreement does not have
such a requirement. This agreement does prohibit us 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 mitigate our exposure to
counterparty credit risk by using major financial institutions with high credit
ratings. In a declining interest rate market, the benefits of the hedge position
are minimized, however, we continue to monitor market conditions.
At June 30, 2004, we had an interest rate swap agreement for a notional amount
of $125.0 million. At June 30, 2004, the weighted average pay rate for the
interest rate swap agreement was 6.94% and the average receive rate was 1.18%.
Based on the fair value of the interest rate swap at June 30, 2004, it would
have cost us $9.3 million to terminate the agreement. A hypothetical decrease of
100 basis points in the receive rate would have increased the cost to terminate
this agreement by approximately $1.9 million.
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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, our principal executive officer and principal financial
officer with the participation and assistance of our management, concluded that
our disclosure controls and procedures, as defined in Rules 13a-15(e)
promulgated under the Securities Exchange Act of 1934, were effective in design
and operation. There have been no changes in our internal controls over
financial reporting that occurred during the quarter ended June 30, 2004 that
have materially affected, or are reasonably likely to materially affect, our
internal controls over financial reporting.
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PART II. OTHER INFORMATION
Item 1. Legal Proceedings
Not applicable.
Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of
Equity Securities
Not applicable.
Item 3. Defaults Upon Senior Securities
On July 30, 2004, we failed to make certain payments in the
aggregate amount of $5.1 million that were then due under our senior credit
facility (which amount is the total arrearage due as of the date of the filing
of this report). Such failure constituted an event of default under our senior
credit facility and our subordinated notes and would permit our obligations
under our senior credit facility and subordinated notes to be declared to be
immediately payable. The requisite majority of both the lenders under our senior
credit facility and the holders of our subordinated notes have entered into
standstill and, in the case of the subordinated notes, waiver agreements on July
30, 2004, subject to certain conditions, pursuant to which they have agreed to
not take any action before August 30, 2004 with respect to such default to
provide us with additional time to facilitate the negotiation and initiation of
the Financial Restructuring discussed in the "Going Concern Matter" section of
the Management's Discussion and Analysis of Financial Condition and Results of
Operations section of this report.
Item 4. Submission of Matters to a Vote of Security Holders
Not applicable.
Item 5. Other Information
Director Resignations. On July 23, 2004, Messrs. Abramson and Hoffen
resigned from our Board of Directors and the Board of Directors of each of our
subsidiaries. Messrs. Abramson and Hoffen were designated to serve on these
Boards of Directors by Morgan Stanley Capital Partners III, L.P. and Morgan
Stanley Dean Witter Capital Partners IV, L.P. (together with certain of their
affiliated private equity funds that have invested in us, the "Morgan Stanley
Entities") under the terms of the transaction agreement among us, the Morgan
Stanley Entities, other institutional investors and certain management
investors. The Morgan Stanley Entities' primary interest in us is in the form of
common stock, preferred stock and warrants to purchase common stock. It is
expected that the Morgan Stanley Entities' entire equity interest in us will be
extinguished in connection with the Financial Restructuring. Neither Mr.
Abramson nor Mr. Hoffen has notified us that he disagrees with us on any matter
relating to our operations, policies or practices.
Postponement of Annual Meeting. Because we have been focused on
negotiating and preparing for the contemplated Financial Restructuring and
because of the likely impact of the Financial Restructuring on our capital
structure, the Board of Directors has postponed indefinitely our annual meeting
of stockholders originally scheduled to be held on August 17, 2004.
Item 6. Exhibits and Reports for Form 8-K
A. Exhibits
See Exhibit Index
B. Reports on Form 8-K
No reports on Form 8-K were filed during the three months ended
June 30, 2004.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
CHOICE ONE COMMUNICATIONS INC.
Registrant
DATE: August 13, 2004 By: /s/ Steve M. Dubnik
---------------------------------------------------
Steve M. Dubnik, Chairman and Chief Executive Officer
(Principal Executive Officer)
By: /s/ Ajay Sabherwal
---------------------------------------------------
Ajay Sabherwal, Executive Vice President, Finance and
Chief Financial Officer
(Principal Financial Officer)
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EXHIBIT INDEX
EXHIBIT
NUMBER DESCRIPTION LOCATION
- ------ ----------- --------
3.1 Amended and Restated Certificate of Incorporated by reference from Exhibit 3.1 to
Incorporation. Choice One Communication Inc.'s Registration
Statement on Form S-1 declared effective on
February 16, 2000 located under Securities and
Exchange Commission File No. 333-91321
("February 2000 Registration Statement").
3.2 Amended and Restated Bylaws. Incorporated by reference from Exhibit 3.2 to
the February 2000 Registration Statement.
3.3 Certificate of Designations for Series A Senior Incorporated by reference from Exhibit 3.1 to
Cumulative Preferred Stock. the August 10, 2000 8-K filing located under
the Securities and Exchange Commission File No.
29279.
3.4 Certificate of Amendment of Certificate of Incorporated by reference from Exhibit 10.25 to
Designations for Series A Senior Cumulative the Company's 10-K filed on April 1, 2002.
Preferred Stock of Choice One Communications
Inc.
3.5 Certificate of Amendment of Certificate of Incorporated by reference from Exhibit 3.4 to
Incorporation with Certificate of Designations, the Company's 10-Q filed on May 15, 2002.
Preferences and Rights of Series A Senior
Cumulative Preferred Stock dated March 30, 2002.
3.6 Certificate of Amendment of Certificate of Incorporated by reference from Exhibit 4.6 to
Designations for Series A Senior Cumulative the Company's 8-K filed on September 27, 2002.
Preferred Stock.
10.1 Second Amendment dated as of May 5, 2004 to the Incorporated by reference from Exhibit 10.3 to
Third Amended and Restated Credit Agreement, dated the Company's Form 10-Q for the period ended
September 13, 2002, among Choice One March 31, 2004.
Communications Inc., as Guarantor, its
subsidiaries as Borrowers, Wachovia Investors,
Inc., as Administrative Agent and Collateral
Agent, General Electric Capital Corporation, as
Syndication Agent, Morgan Stanley Senior Funding,
Inc., as Documentation Agent, and the Lenders
thereto
10.2 Third Amendment dated as of May 12, 2004 to the Incorporated by reference from Exhibit 10.4 to
Third Amended and Restated Credit Agreement, dated the Company's Form 10-Q for the period ended
September 13, 2002, among Choice One March 31, 2004.
Communications Inc., as Guarantor, its
subsidiaries as Borrowers, General Electric
Capital Corporation, as successor administrative
agent and syndication agent, and the Lenders
thereto
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EXHIBIT
NUMBER DESCRIPTION LOCATION
- ------- ----------- --------
10.3 Fourth Amendment dated as of May 25, 2004 to Filed herewith
the Third Amended and Restated Credit
Agreement, dated September 13, 2002, among
Choice One Communications Inc., as Guarantor,
its subsidiaries as Borrowers, General Electric
Capital Corporation, as successor administrative
agent and syndication agent, and the Lenders
thereto
10.4 Standstill Agreement and Conditional Amendment to Incorporated by reference from Exhibit 10.1 to
the Credit Agreement, dated as of June 30, 2004, the Company's Form 8-K filed on July 1, 2004.
by and among the registrant, its subsidiaries, the
Administrative Agent, and the Lenders pursuant to
the Company's Third Amended and Restated Credit
Agreement dated as of September 13, 2002 and as
amended on November 12, 2002, May 5, 2004, May 12,
2004 and May 25, 2004.
10.5 Second Standstill Agreement and Conditional Incorporated by reference from Exhibit 10.1 to
Amendment to the Credit Agreement, dated as of the Company's Form 8-K filed on August 2, 2004.
July 30, 2004, by and among the registrant, its
subsidiaries, the Administrative Agent, and the
Lenders pursuant to the Company's Third Amended
and Restated Credit Agreement dated as of
September 13, 2002 and as amended on November 12,
2002, May 5, 2004, May 12, 2004 and May 25, 2004.
10.6 Subordinated Notes Waiver and Agreement, dated Incorporated by reference from Exhibit 10.2 to
as of July 30, 2004, by and among the registrant the Company's Form 8-K filed on August 2,
and each of the other parties thereto. 2004.
10.7 Waiver Agreement and Amendment to Swap Filed herewith
Transaction Documents, dated as of August 9,
2004 among the subsidiaries of the registrant
and Wachovia Bank, N.A,
31.1 Certification by Chief Executive Officer filed Filed herewith
herewith pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 302 of the Sarbanes-
Oxley Act of 2002.
31.2 Certification Chief Financial Officer filed Filed herewith
herewith pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 302 of the Sarbanes-
Oxley Act of 2002.
32.1 Certification by Chief Executive Officer and Chief Filed herewith
Financial Officer filed herewith pursuant to 18
U.S.C. Section 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.
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