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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE YEAR ENDED DECEMBER 31, 2000
Commission File Number: 0-24061
US LEC CORP.
(Exact name of registrant as specified in its charter)
DELAWARE 56-2065535
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
Morrocroft III, 6801 Morrison Boulevard
CHARLOTTE, NORTH CAROLINA 28211
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (704) 319-1000
Securities registered pursuant to Section 12(b) of Act: None.
Securities registered pursuant to Section 12(g) of Act: Class A Common
Stock, par value $.01 per share.
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. X Yes No
-----------
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]
The aggregate market value of voting stock of the registrant held by
non-affiliates of the registrant was $79,046,345 as of March 20, 2001 based on
the closing sales price on The Nasdaq National Market as of that date. For
purposes of this calculation only, affiliates are deemed to be directors and
executive officers of the registrant.
As of March 20, 2001, there were 11,008,885 shares of Class A Common
Stock and 16,759,270 shares of Class B Common Stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant's Proxy Statement ("the Proxy Statement") for
its Annual Meeting of Stockholders to be held on May 3, 2001 are incorporated by
reference into Part III of this report.
US LEC CORP.
2000 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS
Page
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PART I
Item 1: Business 3
Item 2: Properties 24
Item 3: Legal Proceedings 24
Item 4. Submission of Matters to a Vote of Security Holders 24
PART II
Item 5: Market for the Registrant's Common Stock and Related Stockholder Matters 25
Item 6: Selected Consolidated Financial Data 26
Item 7: Management's Discussion and Analysis of Financial Condition and Results
of Operations 27
Item 7A: Quantitative and Qualitative Disclosures about Market Risk 38
Item 8: Financial Statements and Supplementary Data 40
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 68
PART III
Item 10: Directors and Executive Officers of the Registrant 69
Item 11: Executive Compensation 69
Item 12: Security Ownership of Certain Beneficial Owners and Management 70
Item 13: Certain Relationships and Related Transactions 70
PART IV
Item 14: Exhibits, Financial Statement Schedules and Reports on Form 8-K 71
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PART I
ITEM 1. BUSINESS
THE COMPANY
US LEC Corp. ("US LEC" or the "Company") is a provider of integrated
telecommunications services, including: local, long distance, data, Internet and
enhanced services to customers in selected markets in Alabama, Florida, Georgia,
Kentucky, Louisiana, Maryland, Mississippi, North Carolina, Pennsylvania, South
Carolina, Tennessee, Virginia and Washington D.C. US LEC is also currently
certified to provide telecommunications services in Connecticut, Delaware,
Indiana, Massachusetts, New Jersey, New York, Ohio and Texas. The predecessor to
US LEC was incorporated in June 1996 after passage of the Telecommunications Act
of 1996 ("Telecom Act"), which enhanced the competitive environment for local
telephone exchange services. On December 31, 1996, the original corporation was
merged into US LEC L.L.C., a limited liability company. On December 31, 1997, in
anticipation of an initial public offering, US LEC L.L.C. was merged into US
LEC. US LEC initiated service in North Carolina in March 1997, becoming one of
the first competitive local exchange carriers ("CLEC") in North Carolina to
provide switched local exchange services. As of December 31, 2000, US LEC's
network was comprised of 23 Lucent 5ESS(R) AnyMedia(TM) digital switches and 17
Lucent CBX500 ATM data switches that are located throughout the Southeast and
mid-Atlantic states, in addition to an Alcatel MegaHub(R) 600ES switch in
Charlotte, North Carolina. The Company primarily serves
telecommunications-intensive customers including businesses, universities,
financial institutions, professional service firms and practices, hospitals,
enhanced service providers, Internet service providers, hotels, automobile
dealerships and government agencies.
BUSINESS STRATEGY
US LEC's objective is to become a leading provider of integrated
telecommunications, Internet and data services to its existing and target
customers and to increase its market share by its expanding product portfolio
and by providing exceptional customer service. The principal elements of US
LEC's business strategy include:
Deploy a Capital-Efficient Network. US LEC utilizes a "smart-build"
strategy of purchasing and deploying switching equipment and leasing the
required fiber optic transmission capacity from competitive access providers
("CAPs"), other CLECs and incumbent local exchange carriers ("ILECs").
Management believes the Company's switch-based, leased-transport strategy
enables it to enter markets and generate revenue and positive cash flow more
rapidly than if the Company first constructed its own transmission facilities.
By leasing fiber transport, this smart-build strategy also reduces the up-front
capital expenditures required to build a network and enter new markets and
avoids the risk of "stranded" investment in under-utilized fiber networks.
Focus of Operations. The Company focuses its network build out and
marketing presence in target markets composed of Tier I cities (major
metropolitan areas such as Atlanta, Miami, Washington D.C. and Philadelphia) and
Tier II cities (mid-size metropolitan areas such as Greensboro, Tampa and
Nashville). The Company has selected its target markets based on a number of
considerations, including the number of potential customers and other
competitors in such markets and the presence of multiple transmission facility
suppliers. The Company currently focuses on markets in the Southeast and
Mid-Atlantic United States. Management believes that the Company's clustered
network will enable it to take advantage of calling patterns and capture an
increasing portion of customer traffic on its network.
Target Telecommunications-Intensive Customers. The Company focuses its
sales efforts on telecommunications-intensive customers including businesses,
universities, financial institutions, professional service firms and practices,
hospitals, enhanced service providers, ISPs, hotels, and
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government agencies. The volume of usage generated by the Company's target
customers allows the Company to efficiently concentrate the telecommunications
traffic of its customers. In addition, the Company frequently is able to sell
enhanced, long distance and data services to complement its local services. This
further enhances network utilization and thereby improves margins, as fixed
network costs are spread over a larger base of services. Unlike some other
CLECs, the Company does not resell ILEC services.
Install a Robust Technology Platform. The Company has chosen the 5ESS(R)
Any Media(TM) digital switch and the Lucent CBX 500 Asynchronous Transfer Mode
("ATM") data switches, both of which are manufactured by Lucent Technologies,
Inc. ("Lucent") to provide a consistent technology platform throughout its
network. As of December 31, 2000, US LEC had 23 Lucent voice switches and 17
Lucent ATM data switches active throughout its network. To enhance its service
offerings, the Company deployed an Alcatel MegaHub(R) 600ES ("Alcatel") tandem
switch in Charlotte. The Alcatel switch complements the Lucent switches and
improves US LEC's ability to provide enhanced services. The Company has also
deployed an Advanced Intelligent Network ("AIN") platform. This AIN platform
positions US LEC for enhanced services as well as allows the Company Signaling
System No. 7 ("SS#7") connectivity independent of the ILECs.
Employ an Experienced Sales Force. Management believes that the
Company's success in a particular market is enhanced by employing a direct sales
force with extensive local market and telecommunications sales experience. The
Company employs this strategy in building its sales force. Salespeople with
experience in a particular market provide the Company with extensive knowledge
of the Company's target customer base and in many cases have existing
relationships with target customers.
Implement Efficient Provisioning Processes with State-of-the-Art Back
Office Support. Management believes that a critical aspect of the success of a
CLEC is timely and effective provisioning systems, which includes the process of
transitioning ILEC or other CLEC customers to the Company's network. The Company
focuses on implementing effective and timely provisioning practices to
efficiently transition customers from the ILEC or other CLECs to the Company
with minimal disruption of the customer's operations. Among other things, US LEC
is approved by Lockheed Martin as a provider of Local Number Portability ("LNP")
for its customers. In addition, the US LEC Network Operations Center ("NOC")
houses the tools to monitor its network. The NOC provides network surveillance,
real-time alarm notification, dispatch services, and 24 hours a day, 7 days a
week availability and notification. In 2000, the Company began a project to
update and upgrade its back office systems through a strategy of deploying "best
of breed" systems for various back office functions including software from
Siebel, MetaSolv, Vitria, and Kenan. Management believes that the project will
be implemented in 2001 and that it will enhance the electronic exchange of
information within US LEC by providing a centralized view of customer and order
tracking data. In addition, the new systems will increase the integrity and
consistency of customer data by reducing paper forms, eliminating data input
redundancies and fully integrating US LEC's front and back office systems.
Offer a Broad Range of Products and Services. US LEC offers customers a
broad range of telecommunication services, which can be bundled. Management
believes a broad product range, competitive pricing, and an opportunity to
bundle services gives US LEC customers an exceptional value. US LEC offers its
customers local access, calling card, enhanced toll-free, digital private line,
dedicated high-speed Internet access, frame relay, web hosting, digital
subscriber line (DSL) and competitively priced long distance service, including
intrastate, interstate, international and toll-free. To further the Company's
product strategy, US LEC has deployed its Asynchronous Transfer Mode ("ATM") and
AIN platforms. These systems provide the Company the ability to provide advanced
voice and data communications products and services.
Provide Outstanding Customer Service. Management believes that a key
element of the success of a CLEC is the ability to satisfy the service needs of
its customers. Among other things, the Company must be able to resolve troubles,
promptly implement change requests, resolve billing issues and promptly add
additional service and capacity. Management believes that providing customers
with outstanding customer care enhances the ability of the Company to retain its
customers, as well as attract new customers.
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Customer care is provided locally by the market-based sales, sales support and
operations team and centrally by US LEC's NOC and customer service center.
US LEC'S NETWORK
During 2000, the Company installed seven new Lucent 5ESS(R) Any Media(TM)
digital switches and 13 new Lucent CBX500 ATM data switches, to bring the
network to 23 voice switches and 17 data switches. The Company has announced
plans to activate additional Lucent switches in, Mobile, Alabama, Ft. Myers,
Florida and a second switch in Atlanta, Georgia. The Company has also announced
that each switching center site will also house a data switch for a total of 26
digital and 25 data switches in addition to its Alcatel MegaHub(R) 600ES switch
in Charlotte. Four of the sites will also be long distance platforms which will
provide additional capability to route and concentrate the Company's long
distance traffic.
US LEC utilizes a "smart build" strategy of purchasing and deploying
switching equipment and leasing fiber optic transmission capacity from CAPs,
other CLECs and ILECs.
Calls originating with a US LEC customer are transported over leased lines
to the US LEC switch and can either be terminated directly on the Company's
network or routed to a long distance carrier, an ILEC or another CLEC, depending
on the location of the call recipient. Similarly, calls originating from the
public switched telephone network and destined for a US LEC customer are routed
through the US LEC switch and delivered to call recipients via leased
transmission facilities.
In order to interconnect its switches to the network of the local
incumbent phone company and to exchange traffic with it, the Company executes
interconnection agreements with the incumbent carriers. The terms and conditions
of the interconnection agreements are effected by the Telecom Act, decisions of
state and federal regulatory bodies and negotiation with the carriers involved.
The Company may voluntarily enter into such an agreement, petition a state
regulatory commission to arbitrate issues that can not be resolved by
negotiation or by opting into agreement executed by the incumbent and other
competitive carriers. The Company has signed or opted into interconnection
agreements with all of the incumbent local carriers where it offers services
requiring such agreements, including BellSouth Telecommunications, Inc.
("BellSouth"), Verizon Communications Inc. ("Verizon"), Sprint Communications
Company L.P. ("Sprint") (See "Business -- Forward Looking Statements and Risk
Factors - Existing BellSouth Interconnection Agreements" and "Business --
Forward Looking Statements and Risk Factors -Interconnection Agreements").
PRODUCTS AND SERVICES
The Company provides local dial-tone services to customers. Local access
is available in many different forms including PRI, T1 Access and Channel
Access. The Company's network is designed to allow a customer to easily increase
or decrease capacity and utilize enhanced services as the telecommunications
requirements of the customer change. The Company also provides directory
assistance and operator services.
US LEC provides long distance services for completing intrastate,
interstate and international calls. The Company also provides toll-free
services, calling cards and typical enhanced services such as voice mail.
The Company has also added data products to its portfolio of products.
The Company offers US LECnet (a direct, dedicated, high-speed connection to the
Internet), frame relay, digital private line and a number of other services such
as email, news feeds and web hosting.
The Company's ability to bundle local, long distance and data services
on the same facility allows it to offer its customers more efficient use of
transport facilities and allows it to aggregate customers' monthly recurring and
usage charges on a single consolidated invoice.
In the third quarter of 2000, the Company introduced the ADVANTAGE T, a
single-rate, bundled
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product offering which allows customers to put local, long distance, dedicated
high-speed Internet access, digital private line and toll-free services all on a
single T-1. Not only can customers choose between multiple products to be
carried, but they can also allocate bandwidth dedicated to each product on the
T-1. Management believes that the development of this product allows US LEC to
expand the total market to which the Company has access.
SALES AND MARKETING
Sales. US LEC employs a highly motivated and experienced direct sales
force. The Company recruits salespeople with strong sales backgrounds in its
markets, including salespeople from long distance companies, telecommunications
equipment manufacturers, network systems integrators, CLECs and ILECs. The
Company expanded its quota-bearing sales force from 127 salespeople at December
31, 1999 to 234 salespeople at December 31, 2000. Management expects to further
increase the Company's sales force to approximately 300 salespeople by the end
of 2001. The Company plans to continue to attract and retain highly qualified
salespeople by offering them an opportunity to work with an experienced
management team in an entrepreneurial environment and to participate in the
potential economic rewards made available through a results-oriented
compensation program. In 2000, US LEC implemented the Customer Account Manager
("CAM") program in an effort to gain additional sales from current customers and
to enhance the Company's relationships with its customer base. The Company also
utilizes independent sales agents to identify and maintain customers.
Marketing. In its existing markets, US LEC seeks to position itself as a
high quality alternative to ILECs and other CLECs for local telecommunication
services by offering network reliability, bundled products and superior customer
support at competitive prices. The Company builds its reputation and brand
identity by working closely with its customers to develop services tailored to
their particular needs and by implementing targeted product offerings and
promotional efforts.
The Company primarily uses three trademarks and service marks: US LEC, a
logo that includes US LEC, and THE COMPETITIVE TELEPHONE COMPANY. These marks
have been registered either on the Principal or the Supplemental Register of the
United States Patent and Trademark Office for uses related to telecommunications
products and services.
Customer Service. Management believes that the Company's ability to
provide superior customer service is a key factor in acquiring new customers and
retaining existing customers. The Company has developed a customer service
strategy that is designed to effectively meet the service requirements of its
target customers. Customer support is provided in a two-tiered structure: the
local operations, sales and account support personnel, and to support these
locally-based teams, a centrally based customer service center and NOC.
Billing. In 2000, the Company migrated its billing function in-house,
allowing the Company to realize cost savings and provide additional services to
customers. Customer bills are available in a variety of formats to meet a
customer's specific needs. US LEC offers customers simplicity and convenience by
sending one bill for all services.
SIGNIFICANT CUSTOMER
In fiscal 1998, 1999, and 2000, BellSouth, operating in the majority of
the Company's markets, accounted for approximately 80%, 70%, and 15%,
respectively, of the Company's net revenue (before reduction for the $12,000,
$27,823 and $0 allowance in 1998, 1999, and 2000, respectively, described above
and in Note 7 to the Company's Consolidated Financial Statements). The majority
of this revenue was generated from reciprocal compensation. Although reciprocal
compensation owed to the Company by BellSouth is not a customer relationship in
the traditional sense, BellSouth is shown here due to the significant
contribution to revenue. At December 31, 1998, 1999, and 2000, BellSouth
accounted for 94%,
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92%, and 70% of the Company's total accounts receivable before allowance,
respectively. The majority of such receivables and revenues in 1998 and 1999,
resulted from traffic associated with Metacomm, LLC ("Metacomm"), a customer of
the Company and BellSouth, which became a related party to the Company during
1998. During 2000, Metacomm ceased to be a customer of BellSouth and the Company
and no revenue was recorded in 2000 related to Metacomm traffic. As a result of
the March 31, 2000 order issued by the North Carolina Utilities Commission
("NCUC") denying reciprocal compensation to the Company from traffic associated
with the Metacomm network, the Company recorded a pre-tax, non-recurring,
non-cash charge of approximately $55,000 (See "Business -- Forward Looking
Statements and Risk Factors -- Disputed Revenue).
EMPLOYEES
As of December 31, 2000, the Company employed 816 people. The Company
expects to employ approximately
REGULATION
The following summary of regulatory developments and legislation does
not purport to describe all present and proposed federal, state and local
regulations and legislation affecting the telecommunications industry. Other
existing federal and state legislation and regulations are currently the subject
of judicial proceedings and legislation, legislative hearings and administrative
proposals which could change, in varying degrees, the manner in which this
industry operates. Neither the outcome of these proceedings and legislation, nor
their impact upon the telecommunications industry or the Company, can be
predicted at this time. This section also includes a brief description of
regulatory and tariff issues pertaining to the operation of the Company.
Overview. The Company's services are subject to varying degrees of
federal, state and local regulation. The Federal Communications Commission (the
"FCC") generally exercises jurisdiction over the facilities of, and services
offered by, telecommunications common carriers that provide interstate or
international communications. The state regulatory commissions (herein "PUCs")
retain jurisdiction over the same facilities and services to the extent they are
used to provide intrastate communications.
Federal Legislation. The Company must comply with the requirements of
common carriage under the Communications Act of 1934, as amended (the
"Communications Act"). The Telecom Act, enacted on February 8, 1996,
substantially revised the Communications Act. The Telecom Act establishes a
regulatory framework for the introduction of local competition throughout the
United States and was intended to reduce unnecessary regulation to the greatest
extent possible. Among other things, the Telecom Act preempts, after notice and
an opportunity for comment, any state or local government from prohibiting any
entity from providing telecommunications service.
The Telecom Act also establishes a dual federal-state regulatory scheme
for eliminating other barriers to competition faced by competitors to the
incumbent local exchange carriers and other new entrants into the local
telephone market. Specifically, the Telecom Act imposes on ILECs certain
interconnection obligations, some of which are implemented by FCC regulations.
The Telecom Act contemplates that states will apply the federal regulations and
oversee the implementation of all aspects of interconnection not subject to FCC
jurisdiction as they oversee interconnection negotiations between ILECs and
their new competitors.
The FCC has significant responsibility in the manner in which the
Telecom Act will be implemented especially in the areas of pricing, universal
service, access charges and price caps. The details of the rules adopted by the
FCC will have a significant effect in determining the extent to which barriers
to competition in local services are removed, as well as the time frame within
which such barriers are eliminated.
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The PUCs also have significant responsibility in implementing the
Telecom Act. Specifically, the states have authority to establish
interconnection pricing, including unbundled loop charges, reciprocal
compensation and wholesale pricing consistent with the FCC regulations. The
states are also charged under the Telecom Act with overseeing the arbitration
process for resolving interconnection negotiation disputes between CLECs and the
ILECs and must approve interconnection agreements, and resolve contract
compliance disputes arising from interconnection agreements. (See "Business --
Forward Looking Statements and Risk Factors -- Disputed Revenues" for a
discussion of the actions before PUCs related to the Company's interconnection
agreement with BellSouth).
The Company has historically earned a significant portion of its revenue
from the ILEC in the form of reciprocal compensation payments due to the
Company. Several ILECs in the Company's territory (principally BellSouth) have
challenged the applicability of the reciprocal compensation related to enhanced
service providers and ISP customers receiving more calls than they make. With
increasing frequency the ILECs with whom US LEC interconnects (principally
BellSouth) have been raising additional objections to their obligations to pay
reciprocal compensation, including challenges to the rates at which such
payments are calculated and the types of traffic to with the obligations apply
(See "Business -- Forward Looking Statements and Risk Factors -- Disputed
Revenues").
The obligations imposed on ILECs by the Telecom Act to promote
competition, such as local number portability, dialing parity, reciprocal
compensation arrangements and non-discriminatory access to telephone poles,
ducts, conduits and rights-of-way also apply to CLECs, including the Company. As
a result of the Telecom Act's applicability to other telecommunications
carriers, it may provide the Company with the ability to reduce its own
interconnection costs by interconnecting directly with non-ILECs, but may also
cause the Company to incur additional administrative and regulatory expenses in
responding to interconnection requests. At the same time, the Telecom Act also
makes competitive entry into other service or geographic markets more attractive
to Regional Bell Operating Companies ("RBOC"), other ILECs, long distance
carriers and other companies and has increased and likely will continue to
increase the level of competition the Company faces. (See "Business --
Competition").
In addition, the Telecom Act provided that ILECs that are subsidiaries
of RBOCs could not offer in-region, long distance services across LATAs until
they had demonstrated that (i) they have entered into an approved
interconnection agreement with a facilities-based CLEC or that no such CLEC has
requested interconnection as of a statutorily determined deadline, (ii) they
have satisfied a 14-element checklist designed to ensure that the ILEC is
offering access and interconnection to all local exchange carriers on
competitive terms and (iii) the FCC has determined that in-region, inter-LATA
approval is consistent with the public interest, convenience and necessity. The
FCC approved Verizon's right to provide interLATA service in New York and SBC's
in Texas, Kansas and Oklahoma, which to the Company's knowledge are the only
interLATA applications by an RBOC that have been approved to date (See "Business
- -- Forward Looking Statements and Risk Factors--Regulation" and "Business --
Forward Looking Statements and Risk Factors--Competition").
Federal Regulation And Related Proceedings. The Telecom Act and the
FCC's efforts to initiate reform have resulted in numerous legal challenges. As
a result, the regulatory framework in which the Company operates is subject to a
great deal of uncertainty. Any changes that result from this uncertainty could
have a material adverse effect on the Company. The FCC has adopted orders
eliminating tariff filing requirements for non-dominant carriers providing
interstate access and domestic interstate long distance services. Although the
FCC order was stayed by the United States Court of Appeals for the District of
Columbia Circuit, that stay has now been lifted. Accordingly, non-dominant
interstate services providers will no longer be able to rely on the filing of
tariffs with the FCC as a means of providing notice to customers of prices,
terms, and conditions under which they offer their domestic interstate
inter-exchange services. During 2001, the Company is required to cancel such
federal tariffs as a result of the FCC's orders. Tariff filing requirements
remain in place for international traffic.
The FCC also has proposed reducing the level of regulation that applies
to the ILECs, and increasing their ability to respond quickly to competition
from the Company and others. For example, in
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accordance with the Telecom Act, the FCC has applied "streamlined" tariff
regulation to the ILECs, which greatly accelerates the time prior to which
changes to tariffed service rates may take effect, and has eliminated the
requirement that ILECs obtain FCC authorization before constructing new domestic
facilities. These actions will allow ILECs to change service rates more quickly
in response to competition. Similarly, the FCC has afforded significant new
pricing flexibility to ILECs subject to price cap regulation. On August 5, 1999,
the FCC adopted an order granting price cap ILECs additional pricing
flexibility. The order provides certain immediate regulatory relief regarding
price cap ILECs and sets forth a framework of "triggers" to provide those
companies with greater flexibility to set rates for interstate access services.
The order also initiated a rulemaking to determine whether the FCC should
regulate the access charges of CLECs, such as the Company. On February 2, 2001,
the D.C. Circuit upheld the FCC rules regarding pricing flexibility. To the
extent such increased pricing flexibility is utilized for ILECs or such
additional regulation is implemented, the Company's ability to compete with
ILECs for certain service could be adversely affected. The FCC has recently
granted pricing flexibility applications for switched access services provided
by BellSouth in a number of cities in its service territory, including in
several of the Company's markets. The FCC also granted flexible pricing
authority for dedicated transport and special access services provided by SBC
entities in certain cities, and for dedicated transport and special access
services provided by Verizon entities in certain cities.
The FCC has taken several actions related to the assignment of telephone
numbers, first in July 1995 mandating the responsibility for administering and
assigning local telephone numbers be transferred from the RBOCs and a few other
ILECs to a neutral entity, and second in July 1996 adopting a regulatory
structure under which a wide range of number portability issues would be
resolved. In March 1997, the FCC affirmed its number portability rules, but it
extended slightly certain deadlines for the implementation of true number
portability. The FCC has established cost recovery rules for long-term number
portability.
On August 8, 1996, the FCC issued an order containing rules providing
guidance to the ILECs, CLECs, long distance companies and PUCs regarding several
provisions of the Telecom Act. The rules include, among other things, FCC
guidance on: (i) discounts for end-to-end resale of ILEC retail local exchange
services (which the FCC suggested should be in the range of 17%-25%); (ii)
availability of unbundled local loops and other unbundled ILEC network elements;
(iii) the use of Total Element Long Run Incremental Costs in the pricing of
these unbundled network elements; (iv) average default proxy prices for
unbundled local loops in each state; (v) mutual compensation proxy rates for
termination of ILEC/CLEC local calls; and (vi) the ability of CLECs and other
service providers to opt into portions of previously-approved interconnection
agreements negotiated by the ILECs with other parties on a most favored nation
(or a "pick and choose") basis. (See "Regulation -- Eighth Circuit Court of
Appeals Decision and Supreme Court Reversal" for a discussion of the Eighth
Circuit Court of Appeals decision related to this order).
On May 8, 1997, the FCC released an order establishing a significantly
expanded federal universal service program which subsidized certain eligible
services. For example, the FCC established new subsidies for services provided
to qualifying schools and libraries with an annual cap of $2.25 billion and for
services provided to rural health care providers with an annual cap of $400
million. The FCC also expanded the federal subsidies to low-income consumers and
consumers in high-cost areas. Providers of interstate telecommunications
service, such as the Company, as well as certain other entities, must pay for
these programs. The Company's share of the schools, libraries and rural health
care funds is based on its share of the total industry telecommunications
service and certain defined telecommunications end user revenues. The Company's
share of all other federal subsidy funds is based on its share of the total
interstate telecommunications service and certain defined telecommunications end
user revenues. Although the Company has made its required contributions to the
fund, the amount of the Company's contribution changes each quarter. As a
result, the Company cannot predict the effect these regulations will have on the
Company in the future. In the May 8 order, the FCC also announced that it will
revise its rules for subsidizing service provided to consumers in high cost
areas. The United States Court of Appeals for the Fifth Circuit upheld those
rules.
In a combined Report and Order and Notice of Proposed Rulemaking
released on December 24, 1996, the FCC made changes and proposed further changes
in the interstate access charge structure. In the
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Report and Order, the FCC removed restrictions on an ILEC's ability to lower
access prices and relaxed the regulation of new switched access services in
those markets where there are other providers of access services. If this
increased pricing flexibility is not effectively monitored by federal
regulators, it could have a material adverse effect on the Company's ability to
compete in providing interstate access services. On May 16, 1997, the FCC
released an order revising its access charge rate structure. The new rules
substantially increase the costs that ILECs subject to the FCC's price cap rules
("price cap LECs") recover through monthly, non-traffic sensitive access charges
and substantially decrease the costs that price cap ILECs recover through
traffic sensitive access charges. In the May 16 order, the FCC also announced
its plan to bring interstate access rate levels more in line with cost. The plan
will include rules to be established that grant price cap LECs increased pricing
flexibility upon demonstrations of increased competition (or potential
competition) in relevant markets. The manner in which the FCC implements this
approach to lowering access charge levels could have a material effect on the
Company's ability to compete in providing interstate access services. Several
parties have appealed the May 16 order. Those appeals were consolidated and
transferred to the United States Court of Appeals for the Eighth Circuit which
upheld the Commission's rules.
The FCC has made and is continuing to consider various reforms to the
existing rate structure for charges assessed on long distance carriers for
allowing them to connect to local networks. These reforms are designed to move
these "access charges," over time, to lower, cost-based rate levels and
structures. These changes will reduce access charges and will shift charges,
which had historically been based on minutes-of-use, to flat-rate, monthly per
line charges on end-user customers rather than long distance carriers. On May
31, 2000 the FCC adopted the proposal of the Coalition for Affordable Long
Distance Service ("CALLS Order") that significantly restructures and, reduces in
some respects, the interstate access charges of the RBOCs, Verizon, AT&T, and
Sprint. Among the more significant regulatory changes established by the CALLS
Order, the RBOCs and Verizon are required to reduce switched access charges to
an average of $0.0055/minute. Price cap ILECs are additionally required to
eliminate the pre-subscribed inter-exchange carrier charge ("PICC") as a
separate charge and fold it into an increased subscriber line charge ("SLC").
AT&T and Sprint have committed in this proceeding to pass on access charge
reductions to consumers, and to eliminate minimum monthly usage charges.
Although the CALLS Order will not apply directly to CLECs, ILEC reductions in
switched access charges will likely place downward pressure on CLECs, including
the Company, to reduce their own switched access charges either in the form of
regulatory pressure or commercial pressure from the IXCs. In addition, IXCs
other than AT&T and Sprint are not subject to the CALLS Order, but may seek to
alter their offerings to conform to AT&T's and Sprint's commitments in this
proceeding. A Petition for Reconsideration of the CALLS Order is currently
before the FCC.
On February 26, 1999, the FCC issued a declaratory ruling and notice of
proposed rulemaking concerning ISP traffic. The FCC concluded in its ruling that
ISP traffic is jurisdictionally mixed, but largely interstate in nature. The FCC
has requested comment as to what reciprocal compensation rules should govern
this traffic upon expiration of existing interconnection agreements. The FCC
also determined that no federal rule existed that governed reciprocal
compensation for ISP traffic at the time existing interconnection agreements
were negotiated and concluded that it should permit states to determine whether
reciprocal compensation should be paid for calls to ISPs under existing
interconnection agreements. In light of the FCC order, state commissions which
previously addressed this issue and required reciprocal compensation to be paid
for ISP traffic may reconsider and may modify their prior rulings. To date,
seven PUCs in states where the Company has earned reciprocal compensation have
affirmed their prior position on this issue. The FCC order has been appealed by
several parties. On March 24, 2000, the United States Court of Appeals for the
D.C. Circuit vacated the FCC's February 26, 1999 declaratory ruling and remanded
it to the FCC. The D.C. Circuit Court of Appeals found that the FCC failed to
clearly explain and support why ISP traffic should be regulated as long distance
traffic rather than as local traffic. This ruling means the FCC will have to
reexamine its rules covering reciprocal compensation as they apply to ISP-bound
traffic. The Company cannot predict the results of such reexamination.
The Company also anticipates that the FCC will initiate a number of
additional proceedings, of its own volition and as a result of requests from
CLECs and others, as a result of the Telecom Act.
10
The FCC also requires carriers to file periodic reports concerning
carriers interstate circuits and deployment of network facilities. The FCC
generally does not exercise direct oversight over cost justification and the
level of charges for services of non-dominant carriers, although it has the
power to do so. The FCC also imposes prior approval requirements on transfers of
control and assignments of operating authorizations. The FCC has the authority
to generally condition, modify, cancel, terminate, or revoke operating authority
for failure to comply with federal laws or rules, regulations and policies of
the FCC. Fines or other penalties also may be imposed for such violations.
Although the Company believes it is in compliance with all applicable laws and
regulations, there can be no assurance that the FCC or third parties will not
raise issues with regard to the Company's compliance with such laws and
regulations.
Eighth Circuit Court Of Appeals Decisions And The Supreme Court
Reversal. Various parties, including ILECs and state PUCs, requested that the
FCC reconsider its own rules and/or filed appeals of the FCC's August 8, 1996
order.
The U.S Court of Appeals for the Eighth Circuit ("8th Circuit") held
that, in general, the FCC does not have jurisdiction over prices for
interconnection, resale, leased unbundled network elements ("UNEs") and traffic
termination. The 8th Circuit also overturned the FCC's "pick and choose" rules
as well as certain other FCC rules implementing the Telecom Act's local
competition provisions. In addition, the 8th Circuit decisions substantially
limited the FCC's authority to enforce the local competition provisions of the
Telecom Act. On January 25, 1999, U.S. Supreme Court reversed the 8th Circuit
and upheld the FCC's authority to issue regulations governing pricing of
unbundled network elements provided by the ILECs in interconnection agreements
(including regulations governing reciprocal compensation). In addition, the
Supreme Court affirmed the "pick and choose" rules which allows carriers to
choose individual portions of existing interconnection agreements with other
carriers and to opt-in only to those portions of the interconnection agreement
that they find most attractive. The Supreme Court did not, however, address
other challenges raised about the FCC's rules at the 8th Circuit because the 8th
Circuit did not decide those challenges. In addition, the Supreme Court
disagreed with the standard applied by the FCC for determining whether an ILEC
should be required to provide a competitor with particular unbundled network
elements. On remand, the FCC largely retained its list of unbundled elements,
but eliminated the requirement that ILECs provide unbundled access to local
switching for customers with four or more lines in the top 50 MSAs, and the
requirement to provide unbundled operator service and directory assistance.
On July 18, 2000, the 8th Circuit issued its order concerning the issues
left unresolved by the Supreme Court. It vacated the FCC's rules regarding the
discount on retail services that ILECs must provide to CLECs, the costing rules
that must be applied in determining the price of unbundled network elements from
ILECs, and the requirement that ILECs must provision combinations of UNEs that
are not already combined. The Supreme Court will hear the latter two issues in
its coming term. It is not possible to predict the outcome of that decision. The
Company does not currently purchase or provision UNEs, and does not anticipate
any adverse effects as a result of the regulation of these two services.
The 8th Circuit decisions and the reversal by the Supreme Court continue
to create uncertainty about the rules governing pricing terms and conditions of
interconnection agreements. This uncertainty makes it difficult to predict
whether the Company will have the ability to negotiate acceptable
interconnection agreements in the future should the Company decide to resale
ILEC services or purchase or provision UNEs.
In August 1998, the FCC determined that high-speed wire-line data
services are telecommunications services subject to regulation under Sections
251 and 252 of the Telecom Act. In the same order, the FCC issued a notice of
proposed rulemaking on terms for the provision of such services on a separate
subsidiary basis. Permitting ILECs to provision data services through separate
affiliates with fewer regulatory requirements could have a material adverse
impact on the Company's ability to compete in the data services sector. The FCC
imposed conditions on the merger of SBC with Ameritech in October 1999 that
permit the provisioning of high-speed wire-line data services via separate
subsidiaries pursuant to various requirements. The D.C. Circuit vacated the
separate subsidiary requirement on January 9, 2001. The
11
Company cannot predict whether these requirements will ultimately prove
enforceable, nor whether they will deter anti-competitive conduct if they are
enforceable.
Slamming. The FCC and many state PUCs have implemented rules to prevent
unauthorized changes in a customer's pre-subscribed local and long distance
carrier (a practice commonly known as "slamming.") Pursuant to the FCC's
slamming rules, a carrier found to have slammed a customer is subject to
substantial fines. In addition, the FCC's slamming rules were revised effective
November 2000 to include new provisions governing liability for slamming, and
provisions allowing state PUCs to elect to administer and enforce the FCC's
slamming rules. These new slamming liability rules substantially increase a
carrier's possible liability for unauthorized carrier changes, and may
substantially increase a carrier's administrative costs in connection with
alleged unauthorized carrier changes (even if the carrier can provide valid
proof that such changes were authorized). Under the new rules, carriers must
immediately remove from the customer's bill all charges incurred within 30 days
following an alleged slam. If the FCC (or the relevant state PUC) determines
that the carrier has slammed the customer, and the customer has not yet paid the
bill, the customer will be absolved from any charges for the first 30 days
following the slam (whereas if the carrier provides clear and convincing proof
that the consumer authorized the change, the carrier may re-bill the customer.)
If the FCC (or relevant state PUC) determines that a carrier has slammed a
customer and the customer has already paid the unauthorized carrier, the
unauthorized carrier must remit to the authorized carrier 150% of all payments
received from a slammed customer. The authorized carrier must in turn remit 50%
of the amount received from the unauthorized carrier back to the slammed
customer. The new slamming liability rules have been appealed to the United
States Court of Appeals for the District of Columbia Circuit. Although the
Company cannot predict the effect that these new liability rules will have on
its business, because virtually all of the Company's customers are connected on
a dedicated basis to US LEC's network, it is unlikely that the Company will
incur any significant liability under these new rules. The FCC also issued
revised rules in August 2000 that are expected to become effective in April 2001
or shortly thereafter, regarding the procedures for changing a subscriber's
pre-subscribed carrier, and establishing new carrier reporting and registration
requirements. Implementation of these new rules may increase the Company's costs
of administering long distance service accounts.
State Regulation. The Company has all of the certifications necessary to
offer its current services in the states of:
State
-----
North Carolina
Georgia
Virginia
Tennessee
South Carolina
Florida
Alabama
Washington, D.C.
Pennsylvania
Maryland
Delaware
New Jersey
New York
Massachusetts
Kentucky
Mississippi
Ohio
Texas
Connecticut
Louisiana
Indiana
12
There are no applications for certification currently pending before any
PUC or the FCC.
To the extent that an area within a state in which the Company operates
is served by a small (in line counts) or rural ILEC not currently subject to
competition, the Company generally does not have authority to service those
areas at this time. Most states regulate entry into local exchange and other
intrastate service markets, and states' regulation of CLECs vary in their
regulatory intensity. The majority of states mandate that companies seeking to
provide local exchange and other intrastate services apply for and obtain the
requisite authorization from the PUC. This authorization process generally
requires the carrier to demonstrate that it has sufficient financial, technical,
and managerial capabilities and that granting the authorization will serve the
public interest.
As a CLEC, the Company is subject to the regulatory directives of each
state in which the Company is certified. In addition to tariff filing
requirements, most states require that CLECs charge just and reasonable rates
and not discriminate among similarly situated customers. Some states also
require the filing of periodic reports, the payment of various regulatory fees
and surcharges, and compliance with service standards and consumer protection
rules. States also often require prior approvals or notifications for certain
transfers of assets, customers or ownership of a CLEC. States generally retain
the right to sanction a carrier or to revoke certifications if a carrier
violates relevant laws and/or regulations.
In all of the states where US LEC is certified, the Company is required
to file tariffs or price lists setting forth the terms, conditions and/or prices
for services which are classified as intrastate. In some states, the Company's
tariff may list a range of prices or a ceiling price for particular services,
and in others, such prices can be set on an individual customer basis, although
the Company may be required to file tariff addenda of the contract terms. The
Company is not subject to price cap or to rate of return regulation in any state
in which it currently provides services. Some states where the Company operates
have adopted de-tarriffing rules
As noted above, the states have the primary regulatory role over
intrastate services under the Telecom Act. The Telecom Act allows state
regulatory authorities to continue to impose competitively neutral and
nondiscriminatory requirements designed to promote universal service, protect
the public safety and welfare, maintain the quality of service and safeguard the
rights of consumers. PUCs will implement and enforce most of the Telecom Act's
local competition provisions, including those governing the specific charges for
local network interconnection. In some states, those charges are being
determined by generic cost proceedings and in other states they are being
established through arbitration proceedings. Depending on how such charges are
ultimately determined, such charges could become a material expense to the
Company.
COMPETITION
As noted above, the regulatory environment in which the Company operates
is changing rapidly. The passage of the Telecom Act combined with other actions
by the FCC and state regulatory authorities continues to promote competition in
the provision of telecommunications services.
ILECs. In each market served by its networks, the Company faces, and
expects to continue to face, significant competition from the ILECs, which
currently dominate their local telecommunications markets as a result of their
historic monopoly position.
The Company competes with the ILECs in its markets for local exchange
services on the basis of product offerings, bundling, reliability,
state-of-the-art technology, price, network design, ease of ordering and
customer service. However, the ILECs have long-standing relationships with their
customers and provide those customers with various transmission and switching
services, a number of which the Company does not currently offer. In addition,
ILECs enjoy a competitive advantage due to their vast financial resources. The
Company has sought, and will continue to seek, to achieve parity with the ILECs
in order to become able to provide a full range of local telecommunications
services. (See "Business -- Regulation" for additional information concerning
the regulatory environment in which the Company operates.) Because US LEC leases
fiber optic transmission capacity to link its customers with its networks, and
uses state-of-
13
the-art technology in its switch platforms, the Company has demonstrated cost
and service quality advantages over some currently available ILEC networks.
Other CLECs. In every market where US LEC has a switching center, one or
more other CLECs are also operating. In some cases, the Company competes
head-to-head with other CLECs and in some cases the other CLECs seek to serve a
different customer base. The Company competes with other CLECs in its markets on
the basis of product offerings, bundling, reliability, state-of-the-art
technology, price, network design, ease of ordering and customer service.
Other Competitors. The Company also faces, and expects to continue to
face, competition from other potential competitors in certain of the markets in
which the Company offers its services. In addition to the ILECs and other CLECs,
potential competitors capable of offering switched local and long distance
services include long distance carriers, cable television companies, electric
utilities, microwave carriers, wireless telephone system operators and private
networks built by large end-users. Many of these potential competitors enjoy
competitive advantages based upon existing relationships with subscribers, brand
name recognition and vast financial resources. A continuing trend toward
business combinations and alliances in the telecommunications industry may
create significant new competitors to the Company.
The Company believes that the Telecom Act, as well as a recent series of
completed and proposed transactions between ILECs and long distance companies
and cable companies, increase the likelihood that barriers to local exchange
competition will be removed. The Telecom Act, as passed, conditioned the
provision of in-region interLATA services by RBOCs upon a demonstration that the
market in which an RBOC seeks to provide such services has been opened to
competition. When ILECs that are RBOC subsidiaries are permitted to provide such
services they will be in a position to offer single source service which will
represent a significant competitive challenge for the Company. ILECs that are
not RBOC subsidiaries may offer single source service presently. The Telecom
Act's limitations on provision of in-region interLATA services have been
challenged by the RBOCs. (See "Business - Regulation").
The Company also competes with long distance carriers in the provision
of long distance services. Although the long distance market is dominated by a
few major competitors, hundreds of other companies also compete in the long
distance marketplace.
FORWARD LOOKING STATEMENTS AND RISK FACTORS
Except for historical statements and discussions, statements contained
in this report constitute "forward looking statements" within the meaning of
Section 27A of the Securities Act of 1933, as amended, and Section 21E of the
Securities Exchange Act of 1934, as amended. In addition, the Company's Annual
Report to Stockholders for the year ended December 31, 2000, Quarterly Reports
on Form 10-Q, Current Reports on Form 8-K and subsequently filed Annual Reports
on Form 10-K, may include forward looking statements. Other written or oral
statements which constitute forward looking statements have been made and may in
the future be made by or on behalf of US LEC, including statements regarding
future operating performance, share of new and existing markets, short-term and
long-term revenue, earnings and cash flow amounts, judicial, statutory and
regulatory developments and general industry growth rates and US LEC's
performance in relation thereto. These statements are identified by the use of
forward-looking terminology such as "believes," "expects," "may," "will,"
"should," "estimates" or "anticipates" or the negative thereof or other
variations thereon or comparable terminology, or by discussions of strategy that
involve risks and uncertainties. These forward looking statements are based on a
number of assumptions concerning future events, including the outcome of
judicial and regulatory proceedings, the adoption of balanced and effective
rules and regulations by the FCC and PUCs, and US LEC's ability to successfully
execute its strategy. These forward looking statements are also subject to a
number of uncertainties and risks, many of which are outside of US LEC's
control, that could cause actual results to differ materially from such
statements. These risks include, but are not limited to, the following:
Disputed Revenues. The deregulation of the telecommunications industry
and the implementation of the Telecommunications Act of 1996 have embroiled the
industry and the Company in numerous
14
proceedings in arbitration, state regulatory commissions, and the courts over
issues including reciprocal compensation and access rates, the characterization
of traffic for compensation purposes, and the interpretation of interconnection
agreements, among other issues. Rulings adverse to the Company on any of the
issues, which are material to it, could have an adverse impact on the Company's
financial results or its operations.
The Company is involved in several legal and regulatory proceedings
regarding revenues and receivables from ILECs, IXCs and other carriers. As of
December 31, 2000, the Company's gross accounts receivable was approximately
$115 million, of which approximately $77 million was attributed to BellSouth and
approximately $13 million was attributed to Sprint.
In the case of BellSouth, the majority of the receivables are being
disputed primarily due to issues regarding reciprocal compensation for ISPs and
certain rate issues. In the case of Sprint, a significant portion of the
receivable is being disputed based on access rates. The following paragraphs
discuss in detail each of the material disputes and associated regulatory or
legal proceeding.
The Metacomm Decision - As the Company has previously reported,
BellSouth Telecommunications, Inc. ("BellSouth") began a proceeding in September
1998 before the North Carolina Utilities Commission ("NCUC") seeking to be
relieved of any obligation under its interconnection agreements with the Company
to pay reciprocal compensation for traffic related to the network operated by
Metacomm, LLC ("Metacomm"), a customer of both the Company and BellSouth. On
March 31, 2000, the NCUC issued an order in this proceeding (the "March 31
Order") that relieved BellSouth from paying reciprocal compensation to the
Company for any minutes of use attributable to Metacomm network traffic and
required the Company to cease billing BellSouth reciprocal compensation for
minutes of use attributable to the Metacomm or any similar network as such
networks are identified in the March 31 Order. The March 31 Order does not
affect in any way the NCUC's order of February 1998 requiring BellSouth to pay
reciprocal compensation to the Company for Internet service provider ("ISP")
traffic in North Carolina (the "NCUC ISP Order"). It relates solely to traffic
on Metacomm's network in North Carolina (the only state in which Metacomm
operated). The Company did not appeal the March 31 Order, although Metacomm is
prosecuting an appeal.
As a result of the March 31 Order, the Company recorded a pre-tax,
non-recurring, non-cash charge of approximately $55 million in the first quarter
of 2000. The charge was composed of the write-off of approximately $153 million
in receivables related to reciprocal compensation revenue offset by previously
established reserves of $39 million and a reduction of $59 million in
commissions payable to Metacomm.
On March 21, 2000, the NCUC issued an interim order (the "March 21
Order") to BellSouth to pay to the Company all reciprocal compensation owing to
the Company for traffic terminated in North Carolina, other than traffic related
to Metacomm and like networks. This order was issued in connection with the
on-going proceeding before the NCUC filed in September 1998 by the Company in
which it seeks payment of reciprocal compensation not related to Metacomm or to
traffic terminated to ISPs, and of other amounts owing to the Company. The
Company's action before the NCUC to recover reciprocal compensation and other
charges for non-Metacomm/non-ISP traffic has been stayed by the NCUC while the
Company and BellSouth conduct NCUC-ordered negotiations to resolve the matter.
The amount due to the Company as a result of this proceeding will be determined
by the negotiations or subsequent ruling by the NCUC regarding the
non-Metacomm/non-ISP charges BellSouth is obligated to pay. The Company is
currently working with BellSouth to determine the amount BellSouth will pay
under the March 21, 2000 Order. Once this is determined by negotiation or NCUC
ruling, the Company will adjust the non-recurring charge relating to the March
31 Order. Management believes that this adjustment will not be material to the
Company's operating results or financial position. If the negotiations are
unsuccessful, the Company will seek a lifting of the stay and seek a hearing and
ruling from the NCUC on its claims against BellSouth.
In 2000, additional paid-in capital has been reduced by $36 million
representing amounts due from Metacomm, which is indirectly controlled by
Richard T. Aab, a majority stockholder of the Company. Due to Mr. Aab's
controlling position in both Metacomm and the Company, this amount is being
treated for financial reporting purposes as a deemed distribution to the
stockholder. At the time such amounts are paid to the Company, the payment will
increase additional paid-in capital as a capital contribution to the Company.
(See Note 14 to the Company's Consolidated Financial Statements)
Other Disputed Reciprocal Compensation Revenue - The Company is also a
party to the following material proceedings in which it seeks collection of
outstanding amounts owed by incumbent local telephone companies, primarily
BellSouth, for non-Metacomm related reciprocal compensation,
15
including reciprocal compensation related to traffic terminating to ISPs and
other customers:
North Carolina -- On February 26, 1998, following a petition by the
Company, the NCUC ordered BellSouth to bill and pay for all ISP-related traffic
(defined above, the "NCUC ISP Order"). Following motions filed by BellSouth, the
NCUC stayed enforcement of its order until June 1, 1998. On April 27, 1998,
BellSouth filed a petition for judicial review of the NCUC ISP Order and an
action for declaratory judgment and other relief (including a request for an
additional stay) with the United States District Court for the Western District
of North Carolina ("U.S. District Court-NC") pending determination of certain
related issues by the Federal Communications Commission ("FCC"). This action was
filed against the Company and the NCUC. In June 1999, the U.S. District Court-NC
dismissed BellSouth's petition without prejudice and remanded it back to the
NCUC for further review. Following the U.S District Court-NC's remand, on June
22, 1999, the NCUC denied BellSouth's request for a further stay of the NCUC ISP
Order.
In addition to denying BellSouth's request for a further stay, the NCUC
filed an appeal with the U.S. Fourth Circuit Court of Appeals (the "4th
Circuit") of the U.S. District Court-NC's order that rejected the NCUC's
defenses, including its defense that the 11th Amendment to the United States
Constitution bars BellSouth from making the NCUC a party to a proceeding in the
federal courts. The Company also appealed and the United States Justice
Department intervened in the appeal. On February 14, 2001 the 4th Circuit issued
a ruling in favor of the Company and the NCUC, ruling that the U.S. District
Court - NC did not have subject matter jurisdiction over the appeal of an
enforcement proceeding and ruling the NCUC was immune from suit under the
Eleventh Amendment of the United States Constitution. On March 5, 2001, the
United States Supreme Court granted a petition for certiorari in which it agreed
to consider these issues in a case originating in the U.S. Circuit Court of
Appeals for the Seventh Circuit. The Company anticipates that BellSouth will
seek review of the Fourth Circuit Court's ruling by the Supreme Court as well.
On July 16, 1999, the Company received a payment of $11.2 million from
BellSouth representing a portion of the amounts due the Company for ISP
reciprocal compensation in North Carolina. In making the payment, BellSouth
stated that it was for ISP traffic the NCUC had ordered it to pay for in the
NCUC ISP Order, including late fees, and that it was reserving all of its appeal
rights with respect to the payment. BellSouth also stated that this payment did
not include any amounts at issue in its September 1998 NCUC proceeding regarding
Metacomm. This partial payment did not cover all outstanding non-Metacomm
related amounts the Company claims are due from BellSouth in North Carolina. In
addition, BellSouth has from time to time made payments to US LEC for reciprocal
compensation related to traffic terminated in North Carolina, but BellSouth has
not paid the entire amount due to the Company for non-Metacomm reciprocal
compensation.
Georgia -- On June 30, 1999, the Company filed a complaint against
BellSouth before the Georgia Public Service Commission ("GAPSC") concerning the
Company's first and second interconnection agreements with BellSouth in Georgia.
These interconnection agreements cover the period through June 1999. On May 17,
2000, the hearing officer reviewing the Company's first and second
interconnection agreements with BellSouth issued a recommended decision to the
GAPSC stating that BellSouth should be ordered to pay US LEC the disputed
reciprocal compensation at the end office rate, pending submission of evidence
by the Company showing that it is entitled to be compensated at the higher
tandem rate. On June 15, 2000, the GAPSC affirmed this recommended decision, and
issued an order requiring BellSouth to pay US LEC reciprocal compensation for
traffic to ISPs and other customers in Georgia at the end office rate (the
"GAPSC Order"). On July 12, 2000, US LEC filed evidence with the GAPSC regarding
its right to be compensated at the tandem rate. On July 14, 2000, BellSouth
filed an appeal of the GAPSC Order with the U.S. District Court for the Northern
District of Georgia ("U.S. District Court-GA") and with the Georgia Superior
Court in and for Fulton County, Georgia. BellSouth asked the Georgia state court
to cede the appeal to the U.S. District Court - GA and asked the latter court
for permission to pay amounts due into court to avoid paying US LEC pending
appeal. On July 18, 2000, the U.S. District Court- GA granted BellSouth's motion
to pay amounts due into court prior to receipt by the Company of any papers
related to that appeal. On October 2, 2000, the U.S. District Court - GA denied
the Company's request for reconsideration of the order allowing BellSouth to pay
amounts due into court. The Georgia State and Federal Courts are setting a
briefing schedule for the proceeding, and the Company and expects a decision
16
sometime in 2001. The GAPSC held a hearing on the tandem/end office rate issue
on March 8, 2001, but has not yet rendered a decision.
Florida -- On July 2, 1999, the Company filed a complaint against
BellSouth before the Florida Public Service Commission ("FLPSC") seeking
recovery of reciprocal compensation for ISP and other traffic in that state. The
FLPSC will also be called upon to decide issues in dispute between the Company
and BellSouth regarding the rate at which reciprocal compensation should be paid
for some of the traffic at issue. The hearing is scheduled to take place later
in 2001.
Tennessee -- On August 6, 1999, the Company filed a complaint against
BellSouth before the Tennessee Regulatory Authority ("TRA") seeking recovery of
reciprocal compensation for ISP and other traffic in that state. The TRA will
also be called upon to decide issues in dispute between the Company and
BellSouth regarding the rate at which reciprocal compensation should be paid for
some of the traffic at issue. There is no hearing scheduled for this matter at
this time.
Management believes that the Company will ultimately obtain favorable
results in the state proceedings described above before the FLPSC and the TRA
and in the pending appeal of the NCUC ISP Order and the GAPSC Order with respect
to the eligibility of ISP traffic for reciprocal compensation. Management's
belief is supported by the determinations of state regulatory bodies and by
courts hearing appeals of the state regulatory decisions, which are discussed
below, notwithstanding the jurisdictional position on ISP traffic taken by the
FCC in February 1999, which has now been vacated, also discussed below. However,
BellSouth may elect to initiate additional proceedings (by way of appeal or
otherwise) or attempt to expand the pending proceedings challenging amounts owed
to the Company. In this regard, BellSouth has asserted a variety of other
objections to paying portions of the reciprocal compensation billed by the
Company. They include assertions that US LEC has miscalculated late payment fees
due from BellSouth and that the Company has billed reciprocal compensation using
the wrong rates. The Company believes BellSouth has asserted these issues and
will attempt to raise further issues, in order to avoid or delay payment. In
September 2000, the FLPSC issued a ruling regarding one of these rate issues
favorable to BellSouth in a proceeding bought by Intermedia Communications, Inc
("Intermedia"). The impact of this ruling has not yet been determined, and the
Company has been informed that Intermedia intends to appeal the decision.
Proceedings on the same issue are pending decision in Georgia and North
Carolina.
FCC's ISP Ruling and Related Proceedings -- In February, 1999, the FCC
issued a declaratory ruling (the "ISP Ruling") which concluded that for
jurisdictional purposes most calls delivered to ISPs should be deemed to
continue to Internet web sites, which are often located in other states. Thus,
the FCC ruled that such calls are jurisdictionally "interstate" in nature.
However, the FCC further declared that, in light of its long-standing policy of
treating calls to ISPs as though they were local, where parties have previously
agreed in interconnection agreements that reciprocal compensation must be paid
for traffic bound for ISPs, the parties should be bound by those agreements, as
interpreted and enforced by state regulatory bodies. The FCC also recognized
that some commissions might reconsider their decisions in light of its ruling.
On March 24, 2000, the U.S. Circuit Court for the District of Columbia
(the "D.C. Circuit") vacated the FCC's ISP Ruling. The D.C. Circuit ruled that
the FCC did not give adequate consideration to a number of facts when it found
that ISP calls were jurisdictionally interstate, including the FCC's own past
analyses of how to determine whether calls dialed to telephone numbers within
the local exchange are interstate or intrastate. The D.C. Circuit also concluded
that the FCC had failed to explain why its jurisdictional analysis had any
relevance to the issue of whether calls to ISPs should be eligible for
reciprocal compensation. The D.C. Circuit sent the case back to the FCC to give
the FCC opportunity to reconsider those questions in light of the D.C. Circuit's
ruling. On June 23, 2000, the FCC requested comments on the issues raised by the
D.C. Circuit in its remand of the ISP Ruling. Initial comments were filed on
July 21, 2000. Reply comments were filed on August 4, 2000. The Company cannot
predict when the FCC will issue its decision on remand.
To date, state regulatory bodies in at least thirty states have
considered the effect of the FCC's ISP
17
Ruling and have overwhelmingly reaffirmed their earlier decisions requiring
payment of reciprocal compensation for this type of traffic or for the first
time determined that such compensation is due. Included among these states are
Alabama, Florida, Georgia and Tennessee, which together with North Carolina (see
discussion above) represent the only states in BellSouth's operating territory
where the Company has significant reciprocal compensation disputes at December
31, 2000. In this regard, the Alabama Public Service Commission (the "APSC")
concluded that the treatment of ISP traffic as local was so prevalent in the
industry at the time BellSouth entered into interconnection agreements with
CLECs that, if it had so intended, BellSouth had an obligation to negate such
local treatment in the agreements by specifically delineating that ISP traffic
was not local traffic subject to the payment of reciprocal compensation. The
APSC decision was affirmed by the United States District Court for the Middle
District of Alabama, and the GAPSC decision was affirmed by the United States
District Court of the Northern District of Georgia. The FLPSC and the TRA have
also reaffirmed decisions that reciprocal compensation is owed for calls to
ISPs. Two BellSouth states - South Carolina and Louisiana - have ruled that
reciprocal compensation is not due for traffic to ISPs. These decisions, which
came before the FCC's ISP Ruling was vacated by the D.C. Circuit, represent a
view adopted by very few other states (The Company did not have ISP reciprocal
compensation recorded in 2000 for traffic in South Carolina or Louisiana.)
State and federal courts considering the issue on appeal have also
universally supported the position that reciprocal compensation is due for
traffic terminated to ISPs. Included among these are decisions of the U.S.
Circuit Courts of Appeal for the Fifth, Seventh, Ninth and Tenth Circuits, all
of which considered the issue in light of the FCC's ISP Ruling and affirmed the
underlying decisions of the state regulatory agencies that reciprocal
compensation is due for traffic terminated to ISPs.
If a decision adverse to the Company is issued in any of these
proceedings by any of the state commissions, or in any federal or state appeal
or review of a favorable decision, or if either the FCC or any of the applicable
state commissions was to alter its view of reciprocal compensation or if
Congress or any state legislature enacted legislation that ended reciprocal
compensation for ISP traffic or all local traffic, such an event could have a
material adverse effect on the Company's operating results and financial
condition. Management estimates the Company's gross trade accounts receivable as
of December 31, 2000 included approximately $54 million of earned, but
uncollected, disputed reciprocal compensation related to non-Metacomm related
ISP traffic.
Potential Future Proceedings. The proceedings described above relate to
certain of the Company's interconnection agreements. As the Company executes new
interconnection agreements or as ILECs raise additional disputes, the Company
may be required to initiate additional proceedings seeking payment of amounts it
believes it is owed.
Legislation - At the end of the last session of Congress, legislation
was introduced in the United States House of Representatives and the United
States Senate that would eliminate all reciprocal compensation for calls to ISPs
and, under some proposals, for all local calls. A House subcommittee approved a
version of this legislation. No action was taken in the Senate. If this or
similar legislation were to become law, it would have a material adverse effect
on the Company.
GTE Reciprocal Compensation Dispute in North Carolina - In addition to
the proceedings involving BellSouth which are discussed above, in February 2000,
the Company received payment from GTE South Incorporated ("GTE") (now Verizon
South Incorporated) for reciprocal compensation for traffic in North Carolina,
including ISP traffic. This payment was pursuant to a commercial arbitration
award rendered January 4, 2000 resulting from a proceeding before the American
Arbitration Association. GTE was ordered to pay US LEC for all reciprocal
compensation for the period ending September 1999 (approximately $650 thousand).
GTE challenged the decision of the arbitrator in the U.S. District Court for the
Eastern District of North Carolina. This challenge was denied by the U.S.
District Court for the Eastern District of North Carolina and judgement was
entered in the Company's favor on January 11, 2001. The judgement was not
appealed so it is a final judgement.
In addition, the Company has filed for arbitration to resolve its
reciprocal compensation dispute with GTE in North Carolina for periods after
September 1999. The hearing in this arbitration took place on
18
February 26-27, 2001, and all post-hearing briefs are scheduled to be filed by
April 23, 2001. Although the Company cannot predict when this arbitrator will
issue a decision, management knows of no reason why the second arbitration
should have an outcome different from the first, favorable arbitration ruling.
The Company anticipates that GTE will appeal any ruling adverse to it.
Existing BellSouth Interconnection Agreements -- In October 2000, the
Company agreed to adopt existing local interconnection agreements with BellSouth
in South Carolina, Kentucky, Louisiana and Mississippi. The Agreements are for a
term of two years and relate back to the expiration date of the prior agreements
in each state, and therefore will expire at varying dates in 2002. The
Agreements provide for reciprocal compensation at rates significantly lower than
in the Company's prior interconnection agreements. These agreements do not
provide for any reciprocal compensation payments for ISP traffic; rather, the
agreements include a true up provision whereby the parties will track that
traffic pending an order from the FCC on the issue. The Company does not have
significant amounts of reciprocal compensation in these states. The Company has
adopted new interconnection agreements in North Carolina, Florida and Tennessee,
all of which relate back to January 1, 2000 and which expire April 2002, October
2002 and November 2002, respectively. These agreements provide for reciprocal
compensation for all local traffic, including ISP traffic, at rates
significantly lower than in the Company's prior interconnection agreements.
However, the agreement for North Carolina provides for a true-up of payments
made for ISP traffic should the FCC determine that reciprocal compensation is
not owing for ISP traffic and that determination is given retroactive effect.
The Company continues to seek interconnection agreements with BellSouth in
Alabama and Georgia. The Company's existing agreements with BellSouth in these
states have expired, but continue in force until new interconnection agreements
are signed. BellSouth filed petitions for arbitration in these states seeking to
obtain state-ordered interconnection agreements, but the Company anticipates
that it will be able to avoid or shorten the arbitration process in these states
by adopting interconnection agreements that will result from recently concluded
arbitrations involving other CLECs. These new agreements will be effective as of
the expiration date of the prior agreements. The Company anticipates that new
interconnection agreements in these states will also provide for significantly
lower rates, but, unlike the agreements in South Carolina, Kentucky, Louisiana
and Mississippi, the Company does not anticipate that payment of reciprocal
compensation for ISP traffic would be affected by a true up provision.
Disputed Access Revenues - A number of IXCs have refused to pay access
charges to CLECs, including those of the Company, on the allegation that the
access charges exceed those of the ILEC serving that territory in an apparent
effort to induce the CLECs, including the Company, to reduce access charges.
Currently there are a number of court cases, regulatory proceedings at the FCC,
and legislative efforts involving such challenges. The Company cannot predict
the outcome of these cases, regulatory proceedings, and legislative efforts or
their impact on access rates. In February 2000, the Company filed suit in U.S.
District Court for the Western District of North Carolina against Sprint
Communications Company L.P. ("Sprint"). This action seeks to collect amounts
owed to the Company for access charges for intrastate and interstate traffic
which was either handed off to Sprint by the Company or terminated to the
Company by Sprint. As of December 31, 2000, Sprint owed the Company
approximately $13 million in access charges. Sprint has refused to pay the
amounts invoiced by the Company on the basis that the rates are higher than the
amounts that Sprint believes are just and reasonable. Sprint claims it is not
obligated to pay more than an undefined incumbent local exchange carrier
("ILEC") rate. The Company's invoices to Sprint are at the rates specified in
the Company's state and federal tariffs. The FCC recently determined that a long
distance company may not withhold interstate access charges on the basis that it
believes the charges to be too high while also continuing to accept the benefits
of interconnection with the local carrier without taking formal action to
challenge the rates. The FCC has ruled that AT&T was obligated to pay such
access charges due to its failure to commence a proceeding or terminate
interconnection. (MGC Communications, Inc. v. AT&T Corp., FCC Release 99-408).
This decision is now final, as AT&T did not appeal the FCC's ruling. In
addition, the FCC ruled recently in an action brought by Sprint against MGC
Communications, Inc. ("MGC") that the fact that a CLEC's filed interstate rates
exceeded those of the competing ILECs was insufficient to establish that the
CLEC's rates were excessive. The FCC dismissed Sprint's challenge to MGC's
rates. Sprint has appealed the FCC's decision to the United States Court of
Appeals for the District of Columbia Circuit, and oral argument is
19
scheduled for April 20, 2001. As a result of these rulings, management
Santicipates a favorable resolution of the Company's dispute with Sprint (See
Business - Forward Looking Statement and Risk Factors - "Legal Proceedings").
Risks Associated with Strategy. The operation, construction, expansion
and development of US LEC's operations depend on, among other things, the
Company's ability to continue to (i) accurately assess potential new markets and
products, (ii) identify, hire and retain qualified personnel, (iii) lease access
to suitable fiber optic transmission facilities, (iv) install and operate
switches and related equipment and (v) obtain any required government
authorizations, all in a timely manner, at reasonable costs and on satisfactory
terms and conditions. In addition, US LEC has experienced rapid growth since its
inception, and management believes that sustained growth will place a strain on
operational, human and financial resources. The Company's ability to manage its
operations and expansion effectively depends on the continued development of
plans, systems and controls for its operational, financial and management needs.
There can be no assurance that the Company will be able to satisfy these
requirements or otherwise manage its operations and growth effectively. The
failure of US LEC to satisfy these requirements could have a material adverse
effect on the Company's financial condition and its ability to fully implement
its operating plans.
The Company's growth strategy also involves the following risks:
Qualified Personnel. A critical component for US LEC's success is hiring
and retaining additional qualified managerial, sales and technical personnel.
Since its inception, the Company has experienced significant competition in
hiring and retaining personnel possessing necessary skills and
telecommunications experience. Although management believes the Company has been
successful in hiring and retaining qualified personnel, there can be no
assurance that US LEC will be able to do so in the future.
Switches and Related Equipment. An essential element of the Company's
current strategy is the provision of switched local service. There can be no
assurance that installation of the switches and associated equipment necessary
to implement the Company's business plan will be completed on a timely basis or
that the Company will not experience technological or operational problems that
cannot be resolved in a satisfactory or timely matter. The failure of the
Company to install and operate successfully switches and other network equipment
could have a material adverse effect on the Company's financial condition and
its ability to attract and retain customers or to enter additional markets.
Interconnection Agreements. The Company has agreements for the
interconnection of its networks with the networks of the ILECs covering each
market in which US LEC either has or is currently installing a switching
platform. US LEC may be required to negotiate new interconnection agreements as
it enters new markets in the future. In addition, as its existing
interconnection agreements expire, it will be required to negotiate extension or
replacement agreements. There can be no assurance that the Company will
successfully negotiate such additional agreements for interconnection with the
ILECs or renewals of existing interconnection agreements on terms and conditions
acceptable to the Company. The Company has signed interconnection agreements
with various ILECs, including BellSouth Telecommunications, Inc. ("BellSouth"),
Sprint Communications Company L.P. ("Sprint"), Verizon Communications
("Verizon") and other carriers. These agreements provide the framework for the
Company to serve its customers when other local carriers are involved. The
Company has signed multiple agreements with BellSouth which govern relationships
in all nine states (See Existing BellSouth Interconnection Agreements above).
Agreements with GTE are in force in states where GTE and the Company
operate. The agreement for Virginia expired in July 2000, and remains in force
and effect until a new agreement is executed. All other agreements expire during
2001 or 2002. The Company continued to seek new interconnection agreements in
these states.
The Company also has interconnection agreements with Verizon in the
states of Virginia, Pennsylvania, Maryland, Delaware, New Jersey and the
District of Columbia. Each of these agreements expired in 2000, and remains in
force and effect until a new agreement is entered into by Verizon and the
Company.
Agreements with Sprint are in force and effect in Florida, Virginia,
North Carolina and Tennessee.
20
Ordering, Provisioning And Billing. The Company has developed processes
and procedures and is working with external vendors, including the ILECs, in the
implementation of customer orders for services, the provisioning, installation
and delivery of such services and monthly billing for those services. The
failure to manage effectively processes and systems for these service elements
or the failure of the Company's current vendors or the ILECs to deliver
ordering, provisioning and billing services on a timely and accurate basis could
have a material adverse effect upon the Company's ability to fully execute its
strategy.
Products and Services. The Company currently offers local, long
distance, data, Internet and enhanced services. In order to address the needs of
its target customers, the Company will be required to emphasize and develop
additional products and services. No assurance can be given that the Company
will be able to provide the range of telecommunication services that its target
customers need or desire.
Acquisitions. US LEC may acquire other businesses as a means of
expanding into new markets or developing new services. The Company is unable to
predict whether or when any prospective acquisitions will occur or the
likelihood of a material transaction being completed on favorable terms and
conditions. Such transactions would involve certain risks including, but not
limited to, (i) difficulties assimilating acquired operations and personnel;
(ii) potential disruptions of the Company's ongoing business; (iii) the
diversion of resources and management time; (iv) the possibility that uniform
standards, controls, procedures and policies may not be maintained; (v) risks
associated with entering new markets in which the Company has little or no
experience; and (vi) the potential impairment of relationships with employees or
customers as a result of changes in management. If an acquisition were to be
made, there can be no assurance that the Company would be able to obtain the
financing to consummate any such acquisition on terms satisfactory to it or that
the acquired business would perform as expected.
Dependence on Key Personnel. The Company's business is managed by a
small number of executive officers, most notably Richard T. Aab, Chairman,
Tansukh V. Ganatra, Vice Chairman and Chief Executive Officer, Aaron D. Cowell,
Jr., President and Michael K. Robinson, Executive Vice President and Chief
Financial Officer. The loss of the services of one or more of these key people
could materially and adversely affect US LEC's business and its prospects. None
of the Company's executive officers have employment agreements and the Company
does not maintain key man life insurance on any of its officers. The competition
for qualified managers in the telecommunications industry is intense.
Accordingly, there can be no assurance that US LEC will be able to hire and
retain necessary personnel in the future to replace any of its key executive
officers, if any of them were to leave US LEC or be otherwise unable to provide
services to US LEC.
Reliance on Leased Capacity. A key element of US LEC's business and
growth strategy is leasing fiber optic transmission capacity instead of
constructing its own transport facilities. In implementing this strategy, the
Company relies upon its ability to lease capacity from CAPs, other CLECs and
LECs operating in its markets. In order for this strategy to be successful, the
Company must be able to negotiate and renew satisfactory agreements with its
fiber optic network providers, and the providers must process provisioning
requests on a timely basis, maintain their networks in good working order and
provide adequate capacity at competitive prices. Although US LEC enters into
agreements with its network providers that are intended to ensure access to
adequate capacity and timely processing of provisioning requests and although US
LEC's interconnection agreements with ILECs generally provide that the Company's
connection and maintenance orders will receive attention at parity with the
ILECs and other CLECs and that adequate capacity will be provided, there can be
no assurance that the ILECs and other network providers will comply with their
contractual (and, in the case of the ILECs, legally required) network
provisioning obligations, or that the provisioning process will be completed for
the Company's customers on a timely and otherwise satisfactory basis.
Furthermore, there can be no assurance that the rates to be charged to US LEC
under future interconnection agreements or lease agreements with other providers
will allow the Company to offer usage rates low enough to attract a sufficient
number of customers and operate its networks at satisfactory margins.
Competition. The telecommunications industry is highly competitive. In
each of the Company's existing and target markets, the Company competes and will
continue to compete principally with the
21
ILECs serving that area. ILECs are established providers of local telephone and
exchange access services to all or virtually all telephone subscribers within
their respective service areas. ILECs also have greater financial and personnel
resources, brand name recognition and long-standing relationships with customers
and with regulatory authorities at the federal and state levels and with most
long distance carriers.
The Company also faces, and expects to continue to face, competition
from other current and potential market entrants, including long distance
carriers seeking to enter, reenter or expand entry into the local exchange
marketplace, and from other CLECs, CAPs, cable television companies, electric
utilities, microwave carriers, wireless telephone system operators and private
networks built by large end-users. In addition, a continuing trend toward
combinations and strategic alliances in the telecommunications industry could
give rise to significant new competitors. Many of these current and potential
competitors have financial, personnel and other resources, including brand name
recognition, substantially greater than those of the Company, as well as other
competitive advantages over the Company.
The Company also competes with long distance carriers in the
provisioning of long distance services. Although the long distance market is
dominated by few major competitors, hundreds of other companies also compete in
the long distance marketplace.
In addition, the regulatory environment in which the Company operates is
undergoing significant change. As this regulatory environment evolves, changes
may occur which could create greater or unique competitive advantages for all or
some of the Company's current or potential competitors, or could make it easier
for additional parties to provide services. (See "Business -- Competition").
At December 31, 2000, the Company served over 3,900 customers. A key
element of the Company's future success will depend on its ability to retain
these customers and minimize loss of revenue associated with customer or
product churn. While the Company has historically achieved significant success
in retaining customers, competition in the Company's marketplace is intense and
the Company anticipates that other carriers will seek to persuade the Company's
customers to switch service provided for some or all of their products.
Regulation. Although passage of the Telecom Act has resulted in
increased opportunities for companies that are competing with the ILECs, no
assurance can be given that changes in current or future regulations adopted by
the FCC or state regulators or other legislative or judicial initiatives
relating to the telecommunications industry would not have a material adverse
effect on the Company. In addition, although the Telecom Act, as passed,
conditions RBOCs' provisioning of in-region long distance service on a showing
that the local market has been opened to competition, in the event a RBOC has
satisfied these conditions, it could (i) remove the incentive RBOCs presently
have to cooperate with companies like US LEC to foster competition within their
service areas so that they can qualify to offer in-region long distance by
allowing RBOCs to offer such services immediately and (ii) give the RBOCs the
ability to offer "one-stop shopping" for both long distance and local service.
In addition to the specific concerns regarding the RBOC's ability to
provide in-region long distance, the regulatory environment facing the Company
is subject to numerous uncertainties. The FCC and PUC orders that were designed
to implement the Telecom Act have been challenged in numerous proceedings. As a
result, the Company must attempt to execute its business strategy without
knowing the rules that will govern its operations and its dealings with other
telecommunications companies including the rates and terms under which it may
charge other carriers for reciprocal compensation and other access charges. Even
though a number of the past regulatory efforts by the FCC and PUCs are or have
been challenged, the Company expects further rule making from the FCC and PUCs.
The outcome of these challenges and the nature and scope of future rule making
are unknown. In particular, the Company anticipates further efforts by other
carriers, primarily ILECs and IXCs, at the FCC, PUC and in legislative
initiatives to seek to cap, reduce and/or eliminate reciprocal compensation and
to cap or significantly reduce other access charges. The Company cannot predict
the degree to which the ILECs and IXCs will be successful in such efforts, or,
if they are, when such changes will take effect. If such changes result in a
significant decrease in the rates which the Company may charge other carriers
for reciprocal compensation and access or if such charges are retroactive, such
changes could have a material adverse effect on the Company.
22
As the regulatory environment changes, it is possible that the Company's
strategy and its execution of the strategy may not be the optimal choice. Any
such changes could also result in additional, unanticipated expenses. There can
be no assurances that regulatory change will not have a material and adverse
effect on the Company. (See "Business -- Regulation").
Legal Proceedings. The Company is currently involved in arbitral,
administrative and judicial proceedings and appeals thereof to collect amounts
owed to the Company by other carriers, primarily BellSouth, Verizon and Sprint.
The Company cannot predict when these matters will be formally resolved and,
although Management anticipates that these pending actions and appeals will be
resolved favorably, no assurance can be given that the Company will be
ultimately successful in these actions or the appeals thereof or that the
Company will collect all amounts that it believes to be due it from these other
carriers, or that if it does collect some or all of the award due to it, when
payment of the awards will be received (See Disputed Revenues.)
Future Capital and Operating Requirements. Implementation of the
Company's business strategy will require significant capital and operating
expenditures during 2001 and future years. In December 1999, the Company amended
its senior secured credit facility increasing the amount available under the
facility to $150 million (the "Credit Facility"). In addition, in February 2000,
the Company announced it had executed a letter of intent with affiliates of Bain
Capital, Inc. and Thomas H. Lee Partners, L.P. to invest up to $300 million in
convertible preferred stock of US LEC (the "Preferred Stock Investment"). The
first tranche of $200 million closed on April 11, 2000. The option for an
additional $100 million will expire on April 11, 2001 and is not expected to be
exercised. (See "Item 7: Management's Discussion and Analysis of Financial
Condition and Results of Operations - Liquidity and Capital Resources"). The
Company's principal capital expenditures relate to the purchase and installation
of its switching platform, related infrastructure and facilities. Management
expects to satisfy its capital and operating requirements primarily with current
cash balances, borrowings under the Credit Facility and cash flow from
operations, although there can be no assurance that the actual expenditures
required to implement the Company's business strategy will not exceed amounts
available from these sources. In addition, the actual amount and timing of the
Company's future expenditures may differ materially from the Company's estimates
as a result of, among other things, the ability of the Company to meet its
planned expansion schedule, the number of its customers and the services for
which they subscribe and regulatory, technological and competitive developments
in the Company's industry. Due to the uncertainty of these factors, actual
revenues and costs may vary from expected amounts, possibly to a material
degree, and such variations are likely to affect the implementation of the
Company's business strategy.
The Company also will continue to evaluate revenue opportunities in
planned and other markets as well as potential acquisitions. The Company expects
to obtain the capital required to pursue additional opportunities from the
Credit Facility and other borrowings, the sale of additional equity or debt
securities or cash generated from operations. In light of the risk factors
discussed herein, there can be no assurance, however, that the Company will be
successful in raising sufficient additional capital on acceptable terms or that
the Company's operations will produce sufficient positive cash flow to pursue
such opportunities should they arise. Failure to raise and generate sufficient
funds, or unanticipated increases in capital requirements may require the
Company to delay or curtail its expansion plans, which could have a material
adverse effect on the Company's growth and its ability to compete in the
telecommunications services industry.
Variability of Quarterly Operating Results. As a result of the
significant expenses associated with the Company's expansion into new markets
and the anticipated decline in reciprocal compensation and access revenue, the
Company's operating results may vary significantly from period to period.
Control By Single Stockholder. As of March 20, 2001, Richard T. Aab
beneficially owned or otherwise controlled 100% of the outstanding shares of
Class B Common Stock representing approximately 91% of the Company's total
voting power. In addition, holders of Class B Common Stock are entitled to vote
as a separate class to elect two members of the Board of Directors and to vote
with the holders of Class A Common Stock for the election of other members of
the Board of Directors. As a result, Mr. Aab,
23
subject to the rights of the holders of the Company's Series A Mandatorily
Redeemable Convertible Preferred Stock, will be able to control the board and
all stockholder decisions and, in general, to determine (without the consent of
the Company's other stockholders) the outcome of any corporate transaction or
other matter submitted to the stockholders for approval, including mergers,
consolidations and the sale of all or substantially all of the Company's assets.
Mr. Aab also has the power to prevent or cause a change in control of the
Company. (See "Item 12: Security Ownership of Certain Beneficial Owners and
Management"). For information on a recent significant development effecting Mr.
Aab's voting control, see Management's Discussion and Analysis of Financial
Condition and Results of Operations and Footnote 14 to the Company's
Consolidated Financial Statements.
ITEM 2. PROPERTIES
The Company's corporate headquarters are located at its principal office
at Morrocroft III, 6801 Morrison Blvd., Charlotte, NC 28211. The Company leases
all of its administrative and sales offices and its switch sites. The various
leases expire in years ranging from 2001 to 2010. Most of these leases have
renewal options. Additional office space and switch sites will be leased or
otherwise acquired as the Company's operations and networks are expanded and as
new networks are constructed.
ITEM 3. LEGAL PROCEEDINGS
US LEC is not currently a party to any material legal proceedings, other
than the GPSC, TRA, FPSC, NCUC and U.S. District Court proceedings, the
arbitrations, and any appeals thereof, related to reciprocal compensation and
other amounts due from BellSouth and other ILECs and the U.S. District Court
proceeding related to access fees due from Sprint Communications (See
"Business--Regulation" and "Forward Looking Statements and Risk Factors" above
and Note 7 of the Company's consolidated financial statements for a detailed
description of these proceedings).
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS
No matters were submitted to a vote of security holders during the quarter
ending December 31, 2000.
24
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER
MATTERS
The Company's common stock trades on The Nasdaq National Market under the
symbol CLEC. As of March 20, 2001, US LEC Corp. had approximately 6,200
beneficial holders of its common stock. Of that total, 129 were stockholders of
record. To date, the Company has not paid cash dividends on its common stock.
The Company currently intends to retain earnings to support operations and
finance expansion and therefore does not anticipate paying cash dividends in the
foreseeable future.
The following table sets forth the high and low closing price information as
reported by Nasdaq during the period indicated since the Company's Class A
Common Stock began trading publicly on April 24, 1998.
Stock Price*
------------
1998 High Low
---- ---- ---
First Quarter N/A N/A
Second Quarter $27.00 $15.00
Third Quarter $25.88 $ 7.31
Fourth Quarter $14.81 $ 9.50
1999 High Low
---- ---- ---
First Quarter $19.50 $13.38
Second Quarter $24.62 $16.50
Third Quarter $33.13 $22.75
Fourth Quarter $32.25 $23.50
2000 High Low
---- ---- ---
First Quarter $46.31 $28.88
Second Quarter $33.64 $15.94
Third Quarter $17.00 $ 7.56
Fourth Quarter $11.22 $ 3.50
*No public market for the stock prior to April 24, 1998
25
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
SELECTED FINANCIAL DATA
For the years ended December 31, 1996, 1997, 1998, 1999 and 2000
(In Thousands, Except Per Share Data and Operating Data, as noted below)
**1996 1997 1998 1999 2000
------ ---- ---- ---- ----
Statement of Operations:
Revenue, Net $ - $ 6,458 $ 84,716 $ 175,180 $ 114,964
Cost of Services - 4,201 33,646 73,613 52,684
Gross Margin - 2,257 51,070 101,567 62,280
Selling, General and Administrative 942 6,117 25,020 48,375 80,684
Depreciation and Amortization 4 443 4,941 11,720 24,365
Loss on Resolution of Disputed Revenue* - - - - 55,345
Provision for Disputed Receivables* - - - - 40,000
Earnings (Loss) from Operations (946) (4,303) 21,109 41,472 (138,114)
Interest Income (Expense), Net (17) (355) 1,623 (2,046) (3,005)
Earnings (Loss) before Income Taxes (963) (4,658) 22,732 39,426 (141,119)
Income Taxes Provision (Benefit) - - 9,305 15,617 (23,727)
Net Earnings (Loss) (963) (4,658) 13,427 23,809 (117,392)
Less: Dividends on Preferred Stock - - - - 8,758
Less: Accretion of Preferred Stock Issuance Cost - - - - 336
Net Earnings (Loss) Attributable to Common Shareholders $ (963) $ (4,658) $ 13,427 $ 23,809 $(126,486)
Net Earnings (Loss) Per Share-Basic $ (0.06) $ (0.25) $ 0.53 $ 0.87 $ (4.58)
Net Earnings (Loss) Per Share-Diluted $ (0.06) $ (0.25) $ 0.52 $ 0.84 $ (4.58)
Weighted Average Shares Outstanding-Basic 17,310 18,653 25,295 27,431 27,618
Weighted Average Shares Outstanding-Diluted 17,310 18,653 25,804 28,411 27,618
Other Financial Data:
Capital Expenditures $ 280 $ 13,055 $ 47,292 $ 57,396 $ 109,740
Net Cash Flow Used in Operating Activities (1,079) (5,594) (19,143) (25,935) (49,319)
Net Cash Flow Used in Investing Activities (466) (5,951) (48,538) (49,696) (111,743)
Net Cash Flow Provided in Financing Activities 2,271 14,008 106,457 48,840 251,709
Operating Data:
Number of States Served - 1 4 7 12
Number of Local Switches - 3 11 16 23
Number of Customers - 142 558 1,946 3,929
Number of Employees 15 78 253 460 816
Number of Sales Employees 3 24 98 180 330
Balance Sheet Data:
Working Capital (Deficit) $ 937 $ (2,269) $ 76,215 $ 113,109 $ 112,402
Accounts Receivable, Net - 6,006 66,214 193,943 61,164
Current Assets 1,068 9,656 112,184 213,269 160,782
Property and Equipment, Net 276 12,889 56,219 102,002 188,052
Total Assets 1,467 22,681 170,203 320,100 373,158
Long-Term Debt 1,671 5,000 20,000 72,000 130,000
Series A Redeemable Convertible Preferred Stock - - - - 202,854
Total Stockholders' Equity (Deficiency) (355) 5,757 112,975 138,870 (22,250)
* See Note 7 of the Company's Consolidated Financial Statements for the
period ended December 31, 2000.
** The Company was a development stage enterprise in 1996. See Note 1 of
the Company's Consolidated Financial Statements for the period ended
December 31, 2000
26
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
Except for the historical information contained herein, this report
contains forward-looking statements, subject to uncertainties and risks,
including the demand for US LEC's services, the ability of the Company to
introduce additional products, the ability of the Company to successfully
attract and retain personnel, competition in existing and potential additional
markets, uncertainties regarding its dealings with ILECs and other
telecommunications carriers and facilities providers, regulatory uncertainties,
the possibility of adverse decisions related to reciprocal compensation and
access charges owing to the Company by BellSouth, Sprint and other carriers, as
well as the Company's ability to begin operations in additional markets. These
and other applicable risks are summarized in the "Forward-Looking Statements and
Risk Factors" section and elsewhere in the Company's Annual Report on Form 10-K
for the period ended December 31, 2000, and in other reports which are on file
with the Securities and Exchange Commission.
The following discussion and analysis should be read in conjunction with
the "Selected Consolidated Financial Data" on page 26 of this report and the
Company's consolidated financial statements and related notes thereto appearing
elsewhere in this report.
Company Overview
US LEC is a rapidly growing switch-based competitive local exchange
carrier ("CLEC") that provides integrated telecommunications services to its
customers. The Company primarily serves telecommunication-intensive customers
including businesses, universities, financial institutions, professional service
firms, hospitals, enhanced service providers ("ESPs"), Internet service
providers ("ISPs"), and hotels. US LEC was founded in June 1996 after passage of
the Telecommunications Act of 1996 (the "Telecom Act"), which enhanced the
competitive environment for local exchange services. US LEC initiated service in
North Carolina in March 1997, becoming one of the first CLECs in North Carolina
to provide switched local exchange services. US LEC currently offers local,
long-distance, data and enhanced services to customers in selected markets in
North Carolina, Florida, Georgia, Tennessee, Virginia, Alabama, Washington D.C.,
Pennsylvania, Mississippi, Maryland, South Carolina, Louisiana and Kentucky. In
addition, US LEC is currently certified to provide telecommunication services in
Indiana, Delaware, New Jersey, New York, Ohio, Texas, Connecticut and
Massachusetts. As of December 31, 2000, US LEC's network was comprised of 23
Lucent 5ESS(R) AnyMedia(TM) digital switches and 17 Lucent CBX500 ATM data
switches that are located throughout the Southeast and mid-Atlantic states, in
addition to an Alcatel MegaHub(R) 600ES switch in Charlotte, North Carolina.
Revenue and Cost of Services
US LEC's revenue is comprised of two primary components: (1) fees paid
by customers for local, long distance, data, Internet and enhanced services, and
(2) access charges, including reciprocal compensation, which is discussed below.
Local, long distance, data, Internet and enhanced service revenue is comprised
of monthly recurring charges, usage charges, and initial non-recurring charges.
Monthly recurring charges include the fees paid by customers for facilities
(lines and trunks) in service and additional features on those facilities. Usage
charges consist of usage-sensitive fees paid for calls made. Initial
non-recurring charges consist primarily of installation charges. Access charges
are comprised of charges paid primarily by inter-exchange carriers ("IXCs") for
the origination and termination of inter-exchange toll and toll-free calls and
reciprocal compensation, which is discussed below. US LEC's "core business"
revenue is comprised of local, long distance, data, Internet, and enhanced
service fees and toll and toll-free access charges other than reciprocal
compensation. The Company does not resell any ILEC services.
Reciprocal compensation arises when a local exchange carrier completes a
call that originated on another local exchange carrier's network. Reciprocal
compensation rates are fixed by an interconnection agreement executed between
those carriers. The majority of the Company's 1998 and 1999 revenue and 11% of
its 2000 revenue was earned from reciprocal compensation and is currently being
disputed by the
27
incumbent local exchange carriers, primarily BellSouth. This dispute primarily
arises from reciprocal compensation charges related to traffic that is
terminated to enhanced service providers, including internet service providers.
(See Disputed Reciprocal Compensation Revenue appearing below for a description
of these proceedings and uncertainties associated with their outcome.)
Although the Company has generated a majority of its revenue from
reciprocal compensation prior to 2000, US LEC was founded to establish a company
that would provide a wide array of telecommunications services to its customers
and reciprocal compensation is not currently considered to be a part of the
Company's core revenue. US LEC has deployed a significant regional network, and
as of December 2000 has active switches in 23 sites, serving over 3,900 medium
to large size customers. Management believes this customer base, achieved in
less than four years, is indicative of the market's acceptance of US LEC's
strategy and service offerings in its core business. Management expects the
Company's core business revenue to continue to increase and reciprocal
compensation to continue to decrease as percentages of total revenue in future
periods as US LEC continues to deploy its network, and expand its customer base,
and as reciprocal compensation rates decline due primarily to rate reductions in
new agreements entered into by the Company with ILECs and to regulatory and
legislative changes and decisions.
In order to interconnect its switches to the network of the local
incumbent phone company and to exchange traffic with it, the Company executes
interconnection agreements with the incumbent carriers. The terms and conditions
of the interconnection agreements are effected by the Telecom Act, decisions of
state and federal regulatory bodies and negotiation with the carriers involved.
The Company may voluntarily enter into such an agreement, petition a state
regulatory commission to arbitrate issues that can not be resolved by
negotiation or by opting into agreement executed by the incumbent and other
competitive carriers. The Company has signed or opted into interconnection
agreements with all of the incumbent local carriers where it offers services
requiring such agreements (See "Business -- Forward Looking Statements and Risk
Factors - Interconnection Agreements, and -Disputed Revenues).
Included in the Company's core revenue are access charges, other than
reciprocal compensation. During 2000, such access charges represented
approximately 33% of the Company's revenue. Management expects the Company's
access revenue to decrease as a percentage of total revenue as the Company's end
customer billings continue to increase, and as access rates decline due
primarily to regulatory changes and decisions. The Company has filed an action
against Sprint to collect access charges for the origination and termination of
toll and toll-free calls (See Disputed Access Revenues appearing below for a
description of these proceedings and uncertainties associated with their
outcome.)
In 2000, the Company began deferring installation revenue from end
customers and from other carriers. The Company is amortizing this revenue over
the average life of the contract. As of December 31, 2000, the Company had $0.6
million recorded in Deferred Revenue on its Consolidated Balance Sheet. In
addition, the Company had $1.5 million recorded in Other Liabilities for the
noncurrent portion of the Deferred Revenue.
The Company's cost of services is comprised primarily of two types of
charges: leased transport charges which comprise approximately three-fourths of
the Company's cost of services and usage sensitive charges (primarily usage
charges associated with the Company's off net toll and toll free services and
access and reciprocal compensation charges owing to other carriers) which
comprise approximately one-fourth of the Company's cost of services. The
Company's leased transport charges are the lease payments incurred by US LEC for
the transmission facilities used to connect the Company's customers to its
switch and to connect to the ILEC and other carrier networks. US LEC, as part of
its "smart-build" strategy, does not currently own any fiber or copper transport
facilities. These facilities are leased from various providers including, in
many cases, the ILEC. The Company's strategy of leasing rather than building its
own fiber transport facilities results in the Company's cost of services being a
significant component of total costs. Management believes that this strategy has
several benefits, including faster time-to-market, more efficient asset
utilization, and diverse interconnection opportunities. The Company has to date
been successful in negotiating lease agreements which generally match in the
aggregate the duration of its customer contracts, thereby allowing the Company
to mitigate the risk of incurring charges associated with transmission
facilities that are not being utilized by customers.
28
In 2000, the Company began deferring installation charges from ILECs
related to Network and End Customer Facilities. The Company is amortizing these
costs over the average life of the contract. During the period ended December
31, 2000, the Company amortized $0.6 million of deferred installation charges
into Cost of Sales. As of December 31, 2000, the Company had $1.2 million
recorded in Other Current Assets and $1.7 million recorded in Other Assets on
its Consolidated Balance Sheet.
Selling, General and Administrative Expenses; Depreciation and Amortization
In addition to the costs of services described above, the Company incurs
certain other expenses. The largest component of selling, general and
administrative expense ("SG&A") relates to employee salaries, related taxes and
benefits, and other incentive-based compensation. Other major categories of SG&A
include expenses associated with leasing real estate for the Company's offices
and switching centers insurance, travel, supplies, legal and accounting.
Depreciation and amortization expense is primarily due to capital
expenditures made by the Company. Gross property, plant and equipment increased
from $61.3 million in 1998, to $118.5 million in 1999, and $228.0 million in
2000. Depreciation and amortization expense increased from $4.9 million in 1998,
to $11.7 million in 1999 and $24.4 million in 2000.
As the Company continues to build its network, SG&A and depreciation and
amortization expense is expected to continue to grow.
Results of Operations
Comparison of Year Ended December 31, 2000 to Year Ended December 31, 1999
Net revenue decreased to $115.0 million for the year ended December 31,
2000, from $175.2 million in 1999. The significant decrease in revenue resulted
from the elimination of reciprocal compensation revenue related to Metacomm and
a reduction of local interconnect rates, partially offset by the Company's
expansion into new markets, an increase in the total number of customers in
existing markets and an increase in telecommunications traffic on its network.
The Company's core business revenue continued to grow in 2000. Core business
revenue, or revenue other than reciprocal compensation and related facility
revenue, increased to $101.9 million for the year ended December 31, 2000 from
$53.5 million for the year ended December 31, 1999, an increase of over 90%. For
the years ended December 31, 2000 and 1999, reciprocal compensation and related
facility revenue decreased to $13.2 million from $121.7 million, respectively,
net of allowances. The Company recorded a $27.8 million reduction against
reciprocal compensation revenue and related receivables for the year ended
December 31, 1999 due to the judicial and regulatory proceedings related to this
disputed revenue and management's assessment that the collectibility of such
revenue was not assured. As of December 31, 1999, the total allowance offsetting
the disputed receivables totaled $39.8 million. Unless otherwise specified, the
results of operations reflected in this report are net of these and other normal
operating adjustments. (See Disputed Revenue appearing below).
The loss on the resolution of disputed revenue was a result of the March
31,2000 NCUC Order that relieved BellSouth from paying reciprocal compensation
to US LEC for any minutes of use attributable to the network operated by
Metacomm, a customer of BellSouth and US LEC, or any similar network. As a
result of this order, the Company recorded a pre-tax non-recurring non-cash
charge of $55 million in the first quarter of 2000. This charge is composed of
the write-off of approximately $153 million in receivables related to reciprocal
compensation revenue offset by a previously established allowance of $39
million, and a reduction of approximately $59 million in reciprocal compensation
commissions payable to Metacomm. The amounts are estimated based on a
methodology that must be agreed to by the NCUC. The Company is currently working
with BellSouth to determine the definitive amounts.
The Company recorded a significant charge relating to disputed
receivables in the fourth quarter of 2000. The $52 million provision is netted
on the Company's Consolidated Statement of Operations against a $12 million
reduction in commissions payable on those receivables, resulting in the $40
million provision on the
29
Company's Consolidated Statement of Operations. Management believes this charge
was necessary due to the uncertainty related to current regulatory proceedings
related to reciprocal compensation and other access charges and the continued
refusal by ILECs, principally BellSouth, to pay amounts believed by the Company
to be owed to it under applicable interconnection agreements and due to Sprint's
failure to pay US LEC's access charges (See Disputed Revenue below).
Cost of services is comprised primarily of leased transport, facility
installation, and usage charges. In 1999, cost of services also included
commission payable to Metacomm on reciprocal compensation revenue. Cost of
services decreased from $73.6 million, or 42% of revenue, for 1999 to $52.7
million, or 46% of revenue, for 2000. This decrease in cost of services was
primarily a result of the decrease in local interconnect rates and the
elimination of commissions payable to Metacomm on reciprocal compensation
revenue, partially offset by the increase in the size of US LEC's network, and
increased usage by its customers other than Metacomm. The increase in cost of
services as a percentage of revenue was due to the increase of core revenue as a
percentage of total revenue and the one-time costs associated with entering
several new markets.
Selling, general and administrative expenses for the year ended December
31, 2000 increased to $80.7 million, or 70% of revenue, compared to $48.4
million, or 28% of revenue, for the year ended December 31, 1999. This increase
was primarily a result of costs associated with developing and expanding the
infrastructure of the Company as it expands into new markets and adds products,
such as expenses associated with personnel, sales and marketing, occupancy,
administration and billing, as well as legal expenses associated with
litigation. The increase in SG&A expense as a percentage of revenue in 2000 was
primarily due to the reduction in reciprocal compensation revenue.
Depreciation and amortization for 2000 increased to $24.4 million from
$11.7 million in 1999 primarily due to the increase in depreciable assets in
service related to US LEC's network expansion.
Interest income for 2000 increased to $4.8 million from $1.1 million in
1999. The increase in interest income in 2000 was primarily due to the investing
of a portion of the proceeds from the issuance of Series A Mandatorily
Redeemable Convertible Preferred Stock on April 11, 2000.
Interest expense for 2000 increased to $7.8 million from $3.1 million in
1999. This increase in interest expense was primarily due to increased
borrowings under the Company's credit facility and an increase in interest
rates.
For the year ended December 31, 2000, the Company recorded a $23.7
million income tax benefit, compared to $15.6 million in expense in 1999. The
$23.7 million benefit for the year ended December 31, 2000 is a net amount which
includes a $35.7 million valuation allowance against deferred tax assets
relating to the anticipated use of federal and state net operating losses.
Net loss for 2000 amounted to $117.4 million, compared to net earnings
of $23.8 million for 1999. Dividends paid and accrued on Series A Mandatorily
Redeemable Convertible Preferred Stock for the year ended December 31, 2000
amounted to $8.8 million (See Note 6 of the Company's Consolidated Financial
Statements). The accretion of preferred stock issuance cost was $0.3 million for
the year ended December 31, 2000.
As a result of the foregoing, net loss attributable to common
shareholders for the year ended December 31, 2000 amounted to $126.6 million, or
($4.58) per share (diluted), compared to net earnings of $23.8 million, or $0.84
per share (diluted) for 1999. The increase in net loss and net loss per share is
attributed to the factors discussed above.
Comparison of Year Ended December 31, 1999 to Year Ended December 31, 1998
Net revenue increased to $175.2 million for the year ended December 31,
1999, from $84.7 million in 1998. Due to the disputed reciprocal compensation
issues as described below, the Company recorded a $27.8 million and $12.0
million allowance against reciprocal compensation revenue and related
receivables
30
for the years ended December 31, 1999 and 1998, respectively, bringing the total
allowance offsetting the related receivables to $39.8 million at December 31,
1999. Unless otherwise specified, the results of operations reflected in this
report are net of these and other normal operating adjustments. This allowance
was made due to the judicial and regulatory proceedings related to this disputed
revenue. (See Disputed Revenue below).
Cost of services in 1998 and 1999 was comprised primarily of leased
transport, facility installation, commissions and usage charges. Cost of
services increased from $33.6 million for 1998 to $73.6 million for 1999. This
increase was primarily a result of the increase in the size of US LEC's network,
increased usage by its customers, and increased commissions on reciprocal
compensation. For the years ended December 31, 1998 and 1999, network costs
represented 40% and 42% of revenue, respectively. The increase in cost as a
percentage of revenue was due to total revenue and the one-time costs associated
with entering several new markets.
SG&A for 1999 increased to $48.4 million, or 28% of revenue, compared to
$25.0 million, or 30% of revenue, for 1998. This increase was primarily a result
of costs associated with developing and expanding the infrastructure of the
Company as it expanded into new markets, such as expenses associated with
personnel, sales and marketing, occupancy, administration and billing, as well
as legal expenses associated with the BellSouth litigation.
Depreciation and amortization for 1999 increased to $11.7 million from
$4.9 million in 1998 primarily due to the increase in depreciable assets in
service related to US LEC's network expansion.
Interest income for 1999 decreased to $1.1 million from $1.9 million in
1998. Interest expense for 1999 increased from 1998 by $2.9 million to $3.1
million. This increase was due to borrowings under the Company's loan agreement
totaling $52.0 million in 1999, bringing total debt to $72.0 million at December
31, 1999.
Provision for income taxes for 1999 was $15.6 million, based on an
effective tax rate of 39.6% compared to a provision in 1998 for $9.3 million,
based on an effective tax rate of 40.9%. As a result of timing differences
between book and tax income primarily related to disputed reciprocal
compensation, the Company had a tax net operating loss carryforward of $40.2
million at December 31, 1999.
Net earnings for 1999 amounted to $23.8 million, or $0.84 per share
(diluted), compared to a net earnings of $13.4 million, or $0.52 per share
(diluted) for 1998. The increase in net earnings and net earnings per share is
attributed to the factors discussed above.
Liquidity and Capital Resources
US LEC's business is capital intensive and its operations require
substantial capital expenditures for the purchase and installation of network
switches, related electronic equipment and facilities. The Company's cash
capital expenditures were $111.6 million and $49.7 million for the years ended
December 31, 2000 and 1999, respectively. In December 1999, the Company amended
its senior secured credit facility increasing the amount available from $75.0
million to $150.0 million. As of December 31, 2000, the outstanding amount under
the credit facility was $130.0 million; therefore, $20.0 million was available
to borrow under the credit facility. While management believes the $106 million
in cash and $20.0 million of availability under the loan agreement will fund the
Company's announced expansion to EBITDA positive, funding for expansion beyond
the Company's announced network deployment and funding to free cash flow
positive may require additional financing unless the Company receives
significant payment of the amounts due to the Company from BellSouth, excluding
amounts related to Metacomm, or from Sprint (See Disputed Revenues appearing
below appearing below for a further discussion related to reciprocal
compensation and other disputed amounts.)
31
On April 11, 2000, the Company issued $200 million of its Series A
Mandatorily Redeemable Convertible Preferred Stock to affiliates of Bain
Capital, Inc. ("Bain") and Thomas H. Lee Partners, L.P. ("THL"). See Note 6 to
the Company's Consolidated Financial Statements for a description of this
transaction and the terms of the Preferred Stock. Proceeds to the Company, net
of commissions and other transaction costs, were approximately $194 million.
Cash used in operating activities was approximately $49.3 million in
2000 compared to $25.9 million in 1999. The increase in cash used in operating
activities was primarily due to the increase in operational activities
associated with the growth of the Company. Additionally, the majority of the
Company's gross accounts receivable at December 31, 2000 continue to be amounts
due from BellSouth for reciprocal compensation, facility charges, and other
charges. Although the Company received a payment of $11.2 million from BellSouth
in July 1999 representing a portion of the amounts due the Company for ISP
reciprocal compensation in North Carolina, management expects receivables due
from BellSouth to continue to increase until the judicial and regulatory
proceedings with BellSouth are resolved. The Company has the same expectations
regarding receivables from Sprint until those judicial proceedings are resolved.
(See Disputed Revenue appearing below for a further discussion related to
reciprocal compensation and other disputed amounts due from BellSouth and
Sprint.)
Cash used in investing activities increased to $111.7 million in 2000
from $49.7 million in 1999. The investing activities are related to purchases of
switching and related telecommunications equipment, office equipment and
leasehold improvements associated with the Company's expansion into additional
locations and markets during 2000.
Cash provided by financing activities increased to $251.7 million for
2000 from $48.8 million in 1999. The increase was primarily due to the issuance
of $200 million in Series A Mandatorily Redeemable Convertible Preferred Stock
(see above) and proceeds from borrowing under the Company's credit facility.
Disputed Revenues
The deregulation of the telecommunications industry and the
implementation of the Telecommunications Act of 1996 have embroiled the industry
and the Company in numerous proceedings in arbitration, state regulatory
commissions, and the courts, as well as disputes over pending legislation over
issues including reciprocal compensation and access rates, the characterization
of traffic for compensation purposes, and the interpretation of interconnection
agreements, among other issues. Rulings or legislation adverse to the Company on
any of the issues, which are material to it, could have an adverse impact on the
Company's financial results or its operations.
The Company is involved in several legal and regulatory proceedings
regarding revenues and receivables from ILECs, IXCs and other carriers. As of
December 31, 2000, the Company's gross accounts receivable was approximately
$115 million, of which approximately $77 million was attributed to BellSouth and
approximately $13 million was attributed to Sprint.
In the case of BellSouth, the majority of the receivables are being
disputed primarily due to issues regarding reciprocal compensation for ISPs and
certain rate issues. In the case of Sprint, a significant portion of the
receivable is being disputed based on access rates. The following paragraphs
discuss in detail each of the material disputes and associated regulatory or
legal proceeding.
The Metacomm Decision - As the Company has previously reported,
BellSouth Telecommunications, Inc. ("BellSouth") began a proceeding in September
1998 before the North Carolina Utilities Commission ("NCUC") seeking to be
relieved of any obligation under its interconnection agreements with the Company
to pay reciprocal compensation for traffic related to the network operated by
Metacomm, LLC ("Metacomm"), a customer of both the Company and BellSouth. On
March 31, 2000, the NCUC issued an order in this proceeding (the "March 31
Order") that relieves BellSouth from paying reciprocal compensation to the
Company for any minutes of use attributable to Metacomm network traffic and
requires the Company to cease billing BellSouth reciprocal compensation for
minutes of use attributable to the Metacomm or any similar network as such
networks are identified in the March 31
32
Order. The March 31 Order does not affect in any way the NCUC's order of
February 1998 requiring BellSouth to pay reciprocal compensation to the Company
for Internet service provider ("ISP") traffic in North Carolina (the "NCUC ISP
Order"). It relates solely to traffic on Metacomm's network in North Carolina
(the only state in which Metacomm operated). The Company did not appeal the
March 31 Order, although Metacomm is prosecuting an appeal.
As a result of the March 31 Order, the Company recorded a pre-tax,
non-recurring, non-cash charge of approximately $55 million in the first quarter
of 2000. The charge was composed of the write-off of approximately $153 million
in receivables related to reciprocal compensation revenue offset by previously
established reserves of $39 million and a reduction of $59 million in
commissions payable to Metacomm.
On March 21, 2000, the NCUC issued an interim order (the "March 21
Order") to BellSouth to pay to the Company all reciprocal compensation owing to
the Company for traffic terminated in North Carolina, other than traffic related
to Metacomm and like networks. This order was issued in connection with the
on-going proceeding before the NCUC filed in September 1998 by the Company in
which it seeks payment of reciprocal compensation not related to Metacomm or to
traffic terminated to ISPs, and of other amounts owing to the Company. The
Company's action before the NCUC to recover reciprocal compensation and other
charges for non-Metacomm/non-ISP traffic has been stayed by the NCUC while the
Company and BellSouth conduct NCUC-ordered negotiations to resolve the matter.
The amount due to the Company as a result of this proceeding will be determined
by the negotiations or subsequent ruling by the NCUC regarding the
non-Metacomm/non-ISP charges BellSouth is obligated to pay. The Company is
currently working with BellSouth to determine the amount BellSouth will pay
under the March 21, 2000 Order. Once this is determined by negotiation or NCUC
ruling, the Company will adjust the non-recurring charge. Management believes
that this adjustment will not be material to the Company's operating results or
financial position. If the negotiations are unsuccessful, the Company will seek
a lifting of the stay and seek a hearing and ruling from the NCUC on its claims
against BellSouth.
In 2000, additional paid-in capital has been reduced by $36 million
representing amounts due from Metacomm, which is indirectly controlled by
Richard T. Aab, a majority stockholder of the Company. Due to Mr. Aab's
controlling position in both Metacomm and the Company, this amount is being
treated for financial reporting purposes as a deemed distribution to the
stockholder. At the time such amounts are paid to the Company, the payment will
increase additional paid-in capital as a capital contribution to the Company.
(See Note 14 to the Company's Consolidated Financial Statements)
Other Disputed Reciprocal Compensation Revenue - The Company is also a
party to the following material proceedings in which it seeks collection of
outstanding amounts owed by incumbent local telephone companies, primarily
BellSouth, for non-Metacomm related reciprocal compensation, including
reciprocal compensation related to traffic terminating to ISPs and other
customers:
North Carolina -- On February 26, 1998, following a petition by the
Company, the NCUC ordered BellSouth to bill and pay for all ISP-related traffic
(defined above, the "NCUC ISP Order"). Following motions filed by BellSouth, the
NCUC stayed enforcement of its order until June 1, 1998. On April 27, 1998,
BellSouth filed a petition for judicial review of the NCUC ISP Order and an
action for declaratory judgment and other relief (including a request for an
additional stay) with the United States District Court for the Western District
of North Carolina ("U.S. District Court-NC") pending determination of certain
related issues by the Federal Communications Commission ("FCC"). This action was
filed against the Company and the NCUC. In June 1999, the U.S. District Court-NC
dismissed BellSouth's petition without prejudice and remanded it back to the
NCUC for further review. Following the U.S District Court-NC's remand, on June
22, 1999, the NCUC denied BellSouth's request for a further stay of the NCUC ISP
Order.
In addition to denying BellSouth's request for a further stay, the NCUC
filed an appeal with the U.S. Fourth Circuit Court of Appeals (the "4th
Circuit") of the U.S. District Court-NC's order that rejected the NCUC's
defenses, including its defense that the 11th Amendment to the United States
Constitution bars BellSouth from making the NCUC a party to a proceeding in the
federal courts. The Company also appealed and the United States Justice
Department intervened in the appeal. On February 14, 2001 the 4th Circuit issued
a ruling in favor of the Company and the NCUC, ruling that the U.S. District
Court - NC did not have subject matter jurisdiction over the appeal of an
enforcement proceeding and ruling the NCUC was immune from suit under the
Eleventh Amendment of the United States Constitution. On March 5, 2001, the
United States Supreme Court granted a petition for certiorari in which it agreed
to consider these issues in a case originating in the U.S. Circuit Court of
Appeals for the Seventh Circuit. The Company anticipates that BellSouth will
seek review of the Fourth Circuit Court's ruling by the Supreme Court as well.
33
On July 16, 1999, the Company received a payment of $11.2 million from
BellSouth representing a portion of the amounts due the Company for ISP
reciprocal compensation in North Carolina. In making the payment, BellSouth
stated that it was for ISP traffic the NCUC had ordered it to pay for in the
NCUC ISP Order, including late fees, and that it was reserving all of its appeal
rights with respect to the payment. BellSouth also stated that this payment did
not include any amounts at issue in its September 1998 NCUC proceeding regarding
Metacomm. This partial payment did not cover all outstanding non-Metacomm
related amounts the Company claims are due from BellSouth in North Carolina. In
addition, BellSouth has from time to time made payments to US LEC for reciprocal
compensation related to traffic terminated in North Carolina, but BellSouth has
not paid the entire amount due to the Company for non-Metacomm reciprocal
compensation.
Georgia -- On June 30, 1999, the Company filed a complaint against
BellSouth before the Georgia Public Service Commission ("GAPSC") concerning the
Company's first and second interconnection agreements with BellSouth in Georgia.
These interconnection agreements cover the period through June 1999. On May 17,
2000, the hearing officer reviewing the Company's first and second
interconnection agreements with BellSouth issued a recommended decision to the
GAPSC stating that BellSouth should be ordered to pay US LEC the disputed
reciprocal compensation at the end office rate, pending submission of evidence
by the Company showing that it is entitled to be compensated at the higher
tandem rate. On June 15, 2000, the GAPSC affirmed this recommended decision, and
issued an order requiring BellSouth to pay US LEC reciprocal compensation for
traffic to ISPs and other customers in Georgia at the end office rate (the
"GAPSC Order"). On July 12, 2000, US LEC filed evidence with the GAPSC regarding
its right to be compensated at the tandem rate. On July 14, 2000, BellSouth
filed an appeal of the GAPSC Order with the U.S. District Court for the Northern
District of Georgia ("U.S. District Court-GA") and with the Georgia Superior
Court in and for Fulton County, Georgia. BellSouth asked the Georgia state court
to cede the appeal to the U.S. District Court - GA and asked the latter court
for permission to pay amounts due into court to avoid paying US LEC pending
appeal. On July 18, 2000, the U.S. District Court- GA granted BellSouth's motion
to pay amounts due into court prior to receipt by the Company of any papers
related to that appeal. On October 2, 2000, the U.S. District Court - GA denied
the Company's request for reconsideration of the order allowing BellSouth to pay
amounts due into court. The Georgia State and Federal Courts are setting a
briefing schedule for the proceeding, and the Company and expects a decision
sometime in 2001. The GAPSC held a hearing on the tandem/end office rate issue
on March 8, 2001, but has not yet rendered a decision. The Company's complaint
did not address the third interconnection agreement in Georgia, which covers the
period from June 1999 to December 1999.
Florida -- On July 2, 1999, the Company filed a complaint against
BellSouth before the Florida Public Service Commission ("FLPSC") seeking
recovery of reciprocal compensation for ISP and other traffic in that state. The
FLPSC will also be called upon to decide issues in dispute between the Company
and BellSouth regarding the rate at which reciprocal compensation should be paid
for some of the traffic at issue. The hearing is scheduled to take place later
in 2001.
Tennessee -- On August 6, 1999, the Company filed a complaint against
BellSouth before the Tennessee Regulatory Authority ("TRA") seeking recovery of
reciprocal compensation for ISP and other traffic in that state. The TRA will
also be called upon to decide issues in dispute between the Company and
BellSouth regarding the rate at which reciprocal compensation should be paid for
some of the traffic at issue. There is no hearing scheduled for this matter at
this time.
Management believes that the Company will ultimately obtain favorable
results in the state proceedings described above before the FLPSC and the TRA
and in the pending appeal of the NCUC ISP Order and the GAPSC Order with respect
to the eligibility of ISP traffic for reciprocal compensation. Management's
belief is supported by the determinations of state regulatory bodies and by
courts hearing appeals of the state regulatory decisions, which are discussed
below, notwithstanding the jurisdictional position on ISP traffic taken by the
FCC in February 1999, which has now been vacated, also discussed below. However,
BellSouth may elect to initiate additional proceedings (by way of appeal or
otherwise) or attempt to expand the pending proceedings challenging amounts owed
to the Company. In this regard, BellSouth has asserted a variety of other
objections to paying portions of the reciprocal compensation billed
34
by the Company. They include assertions that US LEC has miscalculated late
payment fees due from BellSouth and that the Company has billed reciprocal
compensation using the wrong rates. The Company believes BellSouth has asserted
these issues and will attempt to raise further issues, in order to avoid or
delay payment. In September 2000, the FLPSC issued a ruling regarding one of
these rate issues favorable to BellSouth in a proceeding bought by Intermedia
Communications, Inc ("Intermedia"). The impact of this ruling has not yet been
determined, and the Company has been informed that Intermedia intends to appeal
the decision. Proceedings on the same issue are pending decision in Georgia and
North Carolina.
FCC's ISP Ruling and Related Proceedings -- In February, 1999, the FCC
issued a declaratory ruling (the "ISP Ruling") which concluded that for
jurisdictional purposes most calls delivered to ISPs should be deemed to
continue to Internet web sites, which are often located in other states. Thus,
the FCC ruled that such calls are jurisdictionally "interstate" in nature.
However, the FCC further declared that, in light of its long-standing policy of
treating calls to ISPs as though they were local, where parties have previously
agreed in interconnection agreements that reciprocal compensation must be paid
for traffic bound for ISPs, the parties should be bound by those agreements, as
interpreted and enforced by state regulatory bodies. The FCC also recognized
that some commissions might reconsider their decisions in light of its ruling.
On March 24, 2000, the U.S. Circuit Court for the District of Columbia
(the "D.C. Circuit") vacated the FCC's ISP Ruling. The D.C. Circuit ruled that
the FCC did not give adequate consideration to a number of facts when it found
that ISP calls were jurisdictionally interstate, including the FCC's own past
analyses of how to determine whether calls dialed to telephone numbers within
the local exchange are interstate or intrastate. The D.C. Circuit also concluded
that the FCC had failed to explain why its jurisdictional analysis had any
relevance to the issue of whether calls to ISPs should be eligible for
reciprocal compensation. The D.C. Circuit sent the case back to the FCC to give
the FCC opportunity to reconsider those questions in light of the D.C. Circuit's
ruling. On June 23, 2000, the FCC requested comments on the issues raised by the
D.C. Circuit in its remand of the ISP Ruling. Initial comments were filed on
July 21, 2000. Reply comments were filed on August 4, 2000. The Company cannot
predict when the FCC will issue its decision on remand.
To date, state regulatory bodies in at least thirty states have
considered the effect of the FCC's ISP Ruling and have overwhelmingly reaffirmed
their earlier decisions requiring payment of reciprocal compensation for this
type of traffic or for the first time determined that such compensation is due.
Included among these states are Alabama, Florida, Georgia and Tennessee, which
together with North Carolina (see discussion above) represent the only states in
BellSouth's operating territory where the Company has significant reciprocal
compensation disputes at December 31, 2000. In this regard, the Alabama Public
Service Commission (the "APSC") concluded that the treatment of ISP traffic as
local was so prevalent in the industry at the time BellSouth entered into
interconnection agreements with CLECs that, if it had so intended, BellSouth had
an obligation to negate such local treatment in the agreements by specifically
delineating that ISP traffic was not local traffic subject to the payment of
reciprocal compensation. The APSC decision was affirmed by the United States
District Court for the Middle District of Alabama, and the GAPSC decision was
affirmed by the United States District Court of the Northern District of
Georgia. The FLPSC and the TRA have also reaffirmed decisions that reciprocal
compensation is owed for calls to ISPs. Two BellSouth states - South Carolina
and Louisiana - have ruled that reciprocal compensation is not due for traffic
to ISPs. These decisions, which came before the FCC's ISP Ruling was vacated by
the D.C. Circuit, represent a view adopted by very few other states (The Company
does not have ISP reciprocal compensation recorded to date for traffic in South
Carolina or Louisiana.)
State and federal courts considering the issue on appeal have also
universally supported the position that reciprocal compensation is due for
traffic terminated to ISPs. Included among these are decisions of the U.S.
Circuit Courts of Appeal for the Fifth, Seventh, Ninth and Tenth Circuits, all
of which considered the issue in light of the FCC's ISP Ruling and affirmed the
underlying decisions of the state regulatory agencies that reciprocal
compensation is due for traffic terminated to ISPs.
If a decision adverse to the Company is issued in any of these
proceedings by any of the state
35
commissions, or in any federal or state appeal or review of a favorable
decision, or if either the FCC or any of the applicable state commissions was to
alter its view of reciprocal compensation or if Congress or any state
legislature enacted legislation that ended reciprocal compensation for ISP
traffic or all local traffic, such an event could have a material adverse effect
on the Company's operating results and financial condition. Management estimates
the Company's gross trade accounts receivable as of December 31, 2000 included
approximately $54 million of earned, but uncollected, disputed reciprocal
compensation related to non-Metacomm related ISP traffic.
Legislation - At the end of the last session of Congress, legislation
was introduced in the United States House of Representatives and the United
States Senate that would eliminate all reciprocal compensation for calls to ISPs
and, under some proposals, for all local calls. A House subcommittee approved a
version of this legislation. No action was taken in the Senate. If this or
similar legislation were to become law, it would have a material adverse effect
on the Company.
GTE Reciprocal Compensation Dispute in North Carolina - In addition to
the proceedings involving BellSouth which are discussed above, in February 2000,
the Company received payment from GTE South Incorporated ("GTE") (now Verizon
South Incorporated) for reciprocal compensation for traffic in North Carolina,
including ISP traffic. This payment was pursuant to a commercial arbitration
award rendered January 4, 2000 resulting from a proceeding before the American
Arbitration Association. GTE was ordered to pay US LEC for all reciprocal
compensation for the period ending September 1999 (approximately $650 thousand).
GTE challenged the decision of the arbitrator in the U.S. District Court for the
Eastern District of North Carolina. This challenge was denied by the U.S.
District Court for the Eastern District of North Carolina and judgement was
entered in the Company's favor on January 11, 2001. The judgement was not
appealed so it is a final judgement.
In addition, the Company has filed for arbitration to resolve its
reciprocal compensation dispute with GTE in North Carolina for periods after
September 1999. The hearing in this arbitration took place on February 26-27,
2001, and all post-hearing briefs are scheduled to be filed by April 23, 2001.
Although the Company cannot predict when this arbitrator will issue a decision,
management knows of no reason why the second arbitration should have an outcome
different from the first, favorable arbitration ruling. The Company anticipates
that GTE will appeal any ruling adverse to it.
Existing BellSouth Interconnection Agreements -- In October 2000, the
Company agreed to adopt existing local interconnection agreements with BellSouth
in South Carolina, Kentucky, Louisiana and Mississippi. The Agreements are for a
term of two years and relate back to the expiration date of the prior agreements
in each state, and therefore will expire at varying dates in 2002. The
Agreements provide for reciprocal compensation at rates significantly lower than
in the Company's prior interconnection agreements. These agreements do not
provide for any reciprocal compensation payments for ISP traffic; rather, the
agreements include a true up provision whereby the parties will track that
traffic pending an order from the FCC on the issue. The Company does not have
significant amounts of reciprocal compensation in these states. The Company has
adopted new interconnection agreements in North Carolina, Florida and Tennessee,
all of which relate back to January 1, 2000 and which expire April 2002, October
2002 and November 2002, respectively. These agreements provide for reciprocal
compensation for all local traffic, including ISP traffic, at rates
significantly lower than in the Company's prior interconnection agreements.
However, the agreement for North Carolina provides for a true-up of payments
made for ISP traffic should the FCC determine that reciprocal compensation is
not owing for ISP traffic and that determination is given retroactive effect.
The Company continues to seek interconnection agreements with BellSouth in
Alabama and Georgia. The Company's existing agreements with BellSouth in these
states have expired, but continue in force until new interconnection agreements
are signed. BellSouth filed petitions for arbitration in these states seeking to
obtain state-ordered interconnection agreements, but the Company anticipates
that it will be able to avoid or shorten the arbitration process in these states
by adopting interconnection agreements that will result from recently concluded
arbitrations involving other CLECs. These new agreements will be effective as of
the expiration date of the prior agreements. The Company anticipates that new
interconnection agreements in these states will also provide for significantly
lower rates, but, unlike the agreements in South Carolina, Kentucky, Louisiana
and Mississippi, the Company does not anticipate that payment of reciprocal
compensation for
36
ISP traffic would be affected by a true up provision.
Interconnection Agreements - The Company has agreements for the
interconnection of its networks with the networks of the ILECs covering each
market in which US LEC either has or is currently installing a switching
platform. US LEC may be required to negotiate new interconnection agreements as
it enters new markets in the future. In addition, as its existing
interconnection agreements expire, it will be required to negotiate extension or
replacement agreements. There can be no assurance that the Company will
successfully negotiate such additional agreements for interconnection with the
ILECs or renewals of existing interconnection agreements on terms and conditions
acceptable to the Company. The Company has signed interconnection agreements
with various ILECs, including BellSouth Telecommunications, Inc. ("BellSouth"),
Sprint Communications Company L.P. ("Sprint"), Verizon Communications
("Verizon") and other carriers. These agreements provide the framework for the
Company to serve its customers when other local carriers are involved. The
Company has signed multiple agreements with BellSouth which govern relationships
in all nine states (See "Existing BellSouth Interconnection Agreements" above).
Agreements with GTE are in force in states where GTE and the Company
operates. The agreement for Virginia expired in July 2000, and remains in force
and effect until a new agreement is executed. All other agreements expire during
2001 or 2002.
The Company also has interconnection agreements with Verizon in the
states of Virginia, Pennsylvania, Maryland, Delaware, New Jersey and the
District of Columbia. Each of these agreements expired in 2000, and remain in
force and effect until a new agreement is entered into by Verizon and the
Company. The Company continues to seek new interconnection agreements in these
states.
Agreements with Sprint are in force and effect in Florida, Virginia,
North Carolina and Tennessee.
Disputed Access Revenues - A number of IXCs have refused to pay access
charges to CLECs, including those of the Company, on the allegation that the
access charges exceed those of the ILEC serving that territory in an apparent
effort to induce the CLECs, including the Company, to reduce access charges.
Currently there are a number of court cases, regulatory proceedings at the FCC,
and legislative efforts involving such challenges. The Company cannot predict
the outcome of these cases, regulatory proceedings, and legislative efforts or
their impact on access rates. In February 2000, the Company filed suit in U.S.
District Court for the Western District of North Carolina against Sprint
Communications Company L.P. ("Sprint"). This action seeks to collect amounts
owed to the Company for access charges for intrastate and interstate traffic
which was either handed off to Sprint by the Company or terminated to the
Company by Sprint. As of December 31, 2000, Sprint owed the Company
approximately $13 million in access charges. Sprint has refused to pay the
amounts invoiced by the Company on the basis that the rates are higher than the
amounts that Sprint believes are just and reasonable. Sprint claims it is not
obligated to pay more than an undefined incumbent local exchange carrier
("ILEC") rate. The Company's invoices to Sprint are at the rates specified in
the Company's state and federal tariffs. The FCC recently determined that a long
distance company may not withhold interstate access charges on the basis that it
believes the charges to be too high while also continuing to accept the benefits
of interconnection with the local carrier without taking formal action to
challenge the rates. The FCC has ruled that AT&T was obligated to pay such
access charges due to its failure to commence a proceeding or terminate
interconnection. (MGC Communications, Inc. v. AT&T Corp., FCC Release 99-408).
This decision is now final, as AT&T did not appeal the FCC's ruling. In
addition, the FCC ruled recently in an action brought by Sprint against MGC
Communications, Inc. ("MGC") that the fact that a CLEC's filed interstate rates
exceeded those of the competing ILECs was insufficient to establish that the
CLEC's rates were excessive. The FCC dismissed Sprint's challenge to MGC's
rates. Sprint has appealed the FCC's decision to the United States Court of
Appeals for the District of Columbia Circuit, and oral argument is scheduled for
April 20, 2001. As a result of these rulings, management anticipates a favorable
resolution of the Company's dispute with Sprint (See "Business -- Forward
Looking Statements and Risk Factors - Legal Proceedings").
Effect of Recently Issued Accounting Pronouncements
Effective January 1, 2001, the Company will adopt Statement of Financial
Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments
and Hedging Activities", as amended by SFAS
37
No. 138, "Accounting for Certain Derivative Instruments and Hedging Activities."
SFAS No. 133 establishes accounting and reporting standards for derivative
instruments and hedging activities by requiring that entities recognize all
derivatives as either assets or liabilities at fair market value on the balance
sheet. The Company believes that the adoption of SFAS No. 133 will not have a
material effect on its results of operations as it does not currently hold any
derivative instruments or engage in hedging activities.
In December 1999, the Securities and Exchange Commission issued Staff
Accounting Bulletin 101, "Revenue Recognition in Financial Statements" ("SAB
101"), to provide guidance on the recognition, presentation, and disclosure of
revenue in the financial statements. The Company adopted SAB 101 effective
October 1, 2000. Management believes such adoption does not have a material
effect on results of operations or the financial position of the Company.
Recent Significant Development
On March 31, 2001, the Company, Richard T. Aab, the Company's Chairman,
controlling shareholder and the indirect controlling owner of Metacomm, and
Tansukh V. Ganatra, the Company's Vice Chairman and Chief Executive Officer,
reached an agreement in principle to effect a recapitalization of the Company
and to resolve Mr. Aab's commitment that Metacomm would fully satisfy its
obligations to the Company for facilities, advances and interest. The agreement
provides in material part (1) that Mr. Aab will make a contribution to the
capital of the Company by delivering to the Company for cancellation 2 million
shares of Class B Common Stock currently controlled by Mr. Aab, (2) that Mr. Aab
and Mr. Ganatra will convert all of the then remaining and outstanding shares of
Class B Common Stock - a total of approximately 14,500,000 such shares will be
outstanding after the 2,000,000 shares are cancelled - into the same number of
shares of Class A Common Stock, (3) the Company will agree to indemnify Mr. Aab
for certain adverse tax effects, if any, relating to the Company's treatment in
its balance sheet of the amount of the Metacomm obligation as a distribution to
shareholder and (4) the Company will agree to indemnify Mr. Ganatra for certain
adverse tax effects, if any, from the conversion of his Class B shares to Class
A shares.
The agreement is subject to obtaining a valuation by a qualified
valuation firm approved by the Company's audit committee that the delivery of
the 2,000,000 shares of Class B Common Stock and the conversion of approximately
14,500,000 shares of Class B Common Stock into the same number of shares of
Class A Common Stock will result in the realization by the Company and its Class
A shareholders of value equal to the outstanding Metacomm obligation, receipt by
the Company of a favorable tax opinion, and the receipt of certain consents.
The Company expects that the proposed transaction will be consummated
within 60 days. Upon closing of the transaction, the number of issued and
outstanding shares of Common Stock (Class A and Class B together) will decrease
by 2,000,000 and, as a result of the elimination of the 10-vote-per-share Class
B Common Stock, Mr. Aab will no longer have voting control of the Corporation's
Common Stock, although he will remain its largest single shareholder. For
purposes of illustration, had this subsequent event occurred on January 1, 2000,
the weighted average number of shares outstanding for the year ended December
31, 2000 would have equaled approximately 25,618,000 and the Company's net loss
per common share would have been $(4.94) diluted versus $(4.58) as reported.
As a result of this transaction, the Company will not receive any cash
or cash equivalents in settlement of the Metacomm obligation. Management has not
included receipt of cash for this obligation for the funding of the Company's
anticipated capital needs. The completion of the settlement transaction will not
have any impact on the computation of the Company's Net Earnings (Loss)
Attributable to Common Stockholders in the Company's Consolidated Statement of
Operations.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
US LEC is exposed to various types of market risk in the normal course
of business, including the impact of interest rate changes on its investments
and debt. As of December 31, 2000, investments
38
consisted primarily of institutional money market funds. All of the Company's
long-term debt consists of variable rate instruments with interest rates that
are based on a floating rate which, at the Company's option, is determined by
either a base rate or the London Interbank Offered Rate, plus, in each case, a
specified margin.
Although US LEC does not currently utilize any interest rate management
tools, it will evaluate the use of derivatives such as, but not limited to,
interest rate swap agreements to manage its interest rate risk. As the Company's
investments are all short-term in nature and its long-term debt is at variable
short-term rates, management believes the carrying values of the Company's
financial instruments approximate fair values.
39
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEPENDENT AUDITORS' REPORT
Board of Directors and Stockholders of
US LEC Corp.
Charlotte, North Carolina
We have audited the accompanying consolidated balance sheets of US LEC
Corp. and subsidiaries as of December 31, 1999 and 2000, and the related
consolidated statements of operations, stockholders' equity (deficiency) and
cash flows for each of the three years in the period ended December 31, 2000.
Our audits also included the financial statement schedule listed in the Index at
Item 14. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States of America. Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly
in all material respects, the financial position of US LEC Corp. and
subsidiaries as of December 31, 1999 and 2000, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 2000 in conformity with accounting principles generally accepted in
the United States of America. Also, in our opinion, such financial statement
schedule, when considered in relation to the basic consolidated financial
statements taken as a whole, presents fairly in all material respects the
information set forth therein.
As discussed in Note 7 to the financial statements, a significant
portion of the Company's accounts receivable and revenues relate to reciprocal
compensation and access charges which are currently in dispute.
/s/ Deloitte & Touche LLP
Charlotte, North Carolina
February 21, 2001
40
US LEC Corp. and Subsidiaries
Consolidated Balance Sheets
(In Thousands)
December 31, December 31,
1999 2000
--------- ---------
Assets
Current Assets
Cash and cash equivalents $ 15,174 $ 105,821
Restricted cash 1,173 1,300
Accounts receivable (net of allowance of $40,074 at
December 31, 1999 and $1,523 at December 31, 2000) 193,943 48,859
Prepaid expenses and other assets 2,979 4,802
--------- ---------
Total current assets 213,269 160,782
Property and Equipment, Net 102,002 188,052
Accounts Receivable (net of an allowance of $0 at December 31, 1999
and $52,000 at December 31, 2000) - 12,306
Deferred Income Taxes - 4,148
Other Assets 4,829 7,871
--------- ---------
Total Assets $ 320,100 $ 373,159
========= =========
Liabilities and Stockholders' Equity (Deficiency)
Current Liabilities
Accounts payable $ 13,050 $ 13,684
Deferred revenue 1,702 3,350
Accrued network costs 12,911 9,302
Accrued commissions, net - related party 22,809 -
Deferred income taxes 15,160 4,148
Commissions payable 23,702 7,012
Accrued expenses - other 10,826 10,884
--------- ---------
Total current liabilities 100,160 48,380
--------- ---------
Long-Term Debt 72,000 130,000
Commissions Payable 9,860
Deferred Income Taxes 8,796 -
Other Liabilities 274 4,315
Series A Mandatorily Redeemable Convertible Preferred Stock
(0 and 10,000 authorized shares, 0 and 209,136 shares issued and outstanding with
redemption values of $0 and $208,758 at December 31, 1999 and 2000,
respectively) (see Note 6) - 202,854
Stockholders' Equity (Deficiency)
Common stock-Class A, $.01 par value (72,925 and 122,925 authorized shares, 10,426
and 10,934 outstanding at December 31, 1999 and December 31, 2000, respectively) 104 109
Common stock-Class B, $.01 par value (17,075 authorized shares, 17,075 and 16,835
outstanding at December 31, 1999 and December 31, 2000, respectively) 171 168
Additional paid-in capital (see Note 11) 108,665 73,813
Retained earnings (deficit) 30,365 (96,121)
Unearned compensation - stock options (435) (219)
--------- ---------
Total stockholders' equity (deficiency) 138,870 (22,250)
--------- ---------
Total Liabilities and Stockholders' Equity (Deficiency) $ 320,100 $ 373,159
========= =========
See notes to consolidated financial statements
41
US LEC Corp. and Subsidiaries
Consolidated Statements of Operations
For the Years Ended December 31, 1998, 1999, and 2000
(In Thousands, Except Per Share Data)
1998 1999 2000
-------- --------- ---------
Revenue, Net (Notes 2, 7 and 9 - includes related party transactions
totaling $6,239 and $9,511 in 1998 and 1999, respectively) $ 84,716 $ 175,180 $ 114,964
Cost of Services (Notes 7 and 9 - includes related party transactions
totaling $19,759 and $38,990 in 1998 and 1999, respectively) 33,646 73,613 52,684
-------- --------- ---------
Gross Margin 51,070 101,567 62,280
Selling, General and Administrative Expenses 25,020 48,375 80,684
Loss on Resolution of Disputed Revenue (Note 7) - - 55,345
Provision for Disputed Receivables, Net (Note 2) - - 40,000
Depreciation and Amortization 4,941 11,720 24,365
-------- --------- ---------
Earnings (Loss) from Operations 21,109 41,472 (138,114)
Other (Income) Expense
Interest Income (1,860) (1,050) (4,834)
Interest Expense (Note 4) 237 3,096 7,839
-------- --------- ---------
Earnings (Loss) Before Income Taxes 22,732 39,426 (141,119)
Income Tax Provision (Benefit) (Note 8) 9,305 15,617 (23,727)
-------- --------- ---------
Net Earnings (Loss) 13,427 23,809 (117,392)
-------- --------- ---------
Less: Preferred Stock Dividends - - 8,758
Less: Accretion of Preferred Stock Issuance Cost - - 336
Net Earnings (Loss) Attributable to Common Stockholders $ 13,427 $ 23,809 $(126,486)
======== ========= =========
Net Earnings (Loss) Per Common Share (Note 12):
Basic $ 0.53 $ 0.87 $ (4.58)
======== ========= =========
Diluted $ 0.52 $ 0.84 $ (4.58)
======== ========= =========
Weighted Average Number of Shares Outstanding (Note 12):
Basic 25,295 27,431 27,618
======== ========= =========
Diluted 25,804 28,411 27,618
======== ========= =========
See notes to consolidated financial statements
42
US LEC Corp. and Subsidiaries
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIENCY)
For the years ended December 31, 1998, 1999 and 2000
(In Thousands)
Common Stock Common Stock
Class A Class B
-----------------------------------------
-----------------------------------------
Balance, December 31, 1997 3,855 $ 39 16,595 $ 166
Public stock offering 6,325 63 - -
Conversion of $5,000 stockholder loans for 481 shares
of Class B common stock - - 481 5
Dividend (Note 4) - - - -
Issuance of stock warrants - - - -
Unearned compensation - stock options - - - -
Exercise of warrants 165 1 - -
Tax effects related to warrants - - - -
Net earnings - - - -
-----------------------------------------
Balance, December 31, 1998 10,345 103 17,076 171
Exercise of stock options 14 - - -
Exercise of warrants 5 - - -
Tax effects related to stock options and warrants - - - -
Issuance of Shares 62 1 - -
Unearned compensation - stock options - - - -
Net earnings - - - -
-----------------------------------------
Balance, December 31, 1999 10,426 104 17,076 171
Exercise of stock options 28 - - -
Exercise of warrants 131 1 - -
Tax effects related to stock options and warrants - - - -
Issuance of Shares 108 1 - -
Unearned compensation - stock options - - - -
Accretion of preferred stock issuance cost - - - -
Conversion of Class B Common Shares
to Class A Common Shares 241 3 (241) (3)
Deemed distribution to related party - - - -
Preferred Stock Dividends - - - -
Net loss - - - -
-----------------------------------------
Balance, December 31, 2000 10,934 $ 109 16,835 $ 168
See Notes to Consolidated Financial Statements
43
Unearned
Additional Retained Compensation
Paid-In Earnings Stock
Capital (Deficit) Options Total
-----------------------------------------------------------
Balance, December 31, 1997 $ 11,173 $ (5,621) $ - $ 5,757
Public stock offering 87,079 - - 87,142
Conversion of $5,000 stockholder loans for 481 shares
of Class B common stock 4,995 - - 5,000
Dividend (Note 4) 1,250 (1,250) - -
Issuance of stock warrants 75 - - 75
Unearned compensation - stock options 819 - (655) 164
Exercise of warrants 471 - - 472
Tax effects related to warrants 938 - - 938
Net earnings - 13,427 - 13,427
-----------------------------------------------------------
Balance, December 31, 1998 106,800 6,556 (655) 112,975
Exercise of stock options 103 - - 103
Exercise of warrants 14 - - 14
Tax effects related to stock options and warrants 28 - - 28
Issuance of Shares 1,749 - - 1,750
Unearned compensation - stock options (29) - 220 191
Net earnings - 23,809 - 23,809
-----------------------------------------------------------
Balance, December 31, 1999 108,665 30,365 (435) 138,870
Exercise of stock options 286 - - 286
Exercise of warrants 372 - - 373
Tax effects related to stock options and warrants 228 - - 228
Issuance of Shares 442 - - 443
Unearned compensation - stock options (65) - 216 151
Accretion of preferred stock issuance cost - (336) - (336)
Conversion of Class B Common Shares
to Class A Common Shares - - - -
Deemed distribution to related party (36,115) - - (36,115)
Preferred Stock Dividends - (8,758) - (8,758)
Net Loss - (117,392) - (117,392)
-----------------------------------------------------------
Balance, December 31, 2000 $73,813 (96,121) $ (219) (22,250)
See Notes to Consolidated Financial Statements
44
US LEC Corp. and Subsidiaries
Consolidated Statements of Cash Flows
(In Thousands)
1998 1999 2000
--------- --------- ----------
Operating Activities
Net earnings (loss) $ 13,427 $ 23,809 $ (117,392)
--------- --------- ----------
Adjustments to reconcile net earnings (loss) to net cash used in
operating activities:
Depreciation and amortization 4,941 11,720 24,365
Loss on resolution of disputed revenue - - 55,345
Accounts receivable allowance 12,024 28,050 40,449
Stock compensation 240 - -
Deferred compensation (655) 191 150
Deferred income taxes 8,367 15,617 (23,727)
Changes in assets and liabilities which provided (used) cash:
Accounts receivable (74,177) (155,779) (33,983)
Prepaid expenses and other assets (579) 495 (1,414)
Other assets (1,271) (41) (2,827)
Accounts payable 1,609 (96) 1,131
Deferred revenue (312) 873 1,648
Accrued network costs 2,737 8,390 (4,460)
Customer commissions payable 4,160 19,103 5,169
Other liabilities - noncurrent - 274 4,041
Accrued commissions payable - related party 5,264 17,464 -
Accrued expenses - other 5,082 3,995 2,186
--------- --------- ----------
Total adjustments (32,570) (49,744) 68,073
--------- --------- ----------
Net cash used in operating activities (19,143) (25,935) (49,319)
--------- --------- ----------
Investing Activities
Purchase of property and equipment (47,721) (49,690) (111,616)
Purchases of certificates of deposit and restricted cash (817) (6) (127)
--------- --------- ----------
Net cash used in investing activities (48,538) (49,696) (111,743)
--------- --------- ----------
Financing Activities
Proceeds from public stock offering 87,142 114 -
Net proceeds from issuance of Series A Preferred Stock - - 193,760
Proceeds from exercise of stock options, warrants, and Employee
Stock Purchase Plan 471 - 1,105
Proceeds from long-term debt 20,000 52,000 155,000
Payments on long-term debt - - (97,000)
Payment for deferred loan fees (1,156) (3,274) (1,156)
Proceeds from notes payable - stockholders 3,289
Repayment of notes payable - stockholders (3,289) - -
--------- --------- ----------
Net cash provided by financing activities 106,457 48,840 251,709
--------- --------- ----------
Net (Decrease) Increase in Cash and Cash Equivalents 38,776 (26,791) 90,647
Cash and Cash Equivalents, Beginning of Period 3,189 41,965 15,174
--------- --------- ----------
Cash and Cash Equivalents, End of Period $ 41,965 $ 15,174 $ 105,821
========= ========= ==========
Supplemental Cash Flow Disclosures
Cash Paid for Interest $ 505 $ 2,748 $ 7,377
========= ========= ==========
Cash Paid for Taxes $ 1,860 $ 2 $ -
========= ========= ==========
Supplemental Noncash Investing and Financing Activities:
At December 31, 1998, 1999, and 2000, $6,838, $11,079, and $10,696,
respectively, of property and equipment additions are included in
outstanding accounts payable.
During 1998, the majority stockholder converted $5,000 of loans to the
Company for 481 shares of Class B Stock.
The dividend resulting from the cancellation of the loan was $1,250.
See notes to consolidated financial statements
45
US LEC Corp. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the years ended December 31, 1998, 1999, and 2000
(In Thousands, Except Per Share Data)
1. ORGANIZATION AND NATURE OF BUSINESS
The consolidated financial statements include the accounts of US LEC
Corp. (the "Company") and its ten wholly owned subsidiaries. All significant
intercompany transactions and balances have been eliminated in consolidation.
The Company was incorporated in 1996 as an S Corporation. Effective December 31,
1996, US LEC Corp. was converted to a limited liability company ("US LEC
L.L.C.") through an exchange of the S Corporation common stock for voting and
nonvoting units of US LEC L.L.C. On December 31, 1997, in anticipation of an
initial public offering of common stock, the Company became a C Corporation
through a merger of US LEC L.L.C. into the Company and the exchange of all of
the limited liability company units into shares of Class A or Class B Common
Stock. On April 29, 1998, the Company completed the sale of 5,500 shares of
Class A Common Stock through an initial public offering. Additionally, on May
12, 1998, the Company issued 825 shares of Class A Common Stock in connection
with the underwriters' exercise of their option to cover over-allotments. The
total offering resulted in net proceeds of approximately $87,142, after
deducting underwriting discounts, commissions and offering expenses. The Company
has used all of the net proceeds of the initial public offering to further
expand and develop its telecommunications network and services.
The Company, through its subsidiaries, provides switched local, long
distance, data, Internet and enhanced telecommunications services primarily to
businesses and other organizations in selected markets in the southeastern
United States. The Company was a development stage enterprise from inception
until March 1997, when it began generating telecommunications revenues.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Revenue Recognition - The Company recognizes revenue on
telecommunications and enhanced communications services in the period that the
service is provided. Revenue is recognized when earned based upon the following
specific criteria: (1) persuasive evidence of arrangement exist (2) services
have been rendered (3) sellers price to the buyer is fixed or determinable and
(4) collectibility is reasonably assured. Reciprocal compensation that we earn
as revenue from other local exchange carriers represents compensation for local
telecommunications traffic terminated on our network that originates on another
carrier's network. To date, a majority of our reciprocal compensation revenue
has been generated from traffic originated by customers of BellSouth
Telecommunications, Inc. ("BellSouth"). The billing, payment and other
arrangements for this reciprocal compensation are governed by interconnection
agreements between BellSouth and the Company. For 1998, 1999 and 2000, revenues
are recorded net of amounts which are due to a customer or outside sales agent
pursuant to each respective telecommunications service contract as well as an
allowance for early termination fees. For the years ended December 31, 1999, and
December 31, 2000, commissions expense of $25,265 and $7,499, respectively, and
revenue reductions related to early termination fees of $121 and $757,
respectively, are netted with gross revenues in the accompanying financial
statements. Early termination fees are recognized when paid and revenue related
to billings in advance of providing services is deferred and recognized when
earned. Reciprocal compensation represents the compensation paid to and by a
competitive local exchange carrier ("CLEC") and the incumbent local exchange
carrier ("ILEC") for termination of a local call on the other's network. During
1998, the Company began recognizing all reciprocal compensation revenue in the
period in which the service was provided as a result of the decision made by the
North Carolina Utilities Commission ("NCUC") on February 26, 1998, in favor of
the Company. However, due to regulatory and judicial proceedings related to
reciprocal compensation revenue, the Company established an allowance against
accounts receivable of $39,823 at December 31, 1999, which had been recorded as
a reduction of revenue of
46
$12,000 and $27,823 throughout the years ended December 31, 1998, and December
31, 1999, respectively (See Note 7).
In 2000, the Company began deferring installation revenue from End
Customers and from other Carriers. The Company is amortizing this revenue over
the average life of the contract. As of December 31, 2000, the Company had $579
recorded in Deferred Revenue on the accompanying Consolidated Balance Sheet. In
addition, the Company had $1,463 recorded in Other Liabilities for the
noncurrent portion of the Deferred Revenue.
Cost of Sales - The Company's cost of services is comprised primarily of
two types of charges: leased transport charges which comprise approximately
two-thirds of the Company's cost of services and usage sensitive charges
(primarily usage charges associated with the Company's off net toll and toll
free services and access and reciprocal compensation charges owing to other
carriers) which comprise approximately one-third of the Company's cost of
services. The Company's leased transport charges are the lease payments incurred
by US LEC for the transmission facilities used to connect the Company's
customers to its switch and to connect to the ILEC and other carrier networks.
US LEC, as part of its "smart-build" strategy, does not currently own any fiber
or copper transport facilities. These facilities are leased from various
providers including, in many cases, the ILEC. The Company's strategy of leasing
rather than building its own fiber transport facilities results in the Company's
cost of services being a significant component of total costs. Management
believes that this strategy has several benefits, including faster
time-to-market, more efficient asset utilization, and diverse interconnection
opportunities. The Company has to date been successful in negotiating lease
agreements which generally match in the aggregate the duration of its customer
contracts, thereby allowing the Company to mitigate the risk of incurring
charges associated with transmission facilities that are not being utilized by
customers.
In 2000, the Company began deferring installation charges from ILECs
related to Network and End Customer Facilities. The Company is amortizing these
costs over the average life of the contract. During the period ended December
31, 2000, the Company amortized $600 of deferred installation charges into Cost
of Sales. As of December 31, 2000, the Company had $1,177 recorded in Other
Current Assets and $1,749 recorded in Other Assets the accompanying Consolidated
Balance Sheet.
Cash and Cash Equivalents - Cash equivalents consist of highly liquid
investments with original maturities of three months or less at the time of
purchase.
Restricted Cash - The restricted cash balance as of December 31, 1999
and December 31, 2000 serves as collateral for letters of credit related to
certain office leases.
Accounts Receivable - The majority of the Company's gross accounts
receivable at December 31, 1998, 1999, and 2000, arose from reciprocal
compensation revenue earned in accordance with terms of an interconnection
agreement with BellSouth. Due to regulatory and judicial proceedings related to
this revenue, the Company recognized such revenues net of estimated disputed
amounts for which collection was not assured during 1998 and 1999, resulting in
an allowance against accounts receivable of $39,823 at December 31, 1999. This
allowance was subsequently reversed in connection with the write-off of the
Metacomm receivable in the first quarter of 2000.
The $52,000 allowance against accounts receivable at December 31, 2000,
was considered necessary due to a number of factors which occurred during 2000;
including, negotiated rates for ISP reciprocal compensation in the Company's new
interconnection agreements, and the age of some of the receivables which
management continues to believe are due from BellSouth. The charge of $52,000
related to this allowance is netted on the Company's Statement of Operations,
against a $12,000 reduction in commissions payable on those receivables, for
which commissions were not due until the related receivables were collected,
resulting in a $40,000 net charge (See Note 7).
The Company has reserved an additional $1.5 million related to
non-reciprocal compensation revenue. In addition, the Company has reclassified
any remaining accounts receivable related to disputed reciprocal compensation
earned prior to January 1, 2000 as non-current on the December 31, 2000 balance
47
sheet, since management now believes that payment on those receivables may not
be received during the next year.
Property and Equipment - Property and equipment is stated at cost less
accumulated depreciation. Depreciation is computed using the straight-line
method over the estimated useful lives of the assets, except for leasehold
improvements as noted below.
The estimated useful lives of the Company's principal classes of property and
equipment are as follows:
Telecommunications switching and other equipment 5 - 9 years
Office equipment, furniture and other 5 years
Leasehold improvements The lesser of the estimated
useful lives or the lease term
The Company capitalized $264 and $1,025 in payroll related costs and $81
and $0 in interest costs during the years ended December 31, 1999 and 2000,
respectively in accordance with the AICPA Statement of Position ("SOP") 98-1,
"Accounting for the Costs of Computer Software Developed or Obtained for
Internal Use."
Long-Lived Assets - The Company reviews the carrying value of its
long-lived assets for impairment whenever events or changes in circumstances
indicate that the carrying value of these assets may not be recoverable.
Measurement of any impairment would include a comparison of estimated
undiscounted future operating cash flows anticipated to be generated during the
remaining life of the assets with their net carrying value. An impairment loss
would be recognized as the amount by which the carrying value of the assets
exceeds their fair value.
Accrued Network Costs - Accrued network costs include management's
estimate of charges for direct access lines, facility charges, outgoing and
incoming minutes, reciprocal compensation and other costs of revenue for a given
period for which bills have not been received by the Company. Management's
estimate is developed from the number of lines and facilities in service,
minutes of use and rates charged by each respective service provider. Subsequent
adjustments to this estimate may result when actual costs are billed by the
service provider to the Company. However, management does not believe such
adjustments will be material to the Company's financial statements.
Debt Issuance Cost - The Company capitalizes loan fees associated with
securing long term debt and amortizes such deferred loan fees over the term of
the debt agreement. The Company had deferred loan fees (net of accumulated
amortization) of $4,405 and $4,738 as of December 31, 1999 and 2000,
respectively, recorded in other assets on the accompanying balance sheet which
are being amortized over 7 years. (See Note 5)
Fair Value of Financial Instruments - Management believes the fair
values of the Company's financial instruments, including cash equivalents,
restricted cash, accounts receivables, and accounts payable approximate their
carrying value. In addition, because the long-term debt consists of variable
rate instruments, their carrying values approximate fair values.
Income Taxes - Income taxes are provided for temporary differences
between the tax and financial accounting basis of assets and liabilities using
the liability method. The tax effects of such differences, as reflected in the
balance sheet, are at the enacted tax rates expected to be in effect when the
differences reverse. Valuation allowances are established when necessary to
reduce deferred tax assets to the amount expected to be realized and are
reversed at such time that realization is believed to be more likely than not.
Concentration of Risk - The Company is exposed to concentration of
credit risk principally from trade accounts receivable. The Company's trade
customers are located in the southeastern and mid-Atlantic United States. The
Company performs ongoing credit evaluations of its customers but does not
typically require collateral deposits to support customer receivables. Credit
risk may be reduced by the fact that the Company's most significant trade
receivables are from large, well-established telecommunications entities.
48
However, at December 31, 1999 and 2000, the majority of the gross accounts
receivable balance is due from BellSouth and is currently in dispute (See Note
7).
The Company is dependent upon certain suppliers for the provision of
telecommunications services to its customers. The Company has executed
interconnection agreements for all of its current operating networks, and a
number of these agreements were re-negotiated in 1999 and 2000. Management
believes that suitable interconnection agreements can be negotiated for the
remaining agreements that have expired and, accordingly, does not expect any
disruption of services. The interconnection agreement with BellSouth expired on
December 31, 1999, but continues in force until new interconnection agreements
are reached. The Company has reached agreements with BellSouth for Florida,
Kentucky, Louisiana, Mississippi, North Carolina, Tennessee and South Carolina
and continues to seek agreements for Alabama and Georgia.. These new agreements
will be effective as of January 1, 2000 (See Note 7).
Use of Estimates - The preparation of financial statements in conformity
with generally accepted accounting principles requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and the disclosure of contingent assets and liabilities at the date
of the financial statements. Actual results could differ from those estimates.
Significant estimates relate to the accrual of network costs payable to other
telecommunications entities and the estimate for the allowance for receivables
due from BellSouth. Any difference between the amounts recorded and amounts
ultimately realized or paid will be adjusted prospectively as new facts become
known (See Note 7).
Advertising - The Company expenses advertising costs in the period
incurred. Advertising expense amounted to $276, $522, and $1,190 for 1998, 1999
and 2000, respectively, which for 1999 were entirely offset by marketing
incentives provided by a vendor.
Significant Customer - In fiscal 1998, 1999, and 2000, BellSouth,
operating in the majority of the Company's markets, accounted for approximately
80%, 70%, and 15%, respectively, of the Company's net revenue (before reduction
for the $12,000, $27,823 and $0 allowance in 1998, 1999, and 2000, respectively,
described above and in Note 7 to the Company's Consolidated Financial
Statements). The majority of this revenue was generated from reciprocal
compensation. Although reciprocal compensation owed to the Company by BellSouth
is not a customer relationship in the traditional sense, BellSouth is shown here
due to the significant contribution to revenue. At December 31, 1998, 1999, and
2000, BellSouth accounted for 94%, 92%, and 70% of the Company's total accounts
receivable before allowance, respectively. The majority of such receivables and
revenues in 1998 and 1999, resulted from traffic associated with Metacomm, LLC
("Metacomm"), a customer of the Company and BellSouth, which became a related
party to the Company during 1998. During 2000, Metacomm ceased to be a customer
of BellSouth and the Company and no revenue was recorded in 2000 related to
Metacomm traffic. As a result of the March 31, 2000 order issued by the North
Carolina Utilities Commission ("NCUC") denying reciprocal compensation to the
Company from traffic associated with the Metacomm network, the Company recorded
a pre-tax, non-recurring, non-cash charge of approximately $55,000 (See Note 7
and 9).
Recent Accounting Pronouncements - Effective January 1, 2001, the
Company will adopt Statement of Financial Accounting Standards ("SFAS") No. 133,
"Accounting for Derivative Instruments and Hedging Activities", as amended by
SFAS No. 138, "Accounting for Certain Derivative Instruments and Hedging
Activities." SFAS No. 133 establishes accounting and reporting standards for
derivative instruments and hedging activities by requiring that entities
recognize all derivatives as either assets or liabilities at fair market value
on the balance sheet. The Company believes that the adoption of SFAS No. 133
will not have a material effect on its results of operations as it does not
currently hold any derivative instruments or engage in hedging activities.
In December 1999, the Securities and Exchange Commission issued Staff
Accounting Bulletin 101, " Revenue Recognition in Financial Statements" ("SAB
101"), to provide guidance on the recognition, presentation, and disclosure of
revenue in the financial statements. The Company adopted SAB 101 effective
October 1, 2000. Management believes such adoption does not have a material
effect on results of operations or the financial position of the Company.
49
Reclassifications - Certain reclassifications have been made to 1998
amounts to conform to the 1999 and 2000 presentation.
3. PROPERTY AND EQUIPMENT
Property and equipment at December 31, 1999 and 2000 is summarized by
major class as follows:
1999 2000
- -----------------------------------------------------------------------------------------------------------
Telecommunications switching and other equipment $ 79,494 $ 145,278
Office equipment, furniture and other 24,950 56,281
Leasehold improvements 14,071 26,444
-----------------------------------
118,515 228,003
Less accumulated depreciation and amortization (16,513) (39,951)
-----------------------------------
Total $ 102,002 $ 188,052
===================================
4. NOTES PAYABLE-STOCKHOLDERS
During 1997, the Company's majority stockholder loaned an aggregate of
$5,000 to the Company. Interest charged on loaned amounts was at prime plus 2%
(10.5% per annum at December 31, 1997). On February 14, 1998, the Company's
majority stockholder exchanged the $5,000 loan for 481 shares of Class B Common
Stock with a fair value of $10.40 per share. The fair value of the Class B
Common Stock issued in the exchange was $1,250 in excess of the carrying value
of the debt. Accordingly, the difference between the carrying value of the debt
and the fair value of the Class B Common Stock issued in the exchange was
recorded as a dividend to the majority stockholder in the first quarter of 1998.
In January 1998, an entity controlled by this stockholder loaned an additional
$2,289 to the Company with an interest rate of 12%. The Company repaid all the
outstanding amounts due under the loan in June 1998.
In January 1998, a stockholder loaned $1,000 to the Company, with an
interest rate of 12%. The Company repaid all the outstanding amounts due under
the loan in June 1998.
Interest expense to related parties totaled $420, $223 and $0 in 1997,
1998 and 1999, respectively.
5. LONG-TERM DEBT
50
In December 1998, the Company entered into a $50,000 senior secured loan
agreement. In June 1999, the Company amended the loan agreement to increase the
amount available from $50,000 to $75,000. In December 1999, the Company again
amended the loan agreement increasing the amount available from $75,000 to
$150,000. The credit facility is now comprised of (i) a $125,000 revolving
credit facility with a term of 18 months and an option to convert into a
six-year term loan at the end of the 18 month period and (ii) a $25,000
revolving credit facility with a six-year term. The interest rate for the
facility is a floating rate based, at the Company's option, on a base rate (as
defined in the loan agreement) or the London Interbank Offered Rate (LIBOR),
plus a specified margin. The amount outstanding under the credit facility at
December 31, 2000, was $130,000. Advances under the agreement as of December 31,
2000, bear interest at an annual rate ranging between approximately 10.6% and
10.8%. The credit facility is subject to certain financial covenants, the most
significant of which relates to the maintenance of levels of revenue, earnings
and debt ratios. The credit facility is secured by a pledge of the capital stock
of the Company's principal operating subsidiaries and a security interest in a
substantial portion of the Company's and its operating subsidiaries' equipment,
receivables, leasehold improvements and general intangibles. Proceeds from the
credit facility have been and will be used to fund capital expenditures and
working capital requirements and for other general corporate purposes. Scheduled
maturities of long-term debt, assuming conversion to a term loan are as follows:
Year ending December 31:
2001 $ -
2002 18,750
2003 18,750
2004 25,000
2005 36,250
Thereafter 31,250
---------
Total $ 130,000
=========
6. SERIES A MANDATORILY REDEEMABLE CONVERTIBLE PREFERRED STOCK
On April 11, 2000, the Company issued $200 million of its Series A
Mandatorily Redeemable Convertible Preferred Stock (the "Series A Preferred
Stock") to affiliates of Bain Capital, Inc. (Bain) and Thomas H. Lee Partners,
L.P. (THL). The Series A Preferred Stock earns dividends on a cumulative basis
at an annual rate of 6%, payable quarterly in shares of Series A Preferred Stock
for three years and at US LEC's option, in cash or shares of Series A Preferred
Stock over the next seven years. In addition, the Series A Preferred Stock
participates on a pro rata basis in the dividends payable to common
shareholders. For the year ended December 31, 2000, the Company issued $6.0
million in Series A Preferred Stock Dividends and has accrued an additional $2.8
million. In the event of any liquidation, dissolution or other winding up of the
affairs of the Company, the holders of Series A Preferred Stock are entitled to
be paid in preference to any distribution to holders of junior securities, an
amount in cash, equal to $1,000 per share plus all accrued and unpaid dividends
on such shares. On or after April 11, 2001, the holders of the shares of Series
A Preferred Stock may convert all or a portion of their shares into shares of
Class A Common Stock at a set conversion price. The initial conversion price of
$35.00 has been adjusted to approximately $34.50 pursuant to the anti-dilution
provisions of the Series A Preferred Stock. The holders of the Series A
Preferred Stock may also convert all or a portion of their shares into Class A
Common Stock at a set conversion price prior to April 11, 2010 in the event of a
change in control or an acquisition event. Each holder of the Series A Preferred
Stock may redeem all or a portion of their Series A Preferred Stock at a price
equal to 101% of $1,000 per share plus all accrued dividends on such shares
after the occurrence of a change in control and for a period of 60 days
following such event. At any time on or after April 11, 2003, the Company may
redeem all of the outstanding shares of Series A Preferred Stock, at a price
equal to $1,000 per share plus all accrued and unpaid dividends on such shares,
only if the market price of a share of common stock for 30 consecutive trading
days during the 90 day period immediately preceding the date of
51
the notice of redemption is at least 150% of the then effective conversion price
and the market price of a share of common stock on the redemption date is also
at least 150% of the then effective conversion price. All outstanding shares of
the Series A Preferred Stock are subject to mandatory redemption on April 11,
2010. Proceeds to the Company, net of commissions and other transaction costs,
were approximately $194 million. On or prior to April 11, 2001, the affiliates
of Bain and THL, at their option, may invest up to an additional $100 million in
the Company's Series B Mandatorily Redeemable Convertible Preferred Stock (the
"Series B Preferred Stock"). The Series B Preferred Stock has an initial
conversion price of $46.50, subject to adjustment pursuant to the anti-dilution
provisions of the Series B Preferred Stock. The holders of the Series B
Preferred Stock may convert all or a portion of these shares into shares of
Class A Common Stock one year after the shares are issued.
The Company incurred $6,240 in expenses related to the issuance of the
Series A Preferred Stock. The cost will be accreted against Retained Earnings
(Deficit) over the life of the agreement. For the period ended December 31,
2000, the Company accreted $336 of these cost. As of December 31, 2000, the
Company had $5,904 in Series A Preferred Stock issuance cost netted with Series
A Mandatorily Redeemable Convertible Preferred Stock on its Consolidated Balance
Sheet.
7. COMMITMENTS AND CONTINGENCIES
The deregulation of the telecommunications industry and the
implementation of the Telecommunications Act of 1996 have embroiled the industry
and the Company in numerous proceedings in arbitration, state regulatory
commissions, and the courts over issues including reciprocal compensation and
access rates, the characterization of traffic for compensation purposes, and the
interpretation of interconnection agreements, among other issues. Rulings
adverse to the Company on any of the issues, which are material to it, could
have an adverse impact on the Company's financial results or its operations.
The Company is involved in several legal and regulatory proceedings
regarding revenues and receivables from ILECs, IXCs and other carriers. As of
December 31, 2000, the Company's gross accounts receivable was approximately
$115 million, of which approximately $77 million was attributed to BellSouth and
approximately $13 million was attributed to Sprint.
In the case of BellSouth, the majority of the receivables are being
disputed primarily due to issues regarding reciprocal compensation for ISPs and
certain rate issues. In the case of Sprint, a significant portion of the
receivable is being disputed based on access rates. The following paragraphs
discuss in detail each of the material disputes and associated regulatory or
legal proceeding.
The Metacomm Decision - As the Company has previously reported,
BellSouth Telecommunications, Inc. ("BellSouth") began a proceeding in September
1998 before the North Carolina Utilities Commission ("NCUC") seeking to be
relieved of any obligation under its interconnection agreements with the Company
to pay reciprocal compensation for traffic related to the network operated by
Metacomm, LLC ("Metacomm"), a customer of both the Company and BellSouth. On
March 31, 2000, the NCUC issued an order in this proceeding (the "March 31
Order") that relieves BellSouth from paying reciprocal compensation to the
Company for any minutes of use attributable to Metacomm network traffic and
requires the Company to cease billing BellSouth reciprocal compensation for
minutes of use attributable to the Metacomm or any similar network as such
networks are identified in the March 31 Order. The March 31 Order does not
affect in any way the NCUC's order of February 1998 requiring BellSouth to pay
reciprocal compensation to the Company for Internet service provider ("ISP")
traffic in North Carolina (the "NCUC ISP Order"). It relates solely to traffic
on Metacomm's network in North Carolina (the only state in which Metacomm
operated). The Company did not appeal the March 31 Order, although Metacomm is
prosecuting an appeal.
As a result of the March 31 Order, the Company recorded a pre-tax,
non-recurring, non-cash charge of approximately $55,000 in the first quarter of
2000. The charge was composed of the write-off of
52
approximately $153,000 in receivables related to reciprocal compensation revenue
offset by previously established reserves of $39,000 and a reduction of $59,000
in commissions payable to Metacomm.
On March 21, 2000, the NCUC issued an interim order (the "March 21
Order") to BellSouth to pay to the Company all reciprocal compensation owing to
the Company for traffic terminated in North Carolina, other than traffic related
to Metacomm and like networks. This order was issued in connection with the
on-going proceeding before the NCUC filed in September 1998 by the Company in
which it seeks payment of reciprocal compensation not related to Metacomm or to
traffic terminated to ISPs, and of other amounts owing to the Company. The
Company's action before the NCUC to recover reciprocal compensation and other
charges for non-Metacomm/non-ISP traffic has been stayed by the NCUC while the
Company and BellSouth conduct NCUC-ordered negotiations to resolve the matter.
The amount due to the Company as a result of this proceeding will be determined
by the negotiations or subsequent ruling by the NCUC regarding the
non-Metacomm/non-ISP charges BellSouth is obligated to pay. The Company is
currently working with BellSouth to determine the amount BellSouth will pay
under the March 21, 2000 Order. Once this is determined by negotiation or NCUC
ruling, the Company will adjust the non-recurring charge. Management believes
that this adjustment will not be material to the Company's operating results or
financial position. If the negotiations are unsuccessful, the Company will seek
a lifting of the stay and seek a hearing and ruling from the NCUC on its claims
against BellSouth.
In 2000, additional paid-in capital has been reduced by $36 million
representing amounts due from Metacomm, which is indirectly controlled by
Richard T. Aab, a majority stockholder of the Company. Due to Mr. Aab's
controlling position in both Metacomm and the Company, this amount is being
treated for financial reporting purposes as a deemed distribution to the
stockholder. At the time such amounts are paid to the Company, the payment will
increase additional paid-in capital as a capital contribution to the Company.
(See Note 14 to the Company's Consolidated Financial Statements)
Other Disputed Reciprocal Compensation Revenue - The Company is also a
party to the following material proceedings in which it seeks collection of
outstanding amounts owed by incumbent local telephone companies, primarily
BellSouth, for non-Metacomm related reciprocal compensation, including
reciprocal compensation related to traffic terminating to ISPs and other
customers:
North Carolina -- On February 26, 1998, following a petition by the
Company, the NCUC ordered BellSouth to bill and pay for all ISP-related traffic
(defined above, the "NCUC ISP Order"). Following motions filed by BellSouth, the
NCUC stayed enforcement of its order until June 1, 1998. On April 27, 1998,
BellSouth filed a petition for judicial review of the NCUC ISP Order and an
action for declaratory judgment and other relief (including a request for an
additional stay) with the United States District Court for the Western District
of North Carolina ("U.S. District Court-NC") pending determination of certain
related issues by the Federal Communications Commission ("FCC"). This action was
filed against the Company and the NCUC. In June 1999, the U.S. District Court-NC
dismissed BellSouth's petition without prejudice and remanded it back to the
NCUC for further review. Following the U.S District Court-NC's remand, on June
22, 1999, the NCUC denied BellSouth's request for a further stay of the NCUC ISP
Order.
In addition to denying BellSouth's request for a further stay, the NCUC
filed an appeal with the U.S. Fourth Circuit Court of Appeals (the "4th
Circuit") of the U.S. District Court-NC's order that rejected the NCUC's
defenses, including its defense that the 11th Amendment to the United States
Constitution bars BellSouth from making the NCUC a party to a proceeding in the
federal courts. The Company also appealed and the United States Justice
Department intervened in the appeal. On February 14, 2001 the 4th Circuit issued
a ruling in favor of the Company and the NCUC, ruling that the U.S. District
Court - NC did not have subject matter jurisdiction over the appeal of an
enforcement proceeding and ruling the NCUC was immune from suit under the
Eleventh Amendment of the United States Constitution. On March 5, 2001, the
United States Supreme Court granted a petition for certiorari in which it agreed
to consider these issues in a case originating in the U.S. Circuit Court of
Appeals for the Seventh Circuit. The Company anticipates that BellSouth will
seek review of the Fourth Circuit Court's ruling by the Supreme Court as well.
On July 16, 1999, the Company received a payment of $11,187 from
BellSouth representing a portion of the amounts due the Company for ISP
reciprocal compensation in North Carolina. In making the payment, BellSouth
stated that it was for ISP traffic the NCUC had ordered it to pay for in the
NCUC ISP Order, including late fees, and that it was reserving all of its appeal
rights with respect to the payment. BellSouth also stated that this payment did
not include any amounts at issue in its September 1998 NCUC proceeding regarding
Metacomm. This partial payment did not cover all outstanding non-Metacomm
related amounts the Company claims are due from BellSouth in North Carolina. In
addition, BellSouth has from time to time made payments to US LEC for reciprocal
compensation related to traffic terminated in
53
North Carolina, but BellSouth has not paid the entire amount due to the Company
for non-Metacomm reciprocal compensation.
Georgia -- On June 30, 1999, the Company filed a complaint against
BellSouth before the Georgia Public Service Commission ("GAPSC") concerning the
Company's first and second interconnection agreements with BellSouth in Georgia.
These interconnection agreements cover the period through June 1999. On May 17,
2000, the hearing officer reviewing the Company's first and second
interconnection agreements with BellSouth issued a recommended decision to the
GAPSC stating that BellSouth should be ordered to pay US LEC the disputed
reciprocal compensation at the end office rate, pending submission of evidence
by the Company showing that it is entitled to be compensated at the higher
tandem rate. On June 15, 2000, the GAPSC affirmed this recommended decision, and
issued an order requiring BellSouth to pay US LEC reciprocal compensation for
traffic to ISPs and other customers in Georgia at the end office rate (the
"GAPSC Order"). On July 12, 2000, US LEC filed evidence with the GAPSC regarding
its right to be compensated at the tandem rate. On July 14, 2000, BellSouth
filed an appeal of the GAPSC Order with the U.S. District Court for the Northern
District of Georgia ("U.S. District Court-GA") and with the Georgia Superior
Court in and for Fulton County, Georgia. BellSouth asked the Georgia state court
to cede the appeal to the U.S. District Court - GA and asked the latter court
for permission to pay amounts due into court to avoid paying US LEC pending
appeal. On July 18, 2000, the U.S. District Court- GA granted BellSouth's motion
to pay amounts due into court prior to receipt by the Company of any papers
related to that appeal. On October 2, 2000, the U.S. District Court - GA denied
the Company's request for reconsideration of the order allowing BellSouth to pay
amounts due into court. The Georgia State and Federal Courts are setting a
briefing schedule for the proceeding, and the Company and expects a decision
sometime in 2001. The GAPSC held a hearing on the tandem/end office rate issue
on March 8, 2001, but has not yet rendered a decision. The Company's complaint
did not address the third interconnection agreement in Georgia, which covers the
period from June 1999 to December 1999.
Florida -- On July 2, 1999, the Company filed a complaint against
BellSouth before the Florida Public Service Commission ("FLPSC") seeking
recovery of reciprocal compensation for ISP and other traffic in that state. The
FLPSC will also be called upon to decide issues in dispute between the Company
and BellSouth regarding the rate at which reciprocal compensation should be paid
for some of the traffic at issue. The hearing is scheduled to take place later
in 2001.
Tennessee -- On August 6, 1999, the Company filed a complaint against
BellSouth before the Tennessee Regulatory Authority ("TRA") seeking recovery of
reciprocal compensation for ISP and other traffic in that state. The TRA will
also be called upon to decide issues in dispute between the Company and
BellSouth regarding the rate at which reciprocal compensation should be paid for
some of the traffic at issue. There is no hearing scheduled for this matter at
this time.
Management believes that the Company will ultimately obtain favorable
results in the state proceedings described above before the FLPSC and the TRA
and in the pending appeal of the NCUC ISP Order and the GAPSC Order with respect
to the eligibility of ISP traffic for reciprocal compensation. Management's
belief is supported by the determinations of state regulatory bodies and by
courts hearing appeals of the state regulatory decisions, which are discussed
below, notwithstanding the jurisdictional position on ISP traffic taken by the
FCC in February 1999, which has now been vacated, also discussed below. However,
BellSouth may elect to initiate additional proceedings (by way of appeal or
otherwise) or attempt to expand the pending proceedings challenging amounts owed
to the Company. In this regard, BellSouth has asserted a variety of other
objections to paying portions of the reciprocal compensation billed by the
Company. They include assertions that US LEC has miscalculated late payment fees
due from BellSouth and that the Company has billed reciprocal compensation using
the wrong rates. The Company believes BellSouth has asserted these issues and
will attempt to raise further issues, in order to avoid or delay payment. In
September 2000, the FLPSC issued a ruling regarding one of these rate issues
favorable to BellSouth in a proceeding bought by Intermedia Communications, Inc
("Intermedia"). The impact of this ruling has not yet been determined, and the
Company has been informed that Intermedia intends to appeal the decision.
Proceedings on the same issue are pending decision in Georgia and North
Carolina.
54
FCC's ISP Ruling and Related Proceedings -- In February, 1999, the FCC
issued a declaratory ruling (the "ISP Ruling") which concluded that for
jurisdictional purposes most calls delivered to ISPs should be deemed to
continue to Internet web sites, which are often located in other states. Thus,
the FCC ruled that such calls are jurisdictionally "interstate" in nature.
However, the FCC further declared that, in light of its long-standing policy of
treating calls to ISPs as though they were local, where parties have previously
agreed in interconnection agreements that reciprocal compensation must be paid
for traffic bound for ISPs, the parties should be bound by those agreements, as
interpreted and enforced by state regulatory bodies. The FCC also recognized
that some commissions might reconsider their decisions in light of its ruling.
On March 24, 2000, the U.S. Circuit Court for the District of Columbia
(the "D.C. Circuit") vacated the FCC's ISP Ruling. The D.C. Circuit ruled that
the FCC did not give adequate consideration to a number of facts when it found
that ISP calls were jurisdictionally interstate, including the FCC's own past
analyses of how to determine whether calls dialed to telephone numbers within
the local exchange are interstate or intrastate. The D.C. Circuit also concluded
that the FCC had failed to explain why its jurisdictional analysis had any
relevance to the issue of whether calls to ISPs should be eligible for
reciprocal compensation. The D.C. Circuit sent the case back to the FCC to give
the FCC opportunity to reconsider those questions in light of the D.C. Circuit's
ruling. On June 23, 2000, the FCC requested comments on the issues raised by the
D.C. Circuit in its remand of the ISP Ruling. Initial comments were filed on
July 21, 2000. Reply comments were filed on August 4, 2000. The Company cannot
predict when the FCC will issue its decision on remand.
To date, state regulatory bodies in at least thirty states have
considered the effect of the FCC's ISP Ruling and have overwhelmingly reaffirmed
their earlier decisions requiring payment of reciprocal compensation for this
type of traffic or for the first time determined that such compensation is due.
Included among these states are Alabama, Florida, Georgia and Tennessee, which
together with North Carolina (see discussion above) represent the only states in
BellSouth's operating territory where the Company has significant reciprocal
compensation disputes at December 31, 2000. In this regard, the Alabama Public
Service Commission (the "APSC") concluded that the treatment of ISP traffic as
local was so prevalent in the industry at the time BellSouth entered into
interconnection agreements with CLECs that, if it had so intended, BellSouth had
an obligation to negate such local treatment in the agreements by specifically
delineating that ISP traffic was not local traffic subject to the payment of
reciprocal compensation. The APSC decision was affirmed by the United States
District Court for the Middle District of Alabama, and the GAPSC decision was
affirmed by the United States District Court of the Northern District of
Georgia. The FLPSC and the TRA have also reaffirmed decisions that reciprocal
compensation is owed for calls to ISPs. Two BellSouth states - South Carolina
and Louisiana - have ruled that reciprocal compensation is not due for traffic
to ISPs. These decisions, which came before the FCC's ISP Ruling was vacated by
the D.C. Circuit, represent a view adopted by very few other states (The Company
does not have ISP reciprocal compensation recorded to date for traffic in South
Carolina or Louisiana.)
State and federal courts considering the issue on appeal have also
universally supported the position that reciprocal compensation is due for
traffic terminated to ISPs. Included among these are decisions of the U.S.
Circuit Courts of Appeal for the Fifth, Seventh, Ninth and Tenth Circuits, all
of which considered the issue in light of the FCC's ISP Ruling and affirmed the
underlying decisions of the state regulatory agencies that reciprocal
compensation is due for traffic terminated to ISPs.
If a decision adverse to the Company is issued in any of these
proceedings by any of the state commissions, or in any federal or state appeal
or review of a favorable decision, or if either the FCC or any of the applicable
state commissions was to alter its view of reciprocal compensation or if
Congress or any state legislature enacted legislation that ended reciprocal
compensation for ISP traffic or all local traffic, such an event could have a
material adverse effect on the Company's operating results and financial
condition. Management estimates the Company's gross trade accounts receivable as
of December 31, 2000 included approximately $54,000 of earned, but uncollected,
disputed reciprocal compensation related to non-Metacomm related ISP traffic.
55
Legislation - At the end of the last session of Congress, legislation
was introduced in the United States House of Representatives and the United
States Senate that would eliminate all reciprocal compensation for calls to ISPs
and, under some proposals, for all local calls. A House subcommittee approved a
version of this legislation. No action was taken in the Senate. If this or
similar legislation were to become law, it would have a material adverse effect
on the Company.
GTE Reciprocal Compensation Dispute in North Carolina - In addition to
the proceedings involving BellSouth which are discussed above, in February 2000,
the Company received payment from GTE South Incorporated ("GTE") (now Verizon
South Incorporated) for reciprocal compensation for traffic in North Carolina,
including ISP traffic. This payment was pursuant to a commercial arbitration
award rendered January 4, 2000 resulting from a proceeding before the American
Arbitration Association. GTE was ordered to pay US LEC for all reciprocal
compensation for the period ending September 1999 (approximately $650). GTE
challenged the decision of the arbitrator in the U.S. District Court for the
Eastern District of North Carolina. This challenge was denied by the U.S.
District Court for the Eastern District of North Carolina and judgement was
entered in the Company's favor on January 11, 2001. The judgement was not
appealed so it is a final judgement.
In addition, the Company has filed for arbitration to resolve its
reciprocal compensation dispute with GTE in North Carolina for periods after
September 1999. The hearing in this arbitration took place on February 26-27,
2001, and all post-hearing briefs are scheduled to be filed by April 23, 2001.
Although the Company cannot predict when this arbitrator will issue a decision,
management knows of no reason why the second arbitration should have an outcome
different from the first, favorable arbitration ruling. The Company anticipates
that GTE will appeal any ruling adverse to it.
Existing BellSouth Interconnection Agreements -- In October 2000, the
Company agreed to adopt existing local interconnection agreements with BellSouth
in South Carolina, Kentucky, Louisiana and Mississippi. The Agreements are for a
term of two years and relate back to the expiration date of the prior agreements
in each state, and therefore will expire at varying dates in 2002. The
Agreements provide for reciprocal compensation at rates significantly lower than
in the Company's prior interconnection agreements. These agreements do not
provide for any reciprocal compensation payments for ISP traffic; rather, the
agreements include a true up provision whereby the parties will track that
traffic pending an order from the FCC on the issue. The Company does not have
significant amounts of reciprocal compensation in these states. The Company has
adopted new interconnection agreements in North Carolina, Florida and Tennessee,
all of which relate back to January 1, 2000 and which expire April 2002, October
2002 and November 2002, respectively. These agreements provide for reciprocal
compensation for all local traffic, including ISP traffic, at rates
significantly lower than in the Company's prior interconnection agreements.
However, the agreement for North Carolina provides for a true-up of payments
made for ISP traffic should the FCC determine that reciprocal compensation is
not owing for ISP traffic and that determination is given retroactive effect.
The Company continues to seek interconnection agreements with BellSouth in
Alabama and Georgia. The Company's existing agreements with BellSouth in these
states have expired, but continue in force until new interconnection agreements
are signed. BellSouth filed petitions for arbitration in these states seeking to
obtain state-ordered interconnection agreements, but the Company anticipates
that it will be able to avoid or shorten the arbitration process in these states
by adopting interconnection agreements that will result from recently concluded
arbitrations involving other CLECs. These new agreements will be effective as of
the expiration date of the prior agreements. The Company anticipates that new
interconnection agreements in these states will also provide for significantly
lower rates, but, unlike the agreements in South Carolina, Kentucky, Louisiana
and Mississippi, the Company does not anticipate that payment of reciprocal
compensation for ISP traffic would be affected by a true up provision.
Interconnection Agreements. - The Company has agreements for the
interconnection of its networks with the networks of the ILECs covering each
market in which US LEC either has or is currently installing a switching
platform. US LEC may be required to negotiate new interconnection agreements as
it enters new markets in the future. In addition, as its existing
interconnection agreements expire, it will be required to negotiate extension or
replacement agreements. There can be no assurance that the Company will
56
successfully negotiate such additional agreements for interconnection with the
ILECs or renewals of existing interconnection agreements on terms and conditions
acceptable to the Company. The Company has signed interconnection agreements
with various ILECs, including BellSouth Telecommunications, Inc. ("BellSouth"),
Sprint Communications Company L.P. ("Sprint"), Verizon Communications
("Verizon") and other carriers. These agreements provide the framework for the
Company to serve its customers when other local carriers are involved. The
Company has signed multiple agreements with BellSouth which govern relationships
in all nine states (See Existing BellSouth Interconnection Agreement above).
Agreements with GTE are in force in states where GTE and the Company
operate. The agreement for Virginia expired in July 2000, and remains in force
and effect until a new agreement is executed. All other agreements expire during
2001 or 2002.
The Company also has interconnection agreements with Verizon in the
states of Virginia, Pennsylvania, Maryland, Delaware, New Jersey and the
District of Columbia. Each of these agreements expired in 2000, and remain in
force and effect until a new agreement is entered into by Verizon and the
Company. The Company continues to seek new interconnection agreements in these
states.
Agreements with Sprint are in force and effect in Florida, Virginia,
North Carolina and Tennessee.
Disputed Access Revenues - A number of IXCs have refused to pay access
charges to CLECs, including those of the Company, on the allegation that the
access charges exceed those of the ILEC serving that territory in an apparent
effort to induce the CLECs, including the Company, to reduce access charges.
Currently there are a number of court cases, regulatory proceedings at the FCC,
and legislative efforts involving such challenges. The Company cannot predict
the outcome of these cases, regulatory proceedings, and legislative efforts or
their impact on access rates. In February 2000, the Company filed suit in U.S.
District Court for the Western District of North Carolina against Sprint
Communications Company L.P. ("Sprint"). This action seeks to collect amounts
owed to the Company for access charges for intrastate and interstate traffic
which was either handed off to Sprint by the Company or terminated to the
Company by Sprint. As of December 31, 2000, Sprint owed the Company
approximately $13 million in access charges. Sprint has refused to pay the
amounts invoiced by the Company on the basis that the rates are higher than the
amounts that Sprint believes are just and reasonable. Sprint claims it is not
obligated to pay more than an undefined incumbent local exchange carrier
("ILEC") rate. The Company's invoices to Sprint are at the rates specified in
the Company's state and federal tariffs. The FCC recently determined that a long
distance company may not withhold interstate access charges on the basis that it
believes the charges to be too high while also continuing to accept the benefits
of interconnection with the local carrier without taking formal action to
challenge the rates. The FCC has ruled that AT&T was obligated to pay such
access charges due to its failure to commence a proceeding or terminate
interconnection. (MGC Communications, Inc. v. AT&T Corp., FCC Release 99-408).
This decision is now final, as AT&T did not appeal the FCC's ruling. In
addition, the FCC ruled recently in an action brought by Sprint against MGC
Communications, Inc. ("MGC") that the fact that a CLEC's filed interstate rates
exceeded those of the competing ILECs was insufficient to establish that the
CLEC's rates were excessive. The FCC dismissed Sprint's challenge to MGC's
rates. Sprint has appealed the FCC's decision to the United States Court of
Appeals for the District of Columbia Circuit, and oral argument is scheduled for
April 20, 2001. As a result of these rulings, management anticipates a favorable
resolution of the Company's dispute with Sprint.
Leases - The Company leases office premises in various locations under
operating lease arrangements. Total rent expense on these leases amounted to
$1,853, $4,195, and $5,734 in 1998, 1999 and 2000, respectively. The Company's
restricted cash balance as of December 31, 1999 and 2000, serves as collateral
for letters of credit for some of these office leases.
Future minimum rental payments under operating leases having initial or
remaining non-cancelable lease terms in excess of one year are as follows:
2001 $ 7,059
2002 7,565
2003 6,998
2004 6,542
57
2005 5,749
Beyond 26,892
--------
$ 60,805
========
Purchase Commitments - At December 31, 1999 and 2000, the Company has
outstanding non-cancelable commitments to purchase switching equipment with an
aggregate cost of $5,275 and $774, respectively.
8. INCOME TAXES
The provision for income taxes in 1998, 1999 and 2000 consists of the following
components:
1998 1999 2000
- ------------------------------------------------------------------------------------------------------------
Current - Charge equivalent to net tax benefit related
to stock options and warrants $ 938 $ 28 $ 281
-----------------------------------------
Deferred
Federal 6,702 12,869 (19,545)
State 1,665 2,720 (4,463)
-----------------------------------------
8,367 15,589 (24,008)
-----------------------------------------
Total provision for income taxes $ 9,305 $ 15,617 $ (23,727)
=========================================
The reconciliation of the statutory federal income tax rate to the
Company's federal and state overall effective income tax rate is as follows:
1998 1999 2000
- ------------------------------------------------------------------------------------------------------------
Statutory federal rate 35.00% 35.00% (35.00)%
State income taxes 5.30 4.49 (2.06)
Change in valuation allowance --- --- 20.05
Miscellaneous .63 .11 .20
-----------------------------------------
Effective tax rate 40.93% 39.60% (16.81)%
=========================================
Deferred income taxes reflect the net tax effects of the temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for tax purposes. Significant components of the
Company's deferred tax assets and liabilities as of December 31, 1998, 1999 and
2000 are as follows:
1999 2000
Deferred tax assets:
Net operating loss carryforward $17,054 $57,568
Deferred state taxes and other 1,696 ---
Accrued expenses 727 1,293
-----------------------
58
Deferred tax assets 19,477 58,861
Less: Valuation Allowance --- (35,669)
-----------------------
Total deferred tax assets 19,477 23,192
-----------------------
Deferred tax liabilities:
Net deferred revenues 33,476 3,747
Depreciation and amortization 9,811 18,937
Other 146 508
-----------------------
Total deferred tax liabilities 43,433 23,192
-----------------------
Net Deferred Tax Liability $23,956 $ 0
=======================
For the period ending December 31, 2000, a valuation allowance has been
provided against the deferred tax assets since management cannot predict, based
on the weight of available evidence, that it is more likely than not that such
assets will be ultimately realized.
At December 31, 2000 the Company has net operating loss carryforwards
for federal and state tax purposes of approximately $135,760. Such losses begin
to expire for federal and state purposes in 2017 and 2012, respectively.
9. RELATED PARTIES
During 1998, the Company's majority stockholder acquired an indirect
controlling interest in Metacomm. Metacomm was engaged in the business of
developing and operating a high-speed data network in North Carolina, and was a
customer of the Company and BellSouth during 1998 and 1999. The Company recorded
$6,239 and $9,511 in revenue earned from services provided to Metacomm (which
did not include revenue from reciprocal compensation due from BellSouth, see
Note 7) during 1998 and 1999, respectively. Metacomm also earned commissions
from the Company for reciprocal compensation revenue relating to Metacomm's
network. The Company recorded $19,759 and $38,990 for 1998 and 1999,
respectively, in reciprocal compensation commission expense earned by Metacomm,
which is included in cost of services in the accompanying financial statements.
Because the amounts due from Metacomm relating to services provided by the
Company and commissions due to Metacomm have the legal right of offset, the
Company recorded a net liability to Metacomm of $5,345 and $22,809, in accrued
commissions, net - related party in the accompanying financial statements. The
Company and Metacomm were parties to agreements by which commissions earned by
Metacomm related to reciprocal compensation would not be paid to Metacomm until
the related reciprocal compensation is collected from the ILEC. However, in 1998
and 1999 the Company advanced to Metacomm $8,257 and $12,015, respectively,
prior to collecting the earned reciprocal compensation from BellSouth. These
payments were subject to a repayment agreement if the related reciprocal
compensation was ultimately determined not to be collectible from BellSouth. On
March 31, 2000 the NCUC issued an order that relieved BellSouth from paying
reciprocal compensation to the Company for any minutes of use attributable to
Metacomm. The Company recorded no revenue associated with the Metacomm network
in 2000. As a result of the order, the Company subsequently recorded a pre-tax,
non-recurring, non-cash charge of approximately $55,000 in the first quarter of
2000. The charge was composed of the write-off of approximately $153,000 in
receivables related to reciprocal compensation revenue offset by previously
established reserves of $39,000 and a reduction of $59,000 in commissions
payable to Metacomm (See Note 7 and 14).
During 1998, the Company incurred $35 in expenses for chartered aircraft
services provided by the majority stockholder.
The Company incurred $89 and $50 in 1998 and 1999, respectively, in
expenses for consulting services provided by Global Vista Communications, LLC
("Global Vista"). As of December 31, 1998 and
59
1999, a liability totaling $6 and $66, respectively, was included in accounts
payable in the Company's financial statements, relating to software and
consulting services purchased from Global Vista. In addition, during 1998, 1999
and 2000, the Company acquired $471, $2,081 and $2, respectively, in software
from Global Vista Communications, LLC ("Global Vista"), a company controlled by
the Company's majority stockholder.
During 1999 and 2000, the Company capitalized $185 and $858,
respectively in site acquisition costs for services performed by Lincoln Harris
LLC, a company controlled by a former member of the Company's Board of
Directors. These costs are included in leasehold improvements in the
accompanying financial statements. In addition, the Company incurred $3 and $95
in 1999 and 2000, respectively, in expenses for services provided by Lincoln
Harris. As of December 31, 1999 and 2000, a liability totaling $46 and $27,
respectively, was recorded in accounts payable in the Company's financial
statements relating to leasehold improvements and services purchased from
Lincoln Harris LLC.
During 1999, the Company entered into an operating lease with H-C REIT,
Inc., a Company controlled by a former member of the Company's Board of
Directors. The lease commenced on May 1, 2000, and continues for a period of ten
years. As part of the new lease agreement, H-C REIT, Inc. agreed to limit the
Company's liability under their existing lease agreement to $500 for early
termination and lease incentive costs. The Company recognized this expense in
1999. During 2000, the Company paid H-C REIT, Inc. $1,706 under this lease
agreement. Future minimum rental payments under the new lease are as follows and
are included in total future minimum rental payments defined under Leases (See
Note 7):
2001 $ 1,916
2002 2,217
2003 2,283
2004 2,350
2005 2,420
Beyond 11,333
-------
Total $22,519
=======
Company management believes that all of the above transactions were
under terms no less favorable to the Company than could be arranged with
unrelated parties.
10. EMPLOYEE BENEFIT PLAN
The Company has a 401(k) savings plan under which employees can
contribute up to 15% of their annual salary. For 1999 and 2000, respectively,
the Company made matching contributions to the plan totaling $381 and $768 based
on 50% of the first 6% of an employee's contribution to the plan. For 1998, the
Company made matching contributions to the plan totaling $41.
11. STOCKHOLDERS' EQUITY
Common Stock - The Company has authorized two classes of common stock,
Class A and Class B. The rights of holders of the Class A Common Stock and the
Class B Common Stock are substantially identical, except that (i) holders of the
Class A Common Stock are entitled to one vote per share and holders of the Class
B Common Stock are entitled to ten votes per share; (ii) holders of the Class B
Common Stock vote as a separate class to elect two members of the Company's
Board of Directors in addition to voting with the holders of Class A Common
Stock in the election of the other members of the Board of Directors; and (iii)
the Class B Common Stock is fully convertible at any time into Class A Common
Stock, at the option of the holder, or automatically upon transfer to certain
third persons, on a one-for-one basis. Pursuant to an agreement among the Class
B stockholders, if a Class B stockholder proposes to sell or transfer Class B
Common Stock to anyone other than a permitted transferee (as defined in the
agreement), the other Class B stockholders who are parties to the agreement
would have a right to acquire the Class B Common Stock that is proposed to be
sold or transferred (Note 14).
60
Capital Contribution - During 1998, the Company's majority stockholder
exchanged a $5,000 loan for 481 shares of Class B Common Stock.
Additional Paid-in-Capital - In 2000, additional paid-in capital has
been reduced by $36 million representing amounts due from Metacomm, which is
indirectly controlled by Richard T. Aab, a majority stockholder of the Company.
Due to Mr. Aab's controlling position in both Metacomm and the Company, this
amount is being treated for financial reporting purposes as a deemed
distribution to the stockholder. At the time such amounts are paid to the
Company, the payment will increase additional paid-in capital as a capital
contribution to the Company. (See Note 14)
Warrants - In January 1998, the Company issued a warrant to a consultant
to purchase 25 shares of Class A Common Stock at $10 per share. This warrant
expired on January 1, 2001. The Company recorded compensation expense of $75 in
1998 associated with the warrant.
Employee Stock Purchase Plan - In May 2000, the Company's shareholders
approved and the Company adopted the Employee Stock Purchase Plan (the "Stock
Purchase Plan"). Under the terms of the Stock Purchase Plan, as of September 1,
2000 ("the effective date"), the Board of Directors reserved 1,000 shares of
common stock for the plan. The Stock Purchase Plan provides for specified
offering periods (initially the period from the effective date to December 31,
2000 and thereafter, the six month periods between January and June and July and
December of each respective year) during which an eligible employee is permitted
to accumulate payroll deductions in a plan account for the purchase of shares of
Class A Common Stock. Substantially all employees may elect to participate in
the Stock Purchase Plan by authorizing payroll deductions in an amount not
exceeding ten percent (10%) of their compensation payable during the offering
period, and not more than $25 annually. The purchase price per share will be the
lower of 85% of the market value of a share as of the first day of each offering
period or 85% of the market value of a share as of the last day of each offering
period. As of December 31, 2000, there were 371 employees participating in the
Stock Purchase Plan, and the company had issued 108 shares at a purchase price
of $4.09 per share, which represents a 15% discount to the closing price on
December 29, 2000 (the "issue date").
Stock Option Plan - In January 1998, the Company adopted the US LEC
Corp. 1998 Omnibus Stock Plan (the "Stock Plan"). In August 1998, the Company
filed a registration statement to register (i) 1,300 shares of Class A Common
Stock reserved for issuance under the Stock Plan and (ii) 180 shares of Class A
Common Stock reserved for issuance upon the exercise of nontransferable warrants
granted by the Company to employees. In April 1999, the Company's stockholders
voted to amend the Plan to increase the number of Class A Common Stock reserved
for issuance under the Plan from 1,300 shares to 2,000 shares and in May 1999,
the Company filed a registration statement to register these additional 700
shares. In May 2000, the Company's stockholders voted to amend the Plan to
increase the number of Class A Common Stock reserved for issuance under the Plan
from 2,000 shares to 3,500 shares and in August 2000, the Company filed a
registration statement to register these additional 1,500 shares. Under the
amended Stock Plan, 3,500 shares of Class A Common Stock have been reserved for
issuance for stock options, stock appreciation rights, restricted stock,
performance awards or other stock-based awards. Options granted under the Stock
Plan are at exercise prices determined by the Board of Directors or its
Compensation Committee. For incentive stock options, the option price may not be
less than the market value of the Class A Common Stock on the date of grant
(110% of market value for greater than 10% stockholders).
In January 1998, the Company granted incentive stock options to
substantially all employees to purchase an aggregate of 183 shares of Class A
Common Stock at $10 per share (fair market value on date of grant was $13 per
share). These options began vesting annually in four equal installments
beginning in January 1999. The Company recorded deferred compensation of $548 in
1998 associated with these options which will be amortized to compensation
expense over the four-year vesting period. The Company amortized $105, $101 and
$60 for 1998, 1999 and 2000, respectively, to compensation expense relating to
these options, after consideration of forfeitures.
Also, during 1998, the Company granted to an employee an option to
purchase 360 shares of Class A Common Stock at $13 per share (fair market value
on the date of grant was $14 per share). The Company recorded deferred
compensation of $360 associated with these options and will amortize this amount
to compensation expense over the four year vesting period. The Company amortized
$60, $90 and $90 for 1998, 1999 and 2000, respectively, to compensation expense
relating to these options. In both 1998 and 1999 the Company granted options to
purchase 5 shares of Class A Common Stock at the fair market
61
value on the date of grant to each of the Company's two and three outside
directors, respectively. These options vested immediately upon grant.
In September 1998, the Company repriced 744 options outstanding to the
fair value on such date of $7.31 per share. As a condition to the repricing,
these options (other than the directors' options) vest over four years beginning
at the repricing date.
62
A summary of the option and warrant activity is as follows:
Options Warrants
------------------------------------------ ----------------------------------------------
Weighted Weighted Weighted Weighted
Average Average Average Average
Number Exercise Fair Value Number Exercise Fair Value
of Price at Date of of Price at Date of
Shares Per Share Grant Warrants Per Warrant Grant
----------------------------------------------------------------------------------------------------------------------------
Balance at December 31, 1996
Granted at fair market value 429 $ 2.86 $ 2.86
Granted at less than fair market
value 15 2.86 6.00
-------- --------
Balance at December 31, 1997
(all exercisable) 444 2.86
Granted at fair market value* 1,324 $ 10.27 $ 3.95 -- --
Granted at less than fair
market value 575 11.88 6.89 25 10.00 $ 13.00
Exercised -- (165) 2.86
Forfeited or cancelled* (817) 14.41 -- --
-------- ---------- -------- --------
Balance at December 31, 1998 1,082 $ 8.00 304 $ 3.45
-------- ---------- -------- --------
Granted at fair market value 794 $ 22.65 $ 10.29 -- --
Exercised (14) 7.85 (5) 2.86
Forfeited or cancelled (67) 12.66 -- --
-------- ---------- -------- --------
Balance at December 31, 1999 1,795 $ 14.30 299 $ 3.46
-------- ---------- -------- --------
Granted at fair market value 1,226 $ 12.58 $ 8.51 -- --
Exercised (29) 10.84 (131) 2.86
Forfeited or cancelled (344) 19.12 -- --
-------- ---------- -------- --------
Balance at December 31, 2000 2,648 $ 12.92 168 $ 3.92
======== ========== ======== ========
* Includes 744 options repriced
A summary of the range of exercise prices and weighted average remaining lives
for options and warrants outstanding and exercisable at December 31, 2000 is as
follows:
Options Outstanding
--------------------------------------------------------------------------------
Weighted
Average Weighted Weighted
Range of Number of Remaining Average Number of Average
Exercise Options Contractual Exercise Options Exercise
Price Outstanding Life Price Exercisable Price
- --------------------------------------------------------------------------------------------------------------
Options granted at
fair market value $3.50 106 9.9 years $ 3.50
6.06 403 9.8 years 6.06
7.31 816 7.7 years 7.31 404 $ 7.31
9.50 - 11.44 257 9.5 years 11.39 2 9.40
12.38 - 16.50 232 8.1 years 14.65 84 14.12
18.00 - 18.00 294 9.4 years 18.00
18.38 - 25.75 143 8.7 years 21.89 28 21.48
26.13 - 26.13 311 9.0 years 26.13 78 26.13
27.69 - 37.13 82 9.0 years 30.51 5 27.69
--------- ------- ------ -------
3.50 - 37.13 2,644 8.8 years 12.92 601 11.53
Options granted at less than
fair market value 10.00 4 7.1 years 10.00 2 10.00
--------- ------- ------ -------
Total options outstanding at
December 31, 2000 $3.50 - $37.13 2,648 8.8 years $12.92 603 $11.52
========= ======== ======= =======
63
Warrants Outstanding
-------------------------------------------------------------
Number of Weighted
Warrants Average Weighted
Range of Outstanding Remaining Average
Exercise and Contractual Exercise
Price Exercisable Life Price
- -------------------------------------------------------------------------------------------------------------------
Warrants granted at fair market value $2.86 143 12.0 months $ 2.86
Warrants granted at less than fair market value 10.00 25 0.0 months 10.00
---- -------
Total options warrants at December 31, 2000 $2.86 - $10.00 168 7.6 months $3.92
---- -------
The Company measures the compensation cost of its stock option plan
under the provisions of Accounting Principles Board (APB) Opinion No. 25,
"Accounting for Stock Issued to Employees", as permitted under Statement of
Financial Accounting Standards (SFAS) No. 123, "Accounting for Stock-Based
Compensation". Under the provisions of APB No. 25, compensation cost is measured
based on the intrinsic value of the equity instrument awarded. Under the
provisions of SFAS No. 123, compensation cost is measured based on the fair
value of the equity instrument awarded.
Had compensation cost for the employee warrants and stock options been
determined consistent with SFAS No. 123, the Company's net earnings (loss) and
net earnings (loss) per share would approximate the following proforma amounts:
1998 1999 2000
As Reported Proforma As Reported Proforma As Reported Proforma
- -----------------------------------------------------------------------------------------------------------
Net earnings (loss) $ 13,427 $ 12,832 $ 23,809 $ 22,463 $ (117,392) $ (121,436)
Preferred dividends -- -- -- -- (8,758) (8,758)
Accretion of preferred
Stock issuance fees -- -- -- -- (336) (336)
---------- ---------- ----------- ----------- ----------- -----------
Net earnings (loss) attributable
to shareholders $ 13,427 $ 12,832 $ 23,809 $ 22,463 $ (126,486) $ (130,530)
Earnings (loss) per share:
Basic 0.53 0.51 0.87 0.82 (4.58) (4.73)
Diluted 0.52 0.50 0.84 0.79 (4.58) (4.73)
The Company estimated the fair value for both the stock options and the
warrants using the Black-Scholes model assuming no dividend yield in 1998, 1999
and 2000; volatility of 40%, 40% and 80% for 1998, 1999 and 2000, respectively,
an average risk-free interest rate of 5.0%, 6.5% and 6.5% for 1998, 1999 and
2000, respectively, an expected life of 12 months for the warrants and 5.8, 5.1
and 5.0 years for the stock options in 1998, 1999 and 2000, respectively. The
weighted average remaining contractual life of warrants and stock options
outstanding at December 31, 2000 was 10 months and 8.8 years, respectively.
The Company estimated the fair value of the Employee Stock Purchase Plan
shares based upon the stock price at December 29, 2000 (the "issue date").
Compensation cost was estimated based upon the intrinsic value of the award at
the issue date.
12. EARNINGS (LOSS) PER SHARE
Earnings (loss) per common and common equivalent share are based on net
income (loss), after consideration of preferred stock dividends, divided by the
weighted average number of common shares outstanding during the period.
Outstanding options and warrants are included in the calculation of dilutive
earnings per common share to the extent they are dilutive. Following is the
reconciliation of earnings (loss) per share for 1998, 1999 and 2000:
64
1998 1999 2000
- -------------------------------------------------------------------------------------
Basic earnings (loss) per share:
Net earnings (loss) $ 13,427 $ 23,809 $(117,392)
Preferred dividends -- -- (8,758)
Accretion of preferred stock
Issuance fees -- -- (336)
------------------------------------
Net earnings (loss) applicable to
Common shareholders 13,427 23,809 (126,486)
Weighted average shares outstanding 25,295 27,431 27,618
------------------------------------
Basic earnings (loss) per share $ 0.53 $ 0.87 $ (4.58)
====================================
Diluted earnings (loss) per share:
Net earnings (loss) $ 13,427 $ 23,809 $(117,392)
Preferred dividends -- -- (8,758)
Accretion of preferred stock
Issuance fees -- -- (336)
- --------------------------------
Net earnings (loss) applicable to
Common shareholders 13,427 23,809 (126,486)
====================================
Weighted average shares outstanding 25,295 27,431 27,618
Dilutive effect of stock options 214 725 --
Dilutive effect of warrants 295 255 --
------------------------------------
Weighted average shares, adjusted 25,804 28,411 27,618
------------------------------------
Diluted earnings (loss) per share $ 0.52 $ 0.84 $ (4.58)
------------------------------------
65
13. QUARTERLY FINANCIAL DATA (UNAUDITED)
The following table summarizes the Company's results of operations as
presented in the consolidated statements of operations by quarter for 2000,
1999, and 1998.
Quarter Ended
--------------------------------------------------
March 31, June 30, Sept. 30, Dec. 31,
2000 2000 2000 2000
- -----------------------------------------------------------------------------------------
Revenue, Net $ 25,363 $ 26,148 $ 29,860 $ 33,593
Cost of Services 11,051 11,714 14,359 15,560
--------------------------------------------------
Gross Margin 14,312 14,434 15,501 18,033
Selling, General and Administrative 16,013 18,764 22,049 23,858
Loss on Resolution of Disputed
Revenue (Note 7) 55,345 - - -
Provision for Disputed
Receivables (Note 7) - - - 40,000
Depreciation and Amortization 4,393 5,674 6,201 8,097
--------------------------------------------------
Loss from Operations (61,439) (10,004) (12,749) (53,922)
Interest Income (Expense), Net (1,890) 324 (278) (1,161)
---------------------------------------------------
Loss Before Income Taxes (63,329) (9,680) (13,027) (55,083)
Provision for Income Taxes (23,727) - - -
---------------------------------------------------
Net Loss (39,602) (9,680) (13,027) (55,083)
Preferred Stock Dividends - 2,633 3,040 3,085
Accretion of Preferred Stock
Issuance Cost - - - 336
---------------------------------------------------
Net Loss Available to
Common Shareholders $(39,602) $(12,313) $(16,067) $(58,504)
===================================================
Net Loss per Share:
Basic $ (1.44) $ ( .45) $ ( .58) $ (2.12)
===================================================
Basic $ (1.44) $ ( .45) $ ( .58) $ (2.12)
===================================================
Weighted Average Shares Outstanding:
Basic 27,513 27,636 27,660 27,661
===================================================
Diluted 27,513 27,636 27,660 27,661
===================================================
66
Quarter Ended
--------------------------------------------------
March 31, June 30, Sept. 30, Dec. 31,
1999 1999 1999 1999
- -----------------------------------------------------------------------------------------
Revenue, Net $ 36,212 $ 43,553 $ 47,348 $ 48,067
Cost of Services 15,762 18,702 19,524 19,625
--------------------------------------------------
Gross Margin 20,450 24,851 27,824 28,442
Selling, General and Administrative 9,666 11,806 13,707 13,196
Depreciation and Amortization 2,320 2,676 3,124 3,600
--------------------------------------------------
Earnings from Operations 8,464 10,369 10,993 11,646
Interest Income (Expense), Net (35) (359) (621) (1,031)
--------------------------------------------------
Earnings Before Income Taxes 8,429 10,010 10,372 10,615
Provision for Income Taxes 3,414 4,035 4,170 3,998
--------------------------------------------------
Net Earnings $ 5,015 $ 5,975 $ 6,202 $ 6,617
==================================================
Net Earnings per Share:
Basic $ .18 $ .22 $ .23 $ .24
==================================================
Diluted $ .18 $ .21 $ .22 $ .23
==================================================
Weighted Average Shares Outstanding:
Basic 27,422 27,427 27,428 27,447
==================================================
Diluted 28,206 28,381 28,520 28,554
==================================================
Quarter Ended
--------------------------------------------------
March 31, June 30, Sept. 30, Dec. 31,
1998 1998 1998 1998
- -----------------------------------------------------------------------------------------
Revenue, Net $ 13,630 $ 18,348 $ 22,291 $ 30,447
Cost of Services 6,473 7,537 7,296 12,340
--------------------------------------------------
Gross Margin 7,157 10,811 14,995 18,107
Selling, General and Administrative 4,426 5,747 6,690 8,157
Depreciation and Amortization 442 925 1,547 2,027
--------------------------------------------------
Earnings from Operations 2,289 4,139 6,758 7,923
Interest Income (Expense), Net (90) 596 704 413
--------------------------------------------------
Earnings Before Income Taxes 2,199 4,735 7,462 8,336
Provision for Income Taxes 880 1,905 2,999 3,521
--------------------------------------------------
Net Earnings $ 1,319 $ 2,830 $ 4,463 $ 4,815
==================================================
Net Earnings per Share:
Basic $ .11 $ .16 $ .18
====================================
Diluted $ .11 $ .16 $ .17
====================================
Weighted Average Shares Outstanding:
Basic 25,548 27,420 27,420
====================================
Diluted 26,082 27,905 28,016
====================================
67
14. SUBSEQUENT EVENT (UNAUDITED)
On March 31, 2001, the Company, Richard T. Aab, the Company's Chairman,
controlling shareholder and the indirect controlling owner of Metacomm, and
Tansukh V. Ganatra, the Company's Vice Chairman and Chief Executive Officer,
reached an agreement in principle to effect a recapitalization of the Company
and to resolve Mr. Aab's commitment that Metacomm would fully satisfy its
obligations to the Company for facilities, advances and interest. The agreement
provides in material part (1) that Mr. Aab will make a contribution to the
capital of the Company by delivering to the Company for cancellation 2,000
shares of Class B Common Stock currently controlled by Mr. Aab, (2) that Mr. Aab
and Mr. Ganatra will convert all of the then remaining and outstanding shares of
Class B Common Stock - a total of approximately 14,500 such shares will be
outstanding after the 2,000 shares are cancelled - into the same number of
shares of Class A Common Stock, (3) the Company will agree to indemnify Mr. Aab
for certain adverse tax effects, if any, relating to the Company's treatment in
its balance sheet of the amount of the Metacomm obligation as a distribution to
shareholder and (4) the Company will agree to indemnify Mr. Ganatra for certain
adverse tax effects, if any, from the conversion of his Class B shares to Class
A shares.
The agreement is subject to obtaining a valuation by a qualified
valuation firm approved by the Company's audit committee that the delivery of
the 2,000 shares of Class B Common Stock and the conversion of the approximately
14,500 shares of Class B Common Stock into the same number of shares of Class A
Common Stock will result in the realization by the Company and its Class A
shareholders of value equal to the outstanding Metacomm obligation, receipt by
the Company of a favorable tax opinion, and the receipt of certain consents.
The Company expects that the proposed transaction will be consummated
within 60 days. Upon closing of the transaction, the number of issued and
outstanding shares of Common Stock (Class A and Class B together) will decrease
by 2,000 and, as a result of the elimination of the 10-vote-per-share Class B
Common Stock, Mr. Aab will no longer have voting control of the Corporation's
Common Stock, although he will remain its largest single shareholder. For
purposes of illustration, had this subsequent event occurred on January 1, 2000,
the weighted average number of shares outstanding for the year ended December
31, 2000 would have equaled approximately 25,618 and the Company's net loss per
common share would have been $(4.94) diluted versus $(4.58) as reported.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
68
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required to be furnished in response to Item 10 related
to directors is incorporated by reference from the sections of the Proxy
Statement that appear under the headings "Members of the Board of Directors
During 2000".
The following table sets forth certain information regarding the
executive officers of US LEC Corp:
Name Age Position
- ---- --- --------
Richard T. Aab 52 Chairman of the Board and Director
Tansukh V. Ganatra 57 Vice Chairman, Chief Executive Officer and Director
Aaron D. Cowell, Jr. 39 President
Michael K. Robinson 44 Executive Vice President and Chief Financial Officer
Richard T. Aab co-founded US LEC in June 1996 and has served as
Chairman of the Board of Directors since that time. He also served as Chief
Executive Officer from June 1996 until July 1999. Between 1982 and 1997, Mr. Aab
held various positions with ACC Corp., an international telecommunications
company in Rochester, NY, including Chairman and Chief Executive Officer, and
served as a director.
Tansukh V. Ganatra co-founded US LEC in June 1996 and has served as a
director since that time. He also served as President and Chief Operating
Officer from June 1996 until July 1999, when he was named Vice Chairman and
Chief Executive Officer. From 1987 to 1997, Mr. Ganatra held various positions
with ACC Corp., including serving as its President and Chief Operating Officer.
Prior to joining ACC Corp., Mr. Ganatra held various positions during a 19-year
career with Rochester Telephone Corp., culminating with the position of Director
of Network Engineering.
Aaron D. Cowell, Jr. joined US LEC in June 1998. At that time, Mr.
Cowell was involved in numerous operating areas of US LEC's business and legal
affairs, including its IPO in April 1998. He became president in January 2000,
and directs US LEC's sales, marketing, engineering, operations, regulatory and
legal functions. Prior to 1998, Mr. Cowell spent 11 years with Moore & Van Allen
PLLC, a large southeastern law firm. Mr. Cowell is a graduate of Harvard Law
School.
Michael K. Robinson held various positions with the telecom sector of
Alcatel, a $30+ billion company headquartered in Paris, France, including
Executive Vice President and Chief Financial Officer of the data network
division, before joining US LEC in July 1998. At US LEC, Mr. Robinson oversees
various functions, including finance, billing, investor relations, corporate
communications, human resources, IT/IS and real estate. Mr. Robinson is a
graduate of the MBA program at Wake Forest University.
ITEM 11. EXECUTIVE COMPENSATION
The information required to be furnished in response to Item 11 is
incorporated by reference from the sections of the Proxy Statement that appear
under the headings "Compensation of Directors" and "Compensation of Executive
Officers".
69
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required to be furnished in response to Item 12 is
incorporated by reference from the section of the Proxy Statement that appear
under the heading "Security Ownership of Certain Beneficial Owners and
Management".
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required to be furnished in response to Item 13 is
incorporated by reference from the section of the Proxy Statement that appear
under the heading "Certain Relationships and Related Transactions".
70
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULE AND REPORTS ON FORM 8-K
(a) Financial Statements, Financial Statement Schedule and Exhibits - The
following documents are filed as part of this Form 10-K.
(1) Financial statements:
A. Consolidated Balance Sheets as of December 31, 1999 and 2000
B. Consolidated Statements of Operations years ended December 31, 1998,
1999 and 2000
C. Consolidated Statements of Stockholders' Equity (Deficiency) years
ended December 31, 1998, 1999 and 2000
D. Consolidated Statements of Cash Flows for the years ended December
31, 1998, 1999 and 2000
E. Notes to Consolidated Financial Statements for the years ended
December 31, 1998, 1999 and 2000
F. Independent Auditors' Report
(2) List of Exhibits:
No. Exhibit
- --- -------
3.1 Restated Certificate of Incorporation of the Company (1)
3.2 Restated Bylaws of the Company
3.3 Certificate of Designation Relating to Series A Convertible Preferred
Stock (2)
4.1 Form of Class A Common Stock Certificate (1)
4.2 Preferred Stock Purchase Agreement, dated April 11, 2000 (2)
4.3 Option Agreement, dated April 11, 2000 (2)
4.4 Corporate Governance Agreement, dated April 11, 2000 (2)
4.5 Registration Rights Agreement, dated April 11, 2000 (2)
10.1 Second Amended and Restated Class B Stockholders Agreement, dated as
of April 11, 2000 Second Amended Loan and Security Agreement, dated
as of December 20, 1999, among US LEC Corp., certain operating
subsidiaries of US LEC Corp., General Electric Capital Corporation,
First Union
10.2 National Bank and Wachovia Bank N.A. (the "Loan and Security
Agreement") (3)
10.3 Amendment dated November 10, 2000 to Loan and Security Agreement
21 Subsidiaries of the Registrant
23 Consent of Deloitte & Touche LLP
(1) Incorporated by reference to Registration Statement from Form S-1 (File
No. 333-46341) filed February 13, 1998.
(2) Incorporated by reference to the Company's Current Report on Form 8-K
filed May 12, 2000.
(3) Incorporated by reference to the Company's Annual Report on Form 10-K
for the fiscal year ended December 31, 1999.
(b) Reports on Form 8-K.
71
No Current Reports on Form 8-K were filed during the fiscal quarter ended
December 31, 2000.
72
SCHEDULE II
VALUATION AND QUALIFYING ACCOUNTS
US LEC CORP. (IN THOUSANDS)
Additions
Balance at
Beginning of Charged to Charged to Balance at End
Period Costs and Other of Period
Description (Dec. 31, 1999) Expenses Accounts Deductions (Dec. 31, 2000)
--------------- ---------- ---------- ---------- ---------------
Allowance against accounts receivables -
current $40,074 $155,074 $0 $193,625 $1,523
Allowance against account receivable -
noncurrent* $0 $52,000 $0 $0 $52,000
Allowance against deferred tax assets $0 $35,669 $0 $0 $35,669
*Shown net of a $12,000 reduction in commission expense related to these
receivables on the Company's Consolidated Statement of Operations.
73
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the
Securities Exchange Act of 1934, as amended, Registrant has duly caused this
report to be signed on its behalf by the undersigned, thereunto duly authorized.
Date: April 3, 2001 By: /s/ Richard T. Aab
------------------
Richard T. Aab
Chairman of the Board
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended,
this report has been signed below by the following persons on behalf of
Registrant and in the capacities and on the dates indicated.
Signature Title Date
--------- ----- ----
/s/ Richard T. Aab Chairman and Director April 3, 2001
------------------
Richard T. Aab
/s/ Tansukh V. Ganatra Vice Chairman, Chief Executive Officer and April 3, 2001
---------------------- Director (Principal Executive Officer)
Tansukh V. Ganatra
/s/ Michael K. Robinson Executive Vice President and April 3, 2001
----------------------- Chief Financial Officer
Michael K. Robinson (Principal Financial and Accounting Officer)
/s/ David M. Flaum Director April 3, 2001
------------------
David M. Flaum
/s/ Steven L. Schoonover Director April 3, 2001
------------------------
Steven L. Schoonover
/s/ Anthony J. Dinovi Director April 3, 2001
---------------------
Anthony J. Dinovi
/s/ Michael A. Krupka Director April 3, 2001
---------------------
Michael A. Krupka
74