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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, 2001
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 $46,159,955 as of March 21, 2002 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 21, 2002 there were 26,388,672 shares of Class A 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 7, 2002 are incorporated by
reference into Part III of this report.
US LEC CORP.
2001 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS
Page
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PART I
Item 1: Business 3
Item 2: Properties 20
Item 3: Legal Proceedings 20
Item 4. Submission of Matters to a Vote of Security Holders 20
PART II
Item 5: Market for the Registrant's Common Stock and Related Stockholder Matters 21
Item 6: Selected Consolidated Financial Data 22
Item 7: Management's Discussion and Analysis of Financial Condition and Results
of Operations 23
Item 7A: Quantitative and Qualitative Disclosures about Market Risk 32
Item 8: Financial Statements and Supplementary Data 33
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure 56
PART III
Item 10: Directors and Executive Officers of the Registrant 57
Item 11: Executive Compensation 58
Item 12: Security Ownership of Certain Beneficial Owners and Management 58
Item 13: Certain Relationships and Related Transactions 58
PART IV
Item 14: Exhibits, Financial Statement Schedules and Reports on Form 8-K 59
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PART I
ITEM 1. BUSINESS
THE COMPANY
US LEC Corp. ("US LEC" or the "Company) is a Charlotte, NC-based
telecommunications carrier providing voice, data and Internet services to over
6,800 mid-to-large-sized business customers throughout the southeastern and
mid-Atlantic United States. As of December 31, 2001, US LEC's network consisted
of 26 Lucent 5ESS(R) AnyMedia(TM) digital switches, 25 Lucent CBX500
Asynchronous Transfer Mode ("ATM") data switches, 4 Juniper Networks(R) M20(TM)
Internet Gateway routers and an Alcatel MegaHub(R) 600ES tandem switch. The US
LEC service area includes Alabama, Florida, Georgia, Kentucky, Louisiana,
Maryland, Mississippi, New Jersey, North Carolina, Pennsylvania, South Carolina,
Tennessee, Virginia and the District of Columbia. The Company primarily serves
telecommunications-intensive business customers such as hotels, universities,
financial institutions, professional service firms and practices, hospitals,
enhanced service providers, Internet service providers, automobile dealerships
and government agencies. 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.
BUSINESS STRATEGY
US LEC's objective is to be the leading provider of voice, data and
Internet services to its existing and target customers, and to increase its
market share by expanding its customer base and 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 owning and deploying switching equipment and leasing the required
fiber optic transmission capacity from competitive access providers ("CAPs"),
other CLECs or incumbent local exchange carriers ("ILECs"). Management believes
the Company's switch-based, leased-transport strategy enables it to enter and
penetrate 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 customer 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 business customers including among
others, hotels, universities, financial institutions, professional service
firms and practices, hospitals, enhanced service providers, Internet service
providers, automobile dealerships and government agencies. By focusing
on such customers, the Company is able to more efficiently concentrate the
telecommunications traffic. In addition, the Company
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frequently is able to bundle 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 dial tone.
Install a Robust Technology Platform. The Company has chosen the 5ESS(R)
Any Media(TM) digital switch and the CBX500 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, 2001, US LEC had
26 Lucent voice switches and 25 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. In addition, the
Company has also deployed 4 Juniper Networks (R) M20 (TM) Internet Gateway
routers to provide reliable, scalable, and high-speed network elements to
significantly enhance the performance of US LEC's Internet access service. The
Company has also deployed an Advanced Intelligent Network ("AIN") platform that
positions US LEC for enhanced services.
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. 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 2001, the Company continued its project of
upgrading its back office systems by deploying "best of breed" systems for
various back office functions. Management believes that the implementation of
these or similar systems will enhance the electronic exchange of information
within US LEC by providing a centralized view of customer and order tracking
data.
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, ATM service and
long distance service, including intrastate, interstate, international and
toll-free. To further the Company's product strategy, US LEC has deployed its
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 customer
issues, 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. 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 2001, the Company activated additional Lucent switches in
Pittsburgh, Pennsylvania, New Orleans, Louisiana, and a second switch in
Atlanta, Georgia to bring the network to 26 switching centers.
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Four of the sites are also long distance platforms that provide additional
capability to route and concentrate the Company's long distance traffic.
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 maintains
interconnection agreements with the incumbent carriers. The Telecom Act,
decisions of state and federal regulatory bodies and negotiation affect the
terms and conditions of the interconnection agreements with the carriers
involved. The Company may voluntarily enter into such an agreement, petition a
state regulatory commission to arbitrate issues that cannot be resolved by
negotiation or by opting into agreements 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") and 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, T-1 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 offers 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 certain enhanced services such as voice mail.
The Company also provides data products including US LECnet (a direct,
dedicated, high-speed connection to the Internet), frame relay, ATM service and
a number of other services such as email, news feeds and web hosting.
The Company's ability to bundle local, long distance, data and Internet
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.
During 2000, the Company introduced the ADVANTAGE T, a single-rate,
bundled 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 this product allows US LEC to
expand the total market to which the Company has access.
Most recently, US LEC expanded its data portfolio with the launch of ATM
service. This new service allows US LEC's customers to dynamically allocate
bandwidth, making the transfer of data communications more efficient and
cost-effective. ATM is currently the core technology in the Internet backbone
and is widely supported by mainstream CPE (Customer Premise Equipment)
manufacturers. US
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LEC provides the new ATM service from its existing ATM-core data network, and
offers customers better control of service costs by allowing them to tailor
their traffic speeds and traffic priorities to fit their actual usage patterns.
ATM is most suited for companies with larger telecommunication needs, and it
allows them to migrate to faster services without significant changes to their
equipment.
SALES AND MARKETING
Sales. US LEC employs a well-trained 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 234 salespeople at December 31, 2000
to 256 salespeople at December 31, 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. During 2001, the Company continued to enhance its sales
force by hiring additional quota bearing and sales support staff, continuing
education regarding the Company's voice and data products and forming a central
group to focus on large sales and data sales.
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 two trademarks and service marks: US LEC, and a
logo that includes US LEC. 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.
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. The Company believes this is an important
aspect of customer acquisition and retention.
EMPLOYEES
As of December 31, 2001, the Company employed 892 people. The Company does
not expect significant changes in its staffing level in 2002. The Company
considers its employee relations to be very good.
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.
6
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.
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. The Supreme Court is considering cases
in which the issue of the PUC's ability to enforce interconnection agreements
has been challenged.
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 "Management's Discussion and Analysis of Financial Condition and Results
of Operations -- 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").
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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 Connecticut, New York,
Massachusetts, and Pennsylvania and SBC's in Arkansas, Texas, Kansas, Missouri,
and Oklahoma. (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
prohibiting the use of tariffs for non-dominant carriers providing international
and domestic interstate long distance services. Accordingly, non-dominant
interstate services providers and international service 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 international and domestic interstate inter-exchange services. The order
does not apply to the switched and special access services of the BOCs and other
local exchange service providers. The FCC allows permissive detariffing of these
services.
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 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. 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 granted pricing flexibility applications for various
interstate access services provided by BOCs in a number of cities, including
cities in BellSouth's service territory, including in several of the Company's
markets.
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
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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. The FCC
has recently initiated rulemaking proceedings to examine various issues on
unusual services, including from whom contributions are required and how the
contribution is calculated.
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 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. The Order was appealed to the U.S. Court of Appeals for the
District of Columbia. The Court remanded the case to the FCC.
On May 21, 2001, the FCC's new rules governing CLEC interstate access
charges became effective. The rules establish an initial maximum rate of 2.5
cents per minute for interstate access charges for the first year. In the second
year, the rate is reduced to 1.8 cents per minute. In the third year, the rate
is further
9
reduced to 1.2 cents per minute. At the end of the third year, the benchmark
rate is reduced to the level of the ILEC. A CLEC may not file tariffs for above
benchmark rates unless the ILEC in whose territory it operates charges a higher
rate, in which case the CLEC may charge the higher ILEC rate or the rate it had
tariffed in the previous six months, if lower than the ILEC's rate. A CLEC may
charge a rate higher than the benchmark if the IXC, through negotiations, agrees
to such higher rate.
In addition, the FCC only allowed a CLEC to charge the benchmark rates in
those areas in which the CLEC was actually serving customers on May 21, 2001. In
new service areas, the CLEC may only tariff rates as high as the ILEC. Several
petitions for reconsideration of the FCC's order were filed with the FCC, as
well as appeals to the U.S. Court of Appeals for the District of Columbia
Circuit. The Court recently granted the FCC's request to hold the appeals in
abeyance until the FCC decides the motions for reconsideration.
In the same order, the FCC determined that a IXC's refusal to serve
customers of a CLEC that tariffs the FCC's benchmark rates would generally
violate the IXC's duty as a common carrier to provide service was a reasonable
decision.
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. The FCC order had 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.
On April 27, 2001, the FCC released its Order on Remand regarding
intercarrier compensation for ISP-bound traffic. The FCC asserted exclusive
jurisdiction over ISP-bound traffic and established a new interim intercarrier
compensation regime for ISP-bound traffic with capped rates above a fixed
traffic exchange ratio. Traffic in excess of a ratio of 3:1 (terminating minutes
to originating minutes) is presumed to be ISP-bound traffic, and is to be
compensated at rates that decrease from $.0015 to $.0007, or the applicable
state-approved rate if lower, over three years. Traffic below the 3:1 threshold
is to be compensated at the rates in existing and future interconnection
agreements. Traffic above the 3:1 ratio is also subject to a growth ceiling
using First Quarter 2001 traffic data as the baseline. Traffic in excess of the
growth ceiling is subject to "bill and keep," an arrangement in which the
originating carrier pays no compensation to the terminating carrier to complete
calls. In addition, when a competitive carrier begins to provide service in a
state it has not previously served, all traffic in excess of the 3:1 ratio is
subject to bill-and-keep arrangements. In exchange for this reduction in
reciprocal compensation obligations to CLECs, the ILECs must offer to exchange
all traffic subject to Section 251 (b) (5) of the Telecommunications Act of
1996, as well as ISP-bound traffic, at the federal capped rates. It is not
possible to estimate the full impact of the FCC Order at this time because the
federal regime does not alter existing contracts except to the extent that they
incorporate changes of federal law, and because adoption of the federal regime
is within the discretion of the ILEC exchanging traffic with CLECs on a
state-by-state basis. In addition, the rules are the subject of petitions for
reconsideration before the FCC and appeals to the U.S. Court of Appeals for the
District of Columbia Circuit. In the event an ILEC determines not to adopt the
federal regime, the ILEC must pay the same rate for ISP bound traffic as for
calls subject to reciprocal compensation. We cannot predict the impact of the
FCC's and the Court's ruling on existing state decisions, the outcome of pending
appeals or future litigation on this issue.
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
10
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 is expected to rule on these cases
by June 2002. 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 resell
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 Company cannot predict whether
these requirements will ultimately prove enforceable, nor whether they will
deter anti-competitive conduct if they are enforceable. The FCC has initiated
rulemaking proceedings to consider whether advanced services offered by ILECs
should be regulated as services offered by a dominant or nondominant carrier. If
the service offerings are deemed nondominant, the ILEC will be subject to
licensed regulation. In a related proceeding, the FCC is seeking to determine
whether advanced services are information services and what regulations should
apply, if that is the case. A finding that
11
advanced services are information services, and not telephone services, could
result in significantly lower levels of regulation. The Company cannot predict
the outcome of these proceedings.
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 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). 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.
The Communications Assistance for Law Enforcement Act ("CALEA") provides
rules to ensure that law enforcement agencies would be able to conduct properly
authorized electronic surveillance of digital and wireless telecommunication
services. CALEA requires telecommunications carriers to modify their equipment,
facilities, and services used to provide telecommunications services to ensure
that they are able to comply with authorized electronic surveillance
requirements. For circuit-switched facilities, carriers were required to
complete these modifications by June 30, 2001. Carriers providing
packet-switched services were required to comply by November 19, 2001. The
deadline for carrier compliance with certain additional requirements has been
extended by the FCC until June 30, 2002. US LEC's network is CALEA compliant.
State Regulation. The Company has all of the certifications necessary to
offer its current services in the states of:
State
-----
North Carolina
Alabama
Mississippi
Kentucky
Maryland
Pennsylvania
Delaware
District of Columbia
New Jersey
Louisiana
Georgia
Virginia
Indiana
New York
Ohio
Connecticut
Massachusetts
12
Tennessee
South Carolina
Florida
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
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
13
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-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, 2001, 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. 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
14
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, the
implementation of the Telecom Act, and the distress of many carriers in the wake
of the downturn in the telecommunications industry have embroiled numerous
industry participants, including the Company, in lawsuits, proceedings and
arbitrations before state regulatory commissions, private arbitration
organizations such as the American Arbitration Association, and courts over many
issues important to the financial and operational success of the Company. These
issues include the interpretation and enforcement of interconnection agreements,
the terms of interconnection agreements the Company may adopt, operating
performance obligations, reciprocal compensation, access rates, rates applicable
to different categories of traffic, and the characterization of traffic for
compensation purposes. The Company anticipates that it will continue to be
involved in various lawsuits, arbitrations, and proceedings (see "Management's
Discussion and Analysis of Financial Condition and Results of Operations
Disputed Revenues") over these and other material issues. The Company
anticipates also that further legislative and regulatory rulemaking will
occur--on the federal and state level--as the industry deregulates and as the
Company enters new markets or offers new products. Rulings adverse to the
Company, adverse legislation, or changes in governmental policy on issues
material to the Company could have a material adverse effect on the Company's
financial condition or results of operations.
15
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 the switches and associated equipment necessary to operate the
Company's network will not experience technological or operational problems that
cannot be resolved in a satisfactory or timely matter. The failure of the
Company to 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 has 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, the Company 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, Sprint, 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).
16
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 effectively manage 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, Francis J. Jules, Chief Executive
Officer, Aaron D. Cowell, Jr., President and Chief Operating Officer 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. 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 ILECs 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
17
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 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, 2001, the Company was providing services to over 6,800
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,
18
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 changes are retroactive, such changes could
have a material adverse effect on the Company.
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 "Management's Discussion and
Analysis of Financial Condition and Results of Operations-- Disputed Revenues.")
Future Capital and Operating Requirements. Implementation of the Company's
business strategy will require significant capital and operating expenditures
during 2002 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"). At December 31, 2001, all $150 million was
borrowed. In April 2000, the Company completed a transaction with
affiliates of Bain Capital, Inc. and Thomas H. Lee Partners, L.P. to invest $200
million in convertible preferred stock of US LEC (the "Preferred Stock
Investment"). (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 expansion of its
switching platform, related infrastructure and facilities. Management expects to
satisfy its capital and operating requirements primarily with current cash
balances, 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 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
existing and other markets as well as potential acquisitions. The Company
expects to obtain the capital required to pursue additional opportunities from
current cash balances, additional 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.
19
Executive Officers of the Registrant
The following table sets forth certain information regarding the executive
officers of US LEC Corp:
Name Age Position
- ---- --- --------
Richard T. Aab 53 Chairman of the Board and Director
Tansukh V. Ganatra 58 Director, Former Vice Chairman and Chief Executive
Officer until his retirement in December 2001
Francis J. Jules 45 Chief Executive Office as of December 2001
Aaron D. Cowell, Jr. 39 President, Chief Operating Officer and General Counsel
Michael K. Robinson 45 Chief Financial Officer and Executive Vice President
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 served as Chief Executive Officer and Vice Chairman
of the Board of Directors from July 1999 until his retirement in December 2001.
He also served as President and Chief Operating Officer from June 1996 until
July 1999. 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. Mr. Ganatra currently serves as a consultant to US LEC Corp.
Francis J. Jules joined US LEC as Chief Executive Officer and as a
Director in December 2001 with more than 20 years of data, communications and
Internet industry experience. He served as president of Winstar Communications,
Inc.("Winstar") from August 2000 to December 2001 at which time he was named
Chief Executive Officer. Mr. Jules served as president of SBC/Ameritech Business
Communications Services ("SBC/Ameritech") from October 1997 to August 2000.
Prior to joining SBC/Ameritech, he held senior management positions with
Northern Telecom (now Nortel), IBM and New York Telephone.
Aaron D. Cowell, Jr. has been involved in numerous operating areas of the
Company's business and legal affairs since 1996, including its IPO in April
1998. Mr. Cowell joined US LEC in June 1998 as executive vice president and
general counsel. Later that year, he assumed responsibility for US LEC's sales
and field sales support functions. In 1999, his executive management duties were
expanded to include US LEC's engineering, operations, regulatory, customer care
services and marketing departments. Mr. Cowell was appointed as president and
chief operating officer of US LEC in 2000. He also holds a position on the
Executive Committee for ALTS (The Association for Local Telecommunications
Services), through which he helps promote regulations and decisions that will
facilitate fair competition in the telecommunications industry. Before joining
US LEC in 1998, Mr. Cowell spent 11 years with Moore & Van Allen PLLC, a large
Southeastern law firm, where he represented, among others, US LEC and Alcatel,
primarily in corporate finance and merger and acquisition matters. Mr. Cowell is
a graduate of Harvard Law School and Duke University.
Michael K. Robinson has been US LEC's executive vice president of finance
and chief financial officer since July 1998. Prior to joining US LEC, Mr.
Robinson held positions with the telecommunications division of Alcatel, an
international telecommunications equipment company headquartered in Paris,
France. From 1996 to July 1998, Mr. Robinson was executive vice president and
chief financial officer of Alcatel Data Networks, a developer and manufacturer
of wide area network data switching equipment for carrier and enterprise
solutions. He was responsible for financial controls, treasury, contracts
management, information systems, and facilities. In addition to his duties at
Alcatel Data Networks, Mr. Robinson was responsible for the worldwide financial
operations of the enterprise and data networking division of Alcatel. From 1989
to 1995, Mr. Robinson was vice president and chief financial officer of Alcatel
Network Systems, which developed, manufactured, and marketed transmission
equipment for telecommunications systems. Prior to joining Alcatel, Mr. Robinson
held various management positions with Windward International and Siecor Corp.
Mr. Robinson holds a masters degree in business administration from Wake Forrest
University.
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 during years through 2016. 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 proceedings, arbitrations, and any appeals thereof, related to reciprocal
compensation, intercarrier access and other amounts due from other carriers. The
Company believes it will be largely successful in these proceedings, and that
any adverse ruling in any pending proceeding or arbitration will not have a
material adverse effect on the Company. (See "Management's Discussion and
Analysis of Financial Condition and Results of Operations--Disputed Revenues")
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDER MATTERS
No matters were submitted to a vote of security holders during the quarter
ending December 31, 2001.
20
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED
STOCKHOLDERS
The Company's common stock trades on The Nasdaq National Market under the
symbol CLEC. As of March 21, 2002, US LEC Corp. had approximately 5,895
beneficial holders of its common stock, and approximately 145 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. In addition, both the credit facility and preferred stock
agreements contain certain limitations on the payment of dividends.
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
2001 High Low
---- ---- ---
First Quarter $9.06 $4.69
Second Quarter $6.50 $2.28
Third Quarter $4.01 $2.32
Fourth Quarter $6.75 $2.73
*No public market for the stock prior to April 24, 1998
21
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
SELECTED FINANCIAL DATA
For the years ended December 31, 1997, 1998, 1999, 2000 and 2001
(In Thousands, Except Per Share Data and Operating Data, as noted below)
1997 1998 1999 2000 2001
---- ---- ---- ---- ----
Statement of Operations:
Revenue, Net $ 6,458 $ 84,716 $175,180 $ 114,964 $178,602
Cost of Services 4,201 33,646 73,613 52,684 90,298
Gross Margin 2,257 51,070 101,567 62,280 88,304
Selling, General and Administrative 6,117 25,020 48,375 80,684 114,898
Depreciation and Amortization 443 4,941 11,720 24,365 35,103
Loss on Resolution of Disputed Revenue* -- -- -- 55,345 --
Provision (Recovery) for Disputed Receivables* -- -- -- 40,000 (7,042)
Earnings (Loss) from Operations (4,303) 21,109 41,472 (138,114) (54,655)
Interest Income (Expense), Net (355) 1,623 (2,046) (3,005) (8,699)
Earnings (Loss) before Income Taxes (4,658) 22,732 39,426 (141,119) (63,354)
Income Taxes Provision (Benefit) -- 9,305 15,617 (23,727) --
Net Earnings (Loss) (4,658) 13,427 23,809 (117,392) (63,354)
Less: Dividends on Preferred Stock -- -- -- 8,758 12,810
Less: Accretion of Preferred Stock Issuance Cost -- -- -- 336 491
Net Earnings (Loss) Attributable to Common Shareholders $(4,658) $ 13,427 $ 23,809 $(126,486) $(76,655)
Net Earnings (Loss) Per Share-Basic $ (0.25) $ 0.53 $ 0.87 $ (4.58) $ (2.83)
Net Earnings (Loss) Per Share-Diluted $ (0.25) $ 0.52 $ 0.84 $ (4.58) $ (2.83)
Weighted Average Shares Outstanding-Basic 18,653 25,295 27,431 27,618 27,108
Weighted Average Shares Outstanding-Diluted 18,653 25,804 28,411 27,618 27,108
Other Financial Data:
Capital Expenditures $13,055 $ 47,292 $ 57,396 $ 109,740 $ 40,425
Net Cash Flow Used in Operating Activities (5,594) (19,143) (25,935) (49,319) (5,971)
Net Cash Flow Used in Investing Activities (5,951) (48,538) (49,696) (111,743) (40,425)
Net Cash Flow Provided in Financing Activities 14,008 106,457 48,840 251,709 21,077
Operating Data:
Number of States Served 1 4 7 12 13
Number of Local Switches 3 11 16 23 26
Number of Customers 142 558 1,946 3,929 6,823
Number of Employees 78 253 460 816 892
Number of Sales and Sales Related Employees 24 98 180 330 365
Balance Sheet Data:
Working Capital (Deficit) $(2,269) $ 76,215 $113,109 $ 112,402 $ 59,972
Accounts Receivable, Net 6,006 66,214 193,943 61,165 42,972
Current Assets 9,656 112,184 213,269 160,782 135,644
Property and Equipment, Net 12,889 56,219 102,002 188,052 188,436
Total Assets 22,681 170,203 320,100 373,159 333,313
Long-Term Debt (including current portion) 5,000 20,000 72,000 130,000 150,000
Series A Redeemable Convertible Preferred Stock -- -- -- 202,854 216,155
Total Stockholders' Equity (Deficiency) 5,757 112,975 138,870 (22,250) (97,325)
*See Note 6 of the Company's Consolidated Financial Statements for the
period ended December 31, 2001.
22
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,
and the possibility of adverse decisions related to reciprocal compensation and
access charges owing to the Company by other carriers. 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, 2001, 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 23 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, including local and long distance voice services, toll free services,
frame relay, high speed internet, ATM and web hosting. The Company primarily
serves telecommunication-intensive business customers including hotels,
universities, financial institutions, professional service firms, hospitals, and
Internet service providers ("ISPs"). 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 service to customers in selected markets in North Carolina,
Florida, Georgia, Tennessee, Virginia, Alabama, Washington D.C., Pennsylvania,
New Jersey, Mississippi, Maryland, South Carolina, Louisiana and Kentucky. In
addition, US LEC is currently certified to provide telecommunication services in
Indiana, Delaware, New York, Ohio, Texas, Connecticut and Massachusetts. As of
December 31, 2001, US LEC's network was comprised of 26 Lucent 5ESS(R)
AnyMedia(TM) digital switches, 25 Lucent CBX500 ATM data switches and 4 Juniper
M20(TM) Internet Gateway routers 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
end customers for local, long distance, data, Internet and enhanced services,
and (2) carrier 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. The Company does not resell any ILEC dial tone
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. In 2001, 2000 and 1999, 8%, 11% and 80% of the Company's revenue
was recognized from reciprocal compensation and was being disputed by the
incumbent local exchange carriers, primarily BellSouth. The dispute primarily
arose from reciprocal compensation charges related to traffic that was
terminated to enhanced service providers, including internet service providers.
23
On October 3, 2001, the Company and BellSouth entered into a settlement
agreement by which they resolved outstanding reciprocal receivables owed the
Company by BellSouth. (See Disputed Revenue appearing below.)
Although the Company 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. US LEC has
deployed a significant regional network, and as of December 2001 has active
switches in 26 sites, serving over 6,800 medium to large size business
customers. Management believes this customer base, achieved in less than five
years, is indicative of the market's acceptance of US LEC's strategy and service
offerings. Management expects the Company's end customer revenue to continue to
increase and carrier access revenue 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 carrier access rates decline due primarily from
rate reductions in new agreements entered into by the Company with ILECs and to
regulatory and legislative actions. During 2001, access charges represented
approximately 39% of the Company's revenue.
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").
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 these contracts. As of December 31, 2001 and 2000, the
Company had $3.8 and $2.1 million, respectively, recorded as deferred
installation revenue, including $1.4 and $0.6 million, respectively, recorded as
current liabilities.
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 these contracts. During the years ended December
31, 2001 and 2000, the Company amortized $2.0 and $0.6 million, respectively, of
deferred installation charges into cost of services. As of December 31, 2001
and 2000, the Company had $3.0 million and $1.7 million, respectively, recorded
in other assets on its consolidated balance sheets.
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.
24
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. During 2001 these categories
represented 63% of total SG&A expense. 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 $118.5 million in 1999, to $228.0 million in 2000 and to $262.2 million in
2001. Depreciation and amortization expense increased from $11.7 million in 1999
to $24.4 million in 2000 and to $35.1 million in 2001.
As the Company continues to expand its network and grow its customer base,
SG&A and depreciation and amortization expense is expected to continue to grow,
but decline as a percentage of revenue.
Stockholders' Deficiency
In 2000, additional paid-in-capital was reduced by approximately $36.0
million representing amounts due from Metacomm, which is indirectly controlled
by Richard T. Aab, the Company's Chairman and largest stockholder. Due to
Mr. Aab's controlling position in both Metacomm and the Company, this amount was
treated for financial reporting purposes as a deemed
distribution to the stockholder.
On March 31, 2001, the Company, Richard T. Aab, and Tansukh V. Ganatra,
the Company's former Vice Chairman and former 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. This transaction was
closed on August 6, 2001. Under the agreement, the following events occurred:
(1) Mr. Aab made a contribution to the capital of the Company by delivering to
the Company for cancellation 2 million shares of Class B Common Stock,
(2) Mr. Aab and Mr. Ganatra converted all of the then remaining and outstanding
shares of Class B Common Stock - a total of approximately 14 million such shares
were outstanding after the 2 million shares were cancelled - into the same
number of shares of Class A Common Stock, (3) the Company agreed 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 agreed to indemnify Mr. Ganatra
for certain adverse tax effects, if any, from the conversion of his Class B
shares to Class A shares.
As required by the agreement, the Company obtained a valuation by a
qualified valuation firm approved by the Company's audit committee that the
delivery of the 2 million shares of Class B Common Stock and the conversion of
the approximately 14 million shares of Class B Common Stock into the same number
of shares of Class A Common Stock resulted in the realization by the Companyand
its Class A shareholders of value approximately equal to the outstanding
Metacomm obligation, received a favorable tax opinion, and received certain
consents.
As a result of this transaction, the number of issued and outstanding
shares of Common Stock (Class A and Class B together) decreased by 2 million
and, as a result of the elimination of the 10-vote-per-share Class B Common
Stock, Mr. Aab no longer holds shares representing a majority of the voting
power of the Company's outstanding common stock.
25
Results of Operations
Comparison of Year Ended December 31, 2001 to Year Ended December 31, 2000
Net revenue increased to $178.6 million for the year ended December 31,
2001, from $115.0 million in 2000. The significant increase in revenue resulted
from an increase in the total number of customers in existing markets and an
increase in telecommunications traffic on its network. In 2001, the Company's
end customer revenue increased to $93.8 million or 53% of total revenue from
$54.2 million or 47% of total revenue in 2000.
The loss on the resolution of disputed revenue in 2000 was a result of an
order issued by the North Carolina Utilities Commission on March 31, 2000 (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 $55.3 million in the first quarter of 2000. This
charge was composed of the write-off of approximately $153.0 million in
receivables related to reciprocal compensation revenue offset by a previously
established allowance of $39.0 million, and a reduction of approximately $59.0
million in reciprocal compensation commissions payable to Metacomm.
The Company recorded a significant charge relating to disputed receivables
in the fourth quarter of 2000. The $52.0 million provision is netted on the
Company's consolidated statement of operations against a $12.0 million reduction
in commissions payable on those receivables, resulting in the $40.0 million
provision on the company's consolidated statement of operations. Management
believed that 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. The Company resolved its disputes with both BellSouth and Sprint during
2001. Included in the 2001 consolidated statement of operations is an amount
approximating $7.0 million, representing a net recovery of amounts previously
recorded as reserves for disputed receivables and certain other related
accruals.(See Disputed Revenue below)
Cost of services is comprised primarily of leased transport, facility
installation, and usage charges. Cost of services increased to $90.3 million, or
50% of revenue for 2001 from $52.7 million, or 45% of revenue, for 2000. This
increase in cost of services was primarily a result of the increase in the size
of US LEC's network, an increase in customers and usage by customers, as well
as a shift to lower margin end customer revenue.
Selling, general and administrative expenses for the year ended December
31, 2001 increased to $107.9 million, or 60% of revenue, compared to $80.7
million, or 70% of revenue, for the year ended December 31, 2000. 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 decrease in selling, general and administrative expenses as a
percentage of revenue in 2001 was primarily due to expense control, an
improvement in back office efficiencies and growth in end customer revenue.
Depreciation and amortization for 2001 increased to $35.1 million from
$24.4 million in 2000 primarily due to the increase in depreciable assets in
service related to US LEC's network expansion.
Interest income for 2001 decreased to $3.2 million from $4.8 million in
2000. The decrease in interest income in 2001 was primarily due to a decline in
cash available for investing and declining rates of return on invested funds.
Interest expense for 2001 increased to $11.9 million from $7.8 million in
2000. This increase in interest expense was primarily due to increased
borrowings under the Company's credit facility partially offset by declining
interest rates.
26
For the year ended December 31, 2001, the Company did not record an income
tax expense or benefit, compared to a $23.7 million income tax benefit in 2000.
In 2001, the income tax benefit, primarily created from operating losses, was
offset by increases in the tax valuation allowance. The $23.7 million benefit
for the year ended December 31, 2000 is net of an increase of $35.7 million in
the valuation allowance against deferred tax assets relating to the anticipated
use of federal and state net operating losses.
Net loss for 2001 amounted to $63.4 million, compared to a net loss of
$117.4 million for 2000. Dividends paid in kind and accrued on Series A
Mandatorily Redeemable Convertible Preferred Stock for the year ended
December 31, 2001 and 2000 amounted to $12.8 million and $8.8 million,
respectively (See Note 5 of the Company's consolidated financial statements).
The accretion of preferred stock issuance cost was $0.5 million and $0.3 million
for the years ended December 31, 2001 and 2000, respectively.
As a result of the foregoing, net loss attributable to common shareholders
for the year ended December 31, 2001 amounted to $ 76.7 million or ($2.83) per
diluted share as compared to $126.5 million, or ($4.58) per diluted share for
2000. The decrease in net loss and net loss per share is attributed to the
factors discussed above.
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 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 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 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 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
commissions 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 45% 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
increase usage by its
27
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 expanded into new markets and added
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 selling, general and administrative expenses 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 in kind and accrued on Series A
Mandatorily Redeemable Convertible Preferred Stock for the year ended
December 31, 2000 amounted to $8.8 million (See Note 5 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 $126.5 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.
Liquidity and Capital Resources
US LEC's business is capital intensive and its operations require
substantial capital expenditures for the expansion of its network
switches, related electronic equipment, information systems, and facilities. The
Company's cash capital expenditures were $40.4 and $111.6 million for the years
ended December 31, 2001 and 2000, respectively. As of December 31, 2001, the
outstanding amount under the Company's senior secured credit facility was $150.0
million. While management believes the $80.5 million in cash at December 31,
2001 will fund the Company's capital requirements until it becomes EBITDA
positive, funding to free cash flow may require additional financing.
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 5 to
the Company's Consolidated Financial Statements for a description of this
28
transaction and the terms of the Preferred Stock. Proceeds to the Company, net
of commissions and other transaction costs, were approximately $193.7 million.
Cash used in operating activities was approximately $5.9 million in 2001
compared to $49.3 million in 2000. The decrease in cash used in operating
activities was primarily due to the collection of amounts due from BellSouth for
reciprocal compensation, facility charges, and other charges and amounts due
from Sprint for access charges. The Company received payment of approximately
$50.0 million from BellSouth and Sprint during 2001 as a result of its
settlements with both companies over disputed revenues (See Disputed Revenue
appearing below).
Cash used in investing activities decreased to $40.5 million in 2001 from
$111.7 million in 2000. 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 primarily during 2000. This decrease is evidence that the
network build-out is substantially complete and capital spending is success
based, as well as continued control of new expenditures.
Cash provided by financing activities decreased to $21.1 million in 2001
from $251.7 million for 2000 due to increased borrowings under the credit
facility and the issuance of preferred stock in 2000. In 2000, the Company
issued $200.0 million in Series A Mandatorily Redeemable Convertible Preferred
Stock (see above). Proceeds from borrowings, net of repayments, under the
Company's credit facility decreased during 2001.
The Company's credit facility is subject to certain financial covenants,
measured quarterly, the most significant of which relates to the achievement of
increasing levels of revenue and earnings, and debt ratios. The Company was in
compliance with these covenants as of the quarter ended December 31, 2001.
Company management believes it will be in compliance with all quarterly
financial covenants during 2002 based upon projected operating results. These
projected operating results are dependent upon the Company meeting quarterly
2002 targets of new customers, existing customer retention, customer usage and
billing rates, and as a result involve some degree of uncertainty. Should any of
these assumptions not be achieved for a particular quarter, it is possible that
a financial covenant will not be met during 2002. Although there can be no
assurances, Company management believes if this were to occur, it would be able
to obtain the necessary waivers or amendments from its lenders. The Company was
successful in obtaining an amendment in the third quarter of 2001 relating to
its minimum quarterly EBITDA financial covenant.
The following table provides a summary of our contractual obligations and
commerical commitments. Additional detail about these items is included in the
notes to the consolidated financial statements.
Payments Due by Period
----------------------
Less than 1-3 4-5 After 5
Contractual Obligations Total 1 year years years years
------- --------- ----- ------ -------
Long-term debt $150,000 $18,750 $100,000 $31,250 $
Operating Leases 53,802 7,708 19,300 10,332 16,462
-------- ------- ------ ------ ------
Total contractual cash obligations $ 203,802 $26,458 $119,300 $41,582 $16,462
Disputed Revenues
The deregulation of the telecommunications industry, the implementation of
the Telecom Act, and the distress of many carriers in the wake of the downturn
in the telecommunications industry have embroiled numerous industry
participants, including the Company, in lawsuits, proceedings and arbitrations
before state regulatory commissions, private arbitration organizations such as
the American Arbitration Association, and courts over many issues important to
the financial and operational success of the Company. These issues include the
interpretation and enforcement of interconnection agreements, the terms of
interconnection agreements the Company may adopt, operating performance
obligations, reciprocal compensation, access rates, rates applicable to
different categories of traffic, and the characterization of traffic for
compensation purposes. The Company anticipates that it will continue to be
involved in various lawsuits, arbitrations, and proceedings over these and other
material issues. The Company anticipates also that further legislative and
regulatory rulemaking will occur--on the federal and state level--as the
industry deregulates and as the Company enters new markets or offers new
products. Rulings adverse to the Company, adverse legislation, or changes in
governmental policy on issues material to the Company could have a material
adverse effect on the Company's financial condition or results of its
operations.
Reciprocal Compensation- On April 27, 2001, the Federal Communications
Commission ("FCC") released an Order on Remand and Report and Order (the "Remand
Order") addressing inter-carrier compensation for traffic terminated to Internet
service providers ("ISPs"). The interpretation and enforcement of the Remand
Order will likely be the most important factor in the Company's efforts to
29
collect reciprocal compensation for ISP-bound traffic in the future. In the
Remand Order, the FCC addressed a number of important issues, including the
rules under which carriers are to compensate each other for traffic terminated
to ISPs and the rates applicable for ISP-bound traffic as well as traffic bound
to other customers.
Importantly, while the Remand Order provides greater certainty about the
Company's right to bill for traffic terminated to ISPs, the effect of the Remand
Order on the Company will depend on how it is interpreted and enforced. In
particular, there are uncertainties as to whether the Remand Order has any
effect on the Company's pending arbitral, commission and judicial proceedings
seeking to collect compensation for traffic terminated to ISPs; whether certain
provisions of the Remand Order will be applied state-by-state, market-by-market
and/or carrier-by-carrier; whether the limitations on growth of ISP traffic in
the Remand Order will survive legal challenge; whether the Remand Order will
satisfy the U.S. District Court of the District of Columbia on whose order the
FCC issued the Remand Order; and whether the incumbent carrier will trigger the
rate reductions and other limitations set forth in the Remand Order. If the
Remand Order is interpreted in a manner adverse to the Company on all or any of
the issues, or if the Remand Order is modified as a result of pending or new
legal challenges, it could have a material adverse effect on the Company. For a
more complete description of the Remand Order see "Business - Regulation".
On October 3, 2001 the Company and BellSouth entered into a settlement
agreement (the "Settlement Agreement") by which they resolved outstanding
reciprocal compensation receivables in the various states in which both operate
and other past payments. BellSouth agreed to pay US LEC approximately $31.0
million, in addition to approximately $10.0 million it paid in August 2001, to
resolve those issues for periods prior to the effective date of the Remand
Order. The Settlement Agreement imposed on the parties certain obligations
regarding the payment of reciprocal compensation in the future, which are in the
process of being implemented. The Settlement Agreement also provides that the
payments made for periods prior to the effective date of the Remand Order are
not subject to adjustment as a result of subsequent changes in the Remand Order.
In September 2001, the Company filed a proceeding with the Virginia State
Corporation Commission ("VSCC") and the FCC seeking to collect reciprocal
compensation from Verizon owing for traffic bound for ISPs as well as other
customers. The VSCC declined jurisdiction over the dispute. In October 2001, the
FCC has accepted jurisdiction over the dispute. The Company cannot predict when
the FCC will take action on this dispute or whether the Company will ultimately
be successful in full; however, management believes that it will be largely
successful in recovering amounts owed by Verizon in light of the Remand Order.
Disputed Access Revenues - A number of IXCs have refused to pay access
charges to CLECs, including the Company, alleging that the access charges exceed
the rates charged by the ILEC. 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.
On April 27, 2001, the FCC released its Seventh Report and Order and
Further Notice of Proposed Rulemaking (the "Access Order") in which it
established a benchmark rate at which a CLEC's interstate access charges will be
presumed to be reasonable and which CLECs may impose on IXCs by tariff. The
Access Order addresses a number of issues important to how CLECs charge IXCs for
originating and terminating interstate toll and toll free traffic.
The Access Order should provide certainty as to the Company's right to
bill IXCs for interstate access at rates above those tariffed by the ILECs.
Notwithstanding the apparent certainty created by the Access Order, its effect
on the Company will depend on how the Access Order is interpreted and enforced
and the outcome of appeals currently pending. If the Access Order is interpreted
or enforced in a manner adverse to the Company as it relates to periods prior to
the effective date, such result could have a material adverse effect on the
Company. For a more complete description of the Access Order, see
"Business - Regulation".
30
On May 30, 2001, the FCC issued a decision in AT&T Corp. v. Business
Telecom Inc. (the "BTI Decision"), in which the FCC determined that the
interstate access rates charged by Business Telecom, Inc. ("BTI") were not just
and reasonable. The FCC determined that just and reasonable rates for BTI were
properly based upon the lowest band of rates charged by the National Exchange
Carriers Association ("NECA"). The FCC based this holding on the limited
evidence before it, tending to show that BTI's operations were similar to those
of small, urban ILECs, many of whom charge the lowest band NECA rates. BTI
settled its appeal of the BTI Decision. As with the Access Order described
above, the BTI Decision's effect on the Company will depend on how the order is
interpreted and enforced. If the BTI Decision is interpreted or enforced in a
manner adverse to the Company, such result could have a material adverse effect
on the Company.
By settlement dated October 5, 2001, Sprint and the Company resolved their
dispute over access charges. Sprint paid the Company approximately $8.0 million,
in addition to approximately $1.5 million it paid in the four months preceding
the settlement, in payment of past due invoices for periods through July 2001.
Legislation - Periodically, legislation has been introduced in the U.S.
House of Representatives or the U.S. Senate to alter or amend the Telecom Act.
It is the Telecom Act which opened the local telephone markets for competition
and outlines many of the ground rules pursuant to which the ILECs and the CLECs
operate with respect to each other. The Company anticipates that additional
efforts will be made to alter or amend the Telecom Act. The Company cannot
predict whether any particular piece of legislation will become law and how the
Telecom Act might be modified. The passage of legislation amending the Telecom
Act could have a material adverse effect on the Company and its financial
results.
Interconnection Agreements with ILECs - The Company has agreements for the
interconnection of its networks with the networks of the ILECs covering each
market in which US LEC has installed 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 or obtain such
additional agreements for interconnection with the ILECs or renewals of existing
interconnection agreements on terms and conditions acceptable to the Company.
Interconnection with Other Carriers - The Company anticipates that as its
interconnections with various carriers increase, the issue of seeking
compensation for the termination or origination of traffic whether by reciprocal
arrangements, access charges or other charges will become increasingly complex.
The Company does not anticipate that it will be cost effective to negotiate
agreements with every carrier with which the Company exchanges originating
and/or terminating traffic. The Company will make a case-by-case analysis of the
cost effectiveness of committing resources to these interconnection agreements
or otherwise billing and paying such carriers.
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 exists (2) services have been rendered
(3) seller's price to the buyer is fixed or determinable and (4) collectibility
is reasonably assured. Reciprocal compensation that is earned as revenue from
other local exchange carriers represents compensation for local
telecommunications traffic terminated on our network that originates on another
carrier's network.
The Company's cost of services is comprised primarily of two types of
charges: leased transport charges which comprise approximately three-quarters 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-quarter 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 the
company owned switch that services that customer 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.
31
Effect of Recently Issued Accounting Pronouncements
Effective January 1, 2001, the Company adopted 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.
SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived
Assets", which supersedes SFAS 121, "Accounting for Impairment or Disposal of
Long-Lived Assets and for Long-Lived Assets to be Disposed of", but retains many
of its fundamental provisions, expands the scope of discontinued operations to
included more disposal transactions. SFAS No. 144 will be effective for the
Company for financial statements issued for the fiscal year beginning January 1,
2002. The Company has evaluated the effect the statement will have on its
consolidated financial statements and related disclosures and does not believe
that the effect will be material.
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, 2001, investments 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.
32
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 (the "Company") as of December 31, 2001 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,
2001. Our audits also included the financial statement schedule listed in the
Index at Item 14. These financial statements and financial statement schedule
are the responsibility of the Company's management. Our responsibility is to
express an opinion on these financial statements and financial statement
schedule 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, 2001 and 2000, and the results of their operations and their
cash flows for each of the three years in the period ended December 31, 2001, 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.
/s/ Deloitte & Touche LLP
Charlotte, North Carolina
February 21, 2002
33
US LEC Corp. and Subsidiaries
Consolidated Balance Sheets
(In Thousands)
December 31, December 31,
2001 2000
------------ ------------
Assets
Current Assets
Cash and cash equivalents $ 80,502 $ 105,821
Restricted cash 1,300 1,300
Accounts receivable (net of allowance of $12,263 and $1,523
at December 31, 2001 and 2000, respectively) 42,972 48,859
Deferred income taxes 1,840 --
Prepaid expenses and other assets 9,030 4,802
--------- ---------
Total current assets 135,644 160,782
Property and Equipment, Net 188,436 188,052
Accounts Receivable (net of an allowance of $52,000 at December 31, 2000) -- 12,306
Deferred Income Taxes -- 4,148
Other Assets 9,233 7,871
--------- ---------
Total Assets $ 333,313 $ 373,159
========= =========
Liabilities and Stockholders'Deficiency
Current Liabilities
Accounts payable $ 10,747 $ 13,684
Accrued network costs 17,877 9,302
Commissions payable 6,679 7,012
Accrued expenses - other 14,928 10,884
Deferred revenue 6,691 3,350
Deferred income taxes -- 4,148
Long-term debt - current portion 18,750 --
--------- ---------
Total current liabilities 75,672 48,380
--------- ---------
Long-Term Debt 131,250 130,000
Commissions Payable -- 9,860
Deferred Income Taxes 1,840 --
Other Liabilities 5,721 4,315
Commitments and Contingencies (Note 6)
Series A Mandatorily Redeemable Convertible Preferred Stock
(10,000 authorized shares, 222 and 209 shares issued and outstanding with
redemption values of $222 and $209 at December 31, 2001 and 2000,
respectively) (Note 5) 216,155 202,854
Stockholders' Deficiency
Common stock-Class A, $.01 par value (122,925 authorized shares,
26,388 and 10,934 outstanding at December 31, 2001 and 2000, respectively) 264 109
Common stock-Class B, $.01 par value (17,075 authorized shares, 0 and 16,835
outstanding at December 31, 2001 and December 2000, respectively) (Note 10) -- 168
Additional paid-in capital (Note 10) 76,421 73,813
Retained deficit (172,777) (96,121)
Unearned compensation - stock options (1,233) (219)
--------- ---------
Total stockholders' deficiency (97,325) (22,250)
--------- ---------
Total Liabilities and Stockholders' Deficiency $ 333,313 $ 373,159
========= =========
See notes to consolidated financial statements
34
US LEC Corp. and Subsidiaries
Consolidated Statements of Operations
For the Years Ended December 31, 2001, 2000, and 1999
(In Thousands, Except Per Share Data)
2001 2000 1999
--------- --------- ---------
Revenue, Net (Notes 2, 6 and 8 - includes related party transactions
totaling $9,511 in 1999) $ 178,602 $ 114,964 $ 175,180
Cost of Services (Notes 2, 6 and 8 - includes related party
transactions totaling $38,990 in 1999, respectively) 90,298 52,684 73,613
--------- --------- ---------
Gross Margin 88,304 62,280 101,567
Selling, General and Administrative Expenses 114,898 80,684 48,375
Loss on Resolution of Disputed Revenue (Note 2) -- 55,345 --
(Recovery) Provision for Disputed Receivables, Net (Note 2) (7,042) 40,000 --
Depreciation and Amortization 35,103 24,365 11,720
--------- --------- ---------
(Loss) Earnings from Operations (54,655) (138,114) 41,472
Other (Income) Expense
Interest Income (3,171) (4,834) (1,050)
Interest Expense (Note 4) 11,870 7,839 3,096
--------- --------- ---------
(Loss) Earnings Before Income Taxes (63,354) (141,119) 39,426
Income Tax Provision (Benefit) (Note 7) -- (23,727) 15,617
--------- --------- ---------
Net (Loss) Earnings (63,354) (117,392) 23,809
--------- --------- ---------
Less: Preferred Stock Dividends (Note 5) 12,810 8,758 --
Less: Accretion of Preferred Stock Issuance Cost (Note 5) 491 336 --
--------- --------- ---------
Net (Loss) Earnings Attributable to Common Stockholders $ (76,655) $(126,486) $ 23,809
========= ========= =========
Net (Loss) Earnings Per Common Share (Note 11):
Basic $ (2.83) $ (4.58) $ 0.87
========= ========= =========
Diluted $ (2.83) $ (4.58) $ 0.84
========= ========= =========
Weighted Average Number of Shares Outstanding (Note 11):
Basic 27,108 27,618 27,431
========= ========= =========
Diluted 27,108 27,618 28,411
========= ========= =========
See notes to consolidated financial statements
35
US LEC Corp. and Subsidiaries
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIENCY)
For the years ended December 2001, 2000 and 1999
(In Thousands)
Common Stock Common Stock
Class A Class B
--------------------------------
--------------------------------
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
Exercise of stock options 2 1 -- --
Issuance of shares 618 6
Unearned compensation - stock options -- -- -- --
Accretion of preferred stock issuance cost -- -- -- --
Conversion of Class B Common Shares
to Class A Common Shares 14,834 148 (16,835) (168)
Preferred stock dividends -- -- -- --
Recapitalization fees -- -- -- --
Net loss -- -- -- --
--------------------------------
Balance, December 31, 2001 26,388 $264 -- $ --
================================
See Notes to Consolidated Financial Statements
36
Unearned
Additional Retained Compensation
Paid-In Earnings Stock
Capital (Deficit) Options Total
-------------------------------------------------
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)
Exercise of stock options 7 (1) -- 7
Issuance of Shares 1,413 -- -- 1,419
Unearned compensation - stock options 1,460 -- (1,014) 446
Accretion of preferred stock issuance cost -- (491) -- (491)
Conversion of Class B Common Shares
to Class A Common Shares and effects of
recapitalization 20 -- -- --
Preferred Stock Dividends -- (12,810) -- (12,810)
Recapitalization fees (292) -- -- (292)
Net loss -- (63,354) -- (63,354)
-------------------------------------------------
Balance, December 31, 2001 $ 76,421 $(172,777) $(1,233) $ (97,325)
=================================================
See Notes to Consolidated Financial Statements
37
US LEC Corp. and Subsidiaries
Consolidated Statements of Cash Flows
(In Thousands)
2001 2000 1999
--------- --------- ---------
Operating Activities
Net (loss) earnings $ (63,354) $(117,392) $ 23,809
--------- --------- ---------
Adjustments to reconcile net (loss) earnings to net
cash used in operating activities:
Depreciation and amortization 35,103 24,365 11,720
Loss on resolution of disputed revenue -- 55,345 --
Deferred compensation 446 150 191
Deferred income taxes 1,840 (23,727) 15,617
Changes in assets and liabilities which provided (used) cash:
Accounts receivable 18,192 6,466 (127,729)
Prepaid expenses and other assets (6,068) (1,414) 495
Other assets (2,294) (2,827) (41)
Accounts payable 2,308 1,131 (96)
Deferred revenue 3,341 1,648 873
Accrued network costs 8,575 (4,460) 8,390
Customer commissions payable (10,193) 5,169 19,103
Other liabilities - noncurrent 1,406 4,041 274
Accrued commissions payable - related party -- -- 17,464
Accrued expenses - other 4,727 2,186 3,995
--------- --------- ---------
Total adjustments 57,383 68,073 (49,744)
--------- --------- ---------
Net cash used in operating activities (5,971) (49,319) (25,935)
--------- --------- ---------
Investing Activities
Purchase of property and equipment (40,425) (111,616) (49,690)
Purchases of certificates of deposit and restricted cash -- (127) (6)
--------- --------- ---------
Net cash used in investing activities (40,425) (111,743) (49,696)
--------- --------- ---------
Financing Activities
Proceeds from public stock offering 6 -- 114
Net proceeds from issuance of Series A Preferred Stock -- 193,760 --
Proceeds from exercise of stock options, warrants, and ESPP 1,419 1,105 --
Proceeds from long-term debt 20,000 155,000 52,000
Payments on long-term debt -- (97,000) --
Payment for deferred loan fees (348) (1,156) (3,274)
--------- --------- ---------
Net cash provided by financing activities 21,077 251,709 48,840
--------- --------- ---------
Net (Decrease) Increase in Cash and Cash Equivalents (25,319) 90,647 (26,791)
Cash and Cash Equivalents, Beginning of Period 105,821 15,174 41,965
--------- --------- ---------
Cash and Cash Equivalents, End of Period $ 80,502 $ 105,821 $ 15,174
========= ========= =========
Supplemental Cash Flow Disclosures
Cash Paid for Interest $ 10,568 $ 7,377 $ 2,748
========= ========= =========
Cash Paid for Taxes $ -- $ -- $ 2
========= ========= =========
Supplemental Noncash Investing and Financing Activities:
At December 31, 2001, 2000, and 1999, $5,452, $10,696, and $11,079,
respectively, of property and equipment additions are included in outstanding
accounts payable.
See notes to consolidated financial statements
38
US LEC Corp. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
For the years ended December 31, 2001, 2000, and, 1999
(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. 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 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.
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 exists (2) services have been rendered
(3) seller's price to the buyer is fixed or determinable and (4) collectibility
is reasonably assured. Reciprocal compensation that is earned 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 as well as orders of the FCC and
PUC's. For 2001, 2000 and 1999, revenues are recorded net of amounts that are
due to a customer or outside sales agent pursuant to each respective
telecommunications service contract. For the years ended December 31, 2001 and
2000 amounts incurred under these contracts of $11,890 and $7,499, 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.
In 2000, the Company began deferring installation revenue from contracts
with end customers and with other carriers. The Company is amortizing this
revenue over the average life of the related contract. As of December 31, 2001
and 2000, the Company had $1,440 and $579, respectively, recorded in Deferred
Revenue as a current liability on the accompanying Consolidated Balance Sheets.
In addition, the Company had $2,428 and $1,463 as of December 31, 2001 and 2000,
respectively, recorded in Other Liabilities for the noncurrent portion of the
Deferred Revenue.
39
Cost of Services - In 2000, the Company began deferring installation
charges from ILECs related to new customers contracts associated with network
and end customer facilities. The Company is amortizing these costs over the
average life of the related contracts. During the years ended December 31, 2001
and 2000, the Company amortized $2,059 and $600, respectively, of deferred
installation charges into cost of services. As of December 31, 2001 and 2000,
the Company had $3,510 and $1,177, respectively, recorded in Other Current
Assets and $2,999 and $1,749, respectively, recorded in Other Assets in the
accompanying Consolidated Balance Sheets relating to unamortized deferred
installation charges.
The Company's cost of services is comprised primarily of two types of
charges: leased transport charges which comprise approximately three-quarters 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-quarter 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 the
Company owned switch that services that customer 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.
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, 2001 and
2000 serves as collateral for letters of credit related to certain office
leases.
Accounts Receivable - The $52,000 allowance against accounts receivable at
December 31, 2000, was considered necessary due to a number of factors which
occurred during 2000; 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.
At December 31, 2000, the Company reserved an additional $1.5 million of
accounts receivable related to revenue sources other than reciprocal
compensation.. In addition, the Company 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 sheet.
40
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 $1,638 and $1,025 in payroll related costs during
the years ended December 31, 2001 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 yet been received by the Company. Management's
estimate is developed from the number of lines and facilities in service,
minutes of use and contractual 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 $1,765 and $949) of $3,922 and $4,738 as of December 31, 2001
and 2000, respectively, recorded in other assets on the accompanying
consolidated balance sheets that are being amortized over the life of the
related debt agreement. (See Note 4)
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 due from end customers and
carriers. The Company's end customers are located in the southeastern and
mid-Atlantic United States. The Company performs ongoing credit evaluations of
its end customers but does not require collateral deposits from a majority of
its end customers. The Company is exposed to additional credit risk due to the
fact that the Company's most significant trade receivables are from large
telecommunications entities.
41
The Company is dependent upon certain suppliers for the provision of
telecommunications services to its customers. The Company has executed
interconnection agreements for all states in which it operates.
Use of Estimates - The preparation of financial statements in conformity
with accounting principles generally accepted in the United States of America
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 allowance for doubtful
accounts receivable, estimated end customer contract life, accrual of network
costs payable to other telecommunications entities, income tax valuation
allowance, and estimated useful lives of fixed assets. Any difference between
the amounts recorded and amounts ultimately realized or paid will be adjusted
prospectively as new facts become known.
Advertising - The Company expenses advertising costs in the period
incurred. Advertising expense amounted to $1,473, $1,900 and $522, for 2001,
2000 and 1999, respectively. Advertising costs for 1999 were offset entirely by
marketing incentives provided by a vendor.
Significant Customer - In 2001, 2000 and 1999 BellSouth, operating in the
majority of the Company's markets, accounted for approximately 10%, 15% and 70%,
respectively, of the Company's net revenue (before reduction for the $27,823
allowance in 1999). The majority of this revenue was generated from reciprocal
compensation. Although reciprocal compensation owed to the Company by BellSouth
is not customer revenue in the traditional sense, BellSouth is shown here
due to the significant contribution to revenue. At December 31, 2001, 2000 and
1999, BellSouth accounted for 16%, 70% and 92%, of the Company's total accounts
receivable before allowance, respectively. The majority of such receivables and
revenues in 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. During 2001,
the Company and BellSouth entered into a settlement agreement (the "Settlement
Agreement") by which they resolved outstanding reciprocal compensation in the
various states in which both operate and other past payments (see Note 6 to
the Company's Consolidated Financial Statements).
Recent Accounting Pronouncements - Effective January 1, 2001, the Company
adopted 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 adoption of SFAS No. 133 did not have a material
effect on its results of operations as the Company does not currently hold any
derivative instruments or engage in hedging activities.
SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived
Assets", which supersedes SFAS 121, "Accounting for Impairment or Disposal of
Long-Lived Assets and for Long-Lived Assets to be Disposed of," but retains many
of its fundamental provisions, expands the scope of discontinued operations to
included more disposal transactions. SFAS No. 144 will be effective for the
Company for financial statements issued for the fiscal year beginning January 1,
2002. The Company has evaluated the effect the statement will have on its
consolidated financial statements and related disclosures and does not believe
that the effect will be material.
Reclassifications - Certain reclassifications have been made to 1999
amounts to conform to the 2001 and 2000 presentation.
42
3. PROPERTY AND EQUIPMENT
Property and equipment at December 31, is summarized by major class as
follows:
2001 2000
- --------------------------------------------------------------------------------
Telecommunications switching and other equipment $161,178 $145,278
Office equipment, furniture and other 72,805 56,281
Leasehold improvements 28,176 26,444
-----------------------------
262,159 228,003
Less accumulated depreciation and amortization (73,723) (39,951)
-----------------------------
Total $188,436 $188,052
=============================
4. LONG-TERM DEBT
The Company's senior secured loan agreement, as amended, is comprised of
(i) a $125,000 credit facility that converted into a six-year term loan as of
June 30, 2001 and (ii) a $25,000 revolving credit facility that matures in
December 2005. 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, 2001, was $150,000, of
which $18,750 is classified as current on the Company's Consolidated Balance
Sheet. Advances under the agreement as of December 31, 2001 bear interest at an
annual rate ranging between approximately 6.20% and 6.43%.
The Company's credit facility is subject to certain financial covenants,
measured quarterly, the most significant of which relates to the achievement of
increasing levels of revenue and earnings and debt ratios. The Company was in
compliance with these covenants as of the quarter ended December 31, 2001.
Company management believes it will be in compliance with all quarterly
financial covenants during 2002 based upon projected operating results. These
projected operating results are dependent upon the Company meeting quarterly
2002 targets of new customers, customer retention, customer usage and billing
rates, and as a result involve some degree of uncertainty. Should any of these
assumptions not be achieved for a particular quarter, it is possible that a
financial covenant will not be met during 2002. Although there can be no
assurances, Company management believes if this were to occur, it would be able
to obtain the necessary waivers or amendments from its lenders. The Company was
successful in obtaining an amendment in the third quarter of 2001 relating to
its minimum quarterly EBITDA financial covenant.
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 are as follows:
Year ending December 31:
2002 $ 18,750
2003 18,750
2004 25,000
2005 56,250
2006 31,250
---------
Total $ 150,000
=========
43
5. SERIES A MANDATORILY REDEEMABLE CONVERTIBLE PREFERRED STOCK
On April 11, 2000, the Company issued $200,000 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. As of December 31, 2001, the Company issued $21,568 in Series A
Preferred Stock Dividends. 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 $32.89
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 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 $194,000.
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 years ended December 31, 2001
and 2000, the Company accreted $491 and $336 of these costs, respectively. As of
December 31, 2001 and 2000, the Company had $5,413 and $5,904 in Series A
Preferred Stock issuance costs, respectively, netted with Series A Mandatorily
Redeemable Convertible Preferred Stock on its Consolidated Balance Sheet.
6. COMMITMENTS AND CONTINGENCIES
The deregulation of the telecommunications industry, the implementation of
the Telecom Act, and the distress of many carriers in the wake of the downturn
in the telecommunications industry have embroiled numerous industry
participants, including the Company, in lawsuits, proceedings and arbitrations
before state regulatory commissions, private arbitration organizations such as
the American Arbitration Association, and courts over many issues important to
the financial and operational success of the Company. These issues include the
interpretation and enforcement of interconnection agreements, the terms of
interconnection agreements the Company may adopt, operating performance
obligations, reciprocal compensation, access rates, rates applicable to
different categories of traffic, and the characterization of traffic for
compensation purposes. The Company anticipates that it will continue to be
involved in various lawsuits, arbitrations, and proceedings over these and other
material issues. The Company anticipates also that further legislative and
regulatory rulemaking will occur--on the federal and state level--as the
industry deregulates and as the Company enters new markets or offers new
products. Rulings adverse to the Company, adverse legislation, or changes in
governmental policy on issues material to the Company could have a material
adverse effect on the Company's financial condition or results of its
operations.
44
Reciprocal Compensation - On April 27, 2001, the Federal Communications
Commission ("FCC") released an Order on Remand and Report and Order (the "Remand
Order") addressing inter-carrier compensation for traffic terminated to Internet
service providers ("ISPs"). The interpretation and enforcement of the Remand
Order will likely be the most important factor in the Company's efforts to
collect reciprocal compensation for ISP-bound traffic in the future. In the
Remand Order, the FCC addressed a number of important issues, including the
rules under which carriers are to compensate each other for traffic terminated
to ISPs and the rates applicable for ISP-bound traffic as well as traffic bound
to other customers.
Importantly, while the Remand Order provides greater certainty about the
Company's right to bill for traffic terminated to ISPs, the effect of the Remand
Order on the Company will depend on how it is interpreted and enforced. In
particular, there are uncertainties as to whether the Remand Order has any
effect on the Company's pending arbitral, commission and judicial proceedings
seeking to collect compensation for traffic terminated to ISPs; whether certain
provisions of the Remand Order will be applied state-by-state, market-by-market
and/or carrier-by-carrier; whether the limitations on growth of ISP traffic in
the Remand Order will survive legal challenge; whether the Remand Order will
satisfy the U.S. District Court of the District of Columbia on whose order the
FCC issued the Remand Order; and whether the incumbent carrier will trigger the
rate reductions and other limitations set forth in the Remand Order. If the
Remand Order is interpreted in a manner adverse to the Company on all or any of
the issues, or if the Remand Order is modified as a result of pending or new
legal challenges, it could have a material adverse effect on the Company. For a
more complete description of the Remand Order, see Busisness - Regulation.
On October 3, 2001 the Company and BellSouth entered into a settlement
agreement (the "Settlement Agreement") by which they resolved outstanding
reciprocal compensation receivables in the various states in which both operate
and other past payments. BellSouth agreed to pay US LEC approximately $31,000,
in addition to approximately $10,000 it paid in August 2001, to resolve those
issues for periods prior to the effective date of the Remand Order. The
Settlement Agreement imposed on the parties certain obligations regarding the
payment of reciprocal compensation in the future, which are in the process of
being implemented. The Settlement Agreement also provides that the payments made
for periods prior to the effective date of the Remand Order are not subject to
adjustment as a result of subsequent changes in the Remand Order.
In September 2001, the Company filed a proceeding with the Virginia State
Corporation Commission ("VSCC") and the FCC seeking to collect reciprocal
compensation from Verizon owing for traffic bound for ISPs as well as other
customers. The VSCC declined jurisdiction over the dispute. In October 2001, the
FCC accepted jurisdiction over the dispute. The Company cannot predict when the
FCC will take action on this dispute or whether the Company will ultimately be
successful in full; however, management believes that it will be largely
successful in recovering amounts owed by Verizon in light of the Remand Order.
Disputed Access Revenues - A number of IXCs have refused to pay access
charges to CLECs, including the Company, alleging that the access charges exceed
the rates charged by the ILEC. 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.
On April 27, 2001, the FCC released its Seventh Report and Order and
Further Notice of Proposed Rulemaking (the "Access Order") in which it
established a benchmark rate at which a CLEC's interstate access charges will be
presumed to be reasonable and which CLECs may impose on IXCs by tariff. The
Access Order addresses a number of issues important to how CLECs charge IXCs for
originating and terminating interstate toll and toll free traffic.
The Access Order should provide certainty as to the Company's right to
bill IXCs for interstate access at rates above those tariffed by the ILECs.
Notwithstanding the apparent certainty created by the
45
Access Order, its effect on the Company will depend on how the Access Order is
interpreted and enforced and the outcome of appeals currently pending. If the
Access Order is interpreted or enforced in a manner adverse to the Company as it
relates to periods prior to the effective date, such result could have a
material adverse effect on the Company. For a more complete description of the
Access Order, please see Business - Regulation.
On May 30, 2001, the FCC issued a decision in AT&T Corp. v. Business
Telecom Inc. (the "BTI Decision"), in which the FCC determined that the
interstate access rates charged by Business Telecom, Inc. ("BTI") were not just
and reasonable. The FCC determined that just and reasonable rates for BTI were
properly based upon the lowest band of rates charged by the National Exchange
Carriers Association ("NECA"). The FCC based this holding on the limited
evidence before it, tending to show that BTI's operations were similar to those
of small, urban ILECs, many of whom charge the lowest band NECA rates. BTI
settled its appeal of the BTI Decision. As with the Access Order described
above, the BTI Decision's effect on the Company will depend on how the order is
interpreted and enforced. If the BTI Decision is interpreted or enforced in a
manner adverse to the Company, such result could have a material adverse effect
on the Company.
By settlement dated October 5, 2001, Sprint and the Company resolved their
dispute over access charges. Sprint paid the Company approximately $8,000, in
addition to approximately $1,500 it paid in the four months preceding the
settlement, in payment of past due invoices for periods through July 2001.
Legislation - Periodically, legislation has been introduced in the U.S.
House of Representatives or the U.S. Senate to alter or amend the Telecom Act.
It is the Telecom Act which opened the local telephone markets for competition
and outlines many of the ground rules pursuant to which the ILECs and the CLECs
operate with respect to each other. The Company anticipates that additional
efforts will be made to alter or amend the Telecom Act. The Company cannot
predict whether any particular piece of legislation will become law and how the
Telecom Act might be modified. The passage of legislation amending the Telecom
Act could have a material adverse effect on the Company and its financial
results.
Interconnection Agreements with ILECs - The Company has agreements for the
interconnection of its networks with the networks of the ILECs covering each
market in which US LEC has installed 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 or obtain such
additional agreements for interconnection with the ILECs or renewals of existing
interconnection agreements on terms and conditions acceptable to the Company.
Interconnection with Other Carriers - The Company anticipates that as its
interconnections with various carriers increase, the issue of seeking
compensation for the termination or origination of traffic whether by reciprocal
arrangements, access charges or other charges will become increasingly complex.
The Company does not anticipate that it will be cost effective to negotiate
agreements with every carrier with which the Company exchanges originating
and/or terminating traffic. The Company will make a case-by-case analysis of the
cost effectiveness of committing resources to these interconnection agreements
or otherwise billing and paying such carriers.
In October 2001, the Company entered into settlement agreements with
BellSouth and Sprint resolving previously disputed accounts receivable. Included
in the accompanying consolidated statement of operations for the twelve months
ended December 31, 2001 is approximately $7,042 representing a net
recovery of amounts previously recorded as reserves for disputed receivables and
certain other accruals related to BellSouth and Sprint. Additionally, during the
twelve months ended December 31, 2001, the Company recorded an additional
provision for doubtful account reserves totaling approximately $13,628. This
amount was recorded based upon management's assessment of the current
collectibility of certain accounts receivable in consideration of the regulatory
and legal environments, existing disputes, current economic conditions and the
condition of certain carriers that the Company does business with. The Company
believes the allowance for doubtful accounts as of December 31, 2001 is
sufficient for known
46
disputes and other impaired receivables.
Leases - The Company leases office premises in various locations under
operating lease arrangements. Total rent expense on these leases amounted to
$7,951, $5,734 and $4,195 in 2001, 2000 and 1999, respectively. The Company's
restricted cash balance as of December 31, 2001, 2000, and 1999 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:
2002 $ 7,708
2003 7,001
2004 6,546
2005 5,753
2006 5,163
Beyond 21,631
-----------
$ 53,802
===========
7. INCOME TAXES
The provision for income taxes consists of the following components:
2001 2000 1999
- ------------------------------------------------------------------------------------------------------
Current - Charge equivalent to net tax benefit related
to stock options and warrants $ -- $ 281 $ 28
--------------------------------------------
Deferred
Federal -- (19,545) 12,869
State -- (4,463) 2,720
--------------------------------------------
-- (24,008) 15,589
--------------------------------------------
Total provision for income taxes $ -- $(23,727) $15,617
============================================
The reconciliation of the statutory federal income tax rate to the
Company's federal and state overall effective income tax rate is as follows:
2001 2000 1999
- --------------------------------------------------------------------------------
Statutory federal rate (35.00)% (35.00)% 35.00%
State income taxes -- (2.06) 4.49
Change in valuation allowance 33.59 20.05 --
Miscellaneous 1.41 .20 .11
----------------------------------------
Effective tax rate 0% (16.81)% 39.60%
========================================
47
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 31,2001, 2000 and
1999 are as follows:
2001 2000 1999
Deferred tax assets:
Net operating loss carryforward $82,322 $57,568 $17,054
Deferred state taxes and other 120 --- 1,696
Accrued expenses 5,908 1,293 727
-------------------------------------
Deferred tax assets 88,350 58,861 19,477
Less: Valuation Allowance (61,045) (35,669) ---
-------------------------------------
Total deferred tax assets 27,305 23,192 19,477
-------------------------------------
Deferred tax liabilities:
Net deferred revenues -- 3,747 33,476
Depreciation and amortization 26,083 18,937 9,811
Other 1,222 508 146
-------------------------------------
Total deferred tax liabilities 27,305 23,192 43,433
-------------------------------------
Net Deferred Tax Liability $ 0 $ 0 $23,956
=====================================
For the years ended December 31, 2001 and 2000, a valuation allowance has
been provided against the net 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, 2001, the Company has net operating loss carryforwards for
federal and state tax purposes of approximately $195,000. Such losses begin to
expire for federal and state purposes in 2017 and 2012, respectively.
8. 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 1999 and 1998. The Company recorded
$9,511 in revenue earned from services provided to Metacomm (which did not
include revenue from reciprocal compensation due from BellSouth, see Note 6)
during 1999. Metacomm also earned commissions from the Company for reciprocal
compensation revenue relating to Metacomm's network. The Company recorded
$38,990 for 1999 in reciprocal compensation commission expense earned by
Metacomm, which is included in cost of services in the accompanying financial
statements. The Company and Metacomm were parties to agreements by which
commissions
48
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 1999 the Company advanced to Metacomm $12,015, prior to collecting
the earned reciprocal compensation 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 2001 or 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.
The Company incurred $50 in 1999 in expenses for consulting services
provided by Global Vista Communications, LLC ("Global Vista"). As of December 31
1999, a liability totaling $66 was included in accounts payable in the Company's
financial statements, relating to software and consulting services purchased
from Global Vista. In addition, during 1999 and 2000, the Company acquired
$2,081 and $2, respectively, in software from Global Vista Communications, LLC
("Global Vista"), a company controlled by the Company's majority stockholder.
During 2000 and 1999, the Company capitalized $858 and $185, 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 $159, $95 and $3 in 2001, 2000 and
1999, respectively, in expenses for services provided by Lincoln Harris. As of
December 31, 2001, 2000 and 1999, a liability totaling $0, $27 and $46,
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 2001 and 2000, the Company paid H-C REIT, Inc.$1,922 and $1,706,
respectively, under this lease agreement.
Company management believes that all of the above transactions were on
terms no less favorable to the Company than could have been arranged with
unrelated parties.
9. EMPLOYEE BENEFIT PLAN
The Company has a 401(k) savings plan under which employees can contribute
up to 15% of their annual salary. For 2001, 2000, and 1999, respectively, the
Company made matching contributions to the plan totaling $1,006, $768 and $381
based on 50% of the first 6% of an employee's contribution to the plan.
10. STOCKHOLDERS' EQUITY
Common Stock -Prior to the completion of the recapitalization transaction
described below, the Company had previously authorized and issued two classes of
common stock, Class A and Class B. As a result of the aforementioned
recapitalization, 2,000 shares of Class B Common stock were cancelled and the
remaining 14,000 shares of Class B were converted into the same number of Class
A Common Shares. The rights of holders of the Class A Common Stock are entitled
to one vote per share in the election of the members of the Board of Directors.
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
49
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. The Company is presently authorized to issue 2,000 shares
of common stock under the Stock Purchase Plan. As of December 31, 2001, there
were 437 employees participating in the Stock Purchase Plan. The Company issued
share amounts of 323, 295, and 108 shares at a purchase price of $2.30, $2.30
and $4.09 per share, respectively, which represents a 15% discount to the
closing price on December 31, 2001, June 30, 2001 and December 29, 2000,
respectively.
Stock Option Plan - In January 1998, the Company adopted the US LEC Corp.
1998 Omnibus Stock Plan (the "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. In May 2001,
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 3,500 shares to
5,000 shares and in 2001, the Company filed a registration statement to register
these additional 1,500 shares. Under the amended Stock Plan, 5,000 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 $73, $60, and
$101 for 2001, 2000, and 1999, 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
$90 for 2001, 2000, and 1999, 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 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 December 2001, the Company granted to an employee an option to purchase
550 shares of Class A Common Stock at $2.91 per share (fair market value on the
date of grant was $5.60 per share). The Company recorded deferred compensation
of $1,480 associated with these options. The Company will amortize compensation
expense over a three year vesting period for 450 of these options. The
remaining 100 shares vested immediately. The Company amortized $283 for 2001 to
compensation expense relating to these vested options.
50
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, 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
======== ========== ======= ===========
Granted at fair market value 1,651 $ 4.41 $ 2.96 -- --
Granted at less than fair
market value 550 2.91 4.41 -- --
Exercised 0 (2) 3.50 -- --
Forfeited or cancelled (346) 12.12 (25) 10.00
-------- ---------- ------- -----------
Balance at December 31, 2001 4,501 $ 8.64 143 $ 2.86
======== ========== ======= ===========
* 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, 2001 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 $2.73 - $3.41 560 9.5 years $ 3.36 -- --
3.50 - 4.11 479 9.2 years 3.98 24 $ 3.50
4.50 - 5.81 567 9.6 years 5.38 -- --
6.06 - 6.88 382 8.8 years 6.12 94 6.06
-- - 7.31 797 6.7 years 7.31 596 7.31
7.69 - 16.50 443 7.9 years 12.65 202 12.74
18.00 - 25.50 355 8.2 years 19.11 112 19.48
25.75 - 37.13 364 8.0 years 27.04 167 26.65
--------- ------- ------ -------
3.50 - 37.13 3,947 8.4 years 9.43 1,195 11.90
Options granted at less than
fair market value 2.91 - 10.00 554 10.0 years 2.96 103 3.12
--------- ------- ------ -------
Total options outstanding at
December 31, 2001 $2.73 -$37.13 4,501 8.6 years $ 8.64 1,298 $11.20
========= ======== ======= =======
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 3 years $ 2.86
--- ------
Total options warrants at December 31, 2001 $2.86 143 3 years $ 2.86
--- ------
51
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:
1999 2000 2001
As Reported Proforma As Reported Proforma As Reported Proforma
- -----------------------------------------------------------------------------------------------------------
Net earnings (loss) $ 23,809 $ 22,463 $ (117,392) $ (121,436) $ (63,354) (70,454)
Preferred dividends -- -- (8,758) (8,758) (12,810) (12,810)
Accretion of preferred
Stock issuance fees -- -- (336) (336) (491) (491)
---------- ---------- ----------- ----------- ----------- -----------
Net earnings (loss) attributable
to shareholders $ 23,809 $ 22,463 $ (126,486) $ (130,530) $ (76,655) (83,755)
Earnings (loss) per share:
Basic 0.87 0.82 (4.58) (4.73) (2.83) (3.09)
Diluted 0.84 0.79 (4.58) (4.73) (2.83) (3.09)
The Company estimated the fair value for both the stock options and the
warrants using the Black-Scholes model assuming no dividend yield in 2001, 2000
and 1999; volatility of 80%, 80%, and 40%, for 2001, 2000, and 1999,
respectively, an average risk-free interest rate of 6.0%, 6.5%, and 6.5% for
2001, 2000, and 1999, respectively, an expected life of 12 months for the
warrants and 4.9, 5.0 and 5.1 years for the stock options in 2001, 2000, and
1999 respectively. The weighted average remaining contractual life of warrants
and stock options outstanding at December 31, 2001 was 3.0 years and 8.6 years,
respectively.
The Company estimated the fair value of the Employee Stock Purchase Plan
shares based upon the stock price at December 31, 2001 (the "issue date").
Compensation cost was estimated based upon the intrinsic value of the award at
the issue date.
In 2000, additional paid-in-capital was reduced by approximately $36,000
representing amounts due from Metacomm, which is indirectly controlled by
Richard T. Aab, the Company's Chairman and largest stockholder. Due to Mr. Aab's
controlling position in both Metacomm and the Company, this amount was treated
for financial reporting purposes as a deemed distribution to the stockholder.
On March 31, 2001, the Company, Richard T. Aab, the Company's Chairman,
controlling shareholder at that time and the indirect controlling owner of
Metacomm, and Tansukh V. Ganatra, the Company's former 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. This transaction was closed on August 6, 2001. Under the
agreement, the following events occurred: (1) Mr. Aab made a contribution to the
capital of the Company by delivering to the Company for cancellation 2,000
shares of Class B Common Stock, (2) Mr. Aab and Mr. Ganatra converted all of the
then remaining and outstanding shares of Class B Common Stock - a total of
approximately 14,000 such shares were outstanding after the 2,000 shares were
cancelled - into the same number of shares of Class A Common Stock. As set out
in the articles of incorporation, Class B Shares that have been converted to
Class A can not be reissued (3) the Company agreed 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 agreed to indemnify Mr. Ganatra for certain
adverse tax effects, if any, from the conversion of his Class B shares to Class
A shares.
52
As required by the agreement, the Company obtained 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 14,000 shares of Class B Common Stock into the same number of
shares of Class A Common Stock would result in the realization by the Company
and its Class A shareholders of value approximately equal to the outstanding
Metacomm obligation, received a favorable tax opinion, and received certain
consents.
As a result of this transaction, the number of issued and outstanding
shares of Common Stock (Class A and Class B together) decreased by 2,000 and, as
a result of the elimination of the 10-vote-per-share Class B Common Stock, Mr.
Aab no longer holds shares representing a majority of the voting power of the
Company's outstanding Common Stock, although he remains its largest single
shareholder.
11. EARNINGS (LOSS) PER SHARE
Earnings (loss) per common and common equivalent share are based on net
income (loss), after consideration of preferred stock dividends, and accretion
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, 2001, 2000 and 1999:
2001 2000 1999
- -------------------------------------------------------------------------------------
Basic earnings (loss) per share:
Net earnings (loss) $(63,354) $(117,392) $23,809
Preferred dividends (12,810) (8,758) --
Accretion of preferred stock Issuance fees (491) (336) --
--------------------------------
Net earnings (loss) applicable to Common
shareholders $(76,655) $(126,486) $23,809
Weighted average shares outstanding 27,108 27,618 27,431
--------------------------------
Basic earnings (loss) per share $ (2.83) $ (4.58) $ 0.87
================================
Diluted earnings (loss) per share:
Net earnings (loss) $(63,354) $(117,392) $23,809
Preferred dividends (12,810) (8,758) --
Accretion of preferred stock Issuance fees (491) (336) --
--------------------------------
Net earnings (loss) applicable to Common
shareholders $(76,655) $(126,486) $23,809
================================
Weighted average shares outstanding 27,108 27,618 27,431
Dilutive effect of stock options -- -- 725
Dilutive effect of warrants -- -- 255
--------------------------------
Weighted average shares, adjusted 27,108 27,618 28,411
--------------------------------
Diluted earnings (loss) per share $ (2.83) $ (4.58) 0.84
===============================
53
12. 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 2001,
2000, and 1999.
Quarter Ended
--------------------------------------------
March 31, June 30, Sept. 30, Dec. 31,
2001 2001 2001 2001
- ---------------------------------------------------------------------------------------------------
Revenue, Net $ 38,055 $ 43,051 $ 45,982 $ 51,513
Cost of Services 19,171 21,911 23,276 25,939
--------------------------------------------
Gross Margin 18,884 21,140 22,706 25,574
Selling, General and Administrative 24,228 26,017 38,087 26,565
Recovery for Disputed Receivables (Note 6) -- -- (7,042) --
Depreciation and Amortization 7,775 7,992 8,752 10,584
--------------------------------------------
Loss from Operations (13,119) (12,869) (17,091) (11,575)
Interest Income (Expense), Net (1,980) (2,189) (2,331) (2,200)
--------------------------------------------
Loss Before Income Taxes (15,099) (15,058) (19,422) (13,775)
Provision for Income Taxes -- -- -- --
---------------------------------------------
Net Loss (15,099) (15,058) (19,422) (13,775)
Preferred Stock Dividends 3,131 3,178 3,226 3,274
Accretion of Preferred Stock
Issuance Cost 120 122 124 125
---------------------------------------------
Net Loss Available to
Common Shareholders $(18,350) $(18,358) $(22,772) $(17,174)
=============================================
Net Loss per Share:
Basic $ (.66) $ (. 66) $ (.85) $ (.66)
=============================================
Diluted $ (.66) $ (. 66) $ (.85) $ (.66)
=============================================
Weighted Average Shares Outstanding:
Basic 27,768 27,771 26,846 26,067
============================================
Diluted 27,768 27,771 26,846 26,067
============================================
54
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 2) 55,345 -- -- --
Provision for Disputed
Receivables (Note 2 and 6) -- -- -- 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
==============================================
55
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
============================================
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
AND FINANCIAL DISCLOSURE
None.
56
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
(1) The information required in response to Item 10 related to
directors is incorporated by reference from the sections of
the Proxy Statement that appear under the heading "Election of
Directors". The information required in response to Item 10
related to Executive Officers is provided in Part I of this
report under the heading "Executive Officers of the
Registrant."
57
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".
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".
58
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, 2001 and 2000
B. Consolidated Statements of Operations years ended December 31,
2001, 2000, and 1999
C. Consolidated Statements of Stockholders' Equity (Deficiency)
years ended December 31, 2001, 2000 and 1999
D. Consolidated Statements of Cash Flows for the years ended
December 31, 2001, 2000, and 1999
E. Notes to Consolidated Financial Statements for the years ended
December 31, 2001, 2000, and 1999
F. Independent Auditors' Report
(2) Schedule II Valuation and Qualifying Accounts
(3) List of Exhibits:
No. Exhibit
- --- -------
3.1 Restated Certificate of Incorporation of the Company (1)
3.2 Restated Bylaws of the Company (2)
3.3 Certificate of Designation Relating to Series A Convertible Preferred Stock (3)
3.4 Amendment to Certificate of Designation Related to Series A Convertible Preferred Stock
4.1 Form of Class A Common Stock Certificate (1)
4.2 Preferred Stock Purchase Agreement, dated April 11, 2000 (3)
4.4 Corporate Governance Agreement, dated April 11, 2000 (3)
4.5 Registration Rights Agreement, dated April 11, 2000 (3)
4.6 Voting and Tag Along Agreement dated as of April 11, 2000 by and among certain Investors, Richard T. Aab,
Melrich Associates, L.P., Tansukh V. Ganatra and Super STAR Associates Limited Partnership.
4.7 Amendment to Voting and Tag-Along Agreement dated as of August 6,2001 by and among
Richard T. Aab, Melrich Associates, L.P., Super STAR Associates Limited Partnership,
Brain Capital CLEC Investors, L.L.C., Thomas H. Lee Equity Fund IV, L.P.,
Thomas H. Lee Foreign Fund IV-B, L.P. and Thomas H. Lee Foreign Fund IV, L.P.
10.2 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
National Bank and Wachovia Bank N.A. (the "Loan and Security Agreement") (4)
10.3 Amendment dated November 10, 2000 to Loan and Security Agreement (2)
10.4 Plan of Recapitalization dated August 6, 2001 by and among the Company, Metacomm,LLC,
Richard T. Aab, Melrich Associates, L.P., Tansukh V. Ganatra and Super STAR Associates
Limited Partnership.
10.5 Indemnity Agreement dated as of August 6, 2001 by and among the Company, Metacomm,
LLC RTA Associates, LLC, Richard T. Aab and Joyce M. Aab.
10.6 Indemnity Agreement dated as of August 6, 2001 by and among the Company, Tansukh V. Ganatra,
Sarlaben T. Ganatra, Rajesh T. Ganatra and Super STAR Associates Limited Partnership.
10.7 Employment Agreement Dated as of December 18, 2001 by and between the Company and Francis J. Jules. (5)
10.8 Consulting Agreement dated as of February 7, 2002 by and between the Company Tansukh V. Ganatra. (5)
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 Annual Report on Form 10-K
for its year ended December 31, 2000.
(b) Reports on Form 8-K.
(3) Incorporated by reference to the Company's Current Report on Form 8-K
filed May 12, 2000.
(4) Incorporated by reference to the Company's Annual Report on Form 10-K for
the fiscal year ended December 31, 1999.
No Current Reports on Form 8-K were filed during the fiscal quarter ended
December 31, 2001.
(5) Management or compensatory plan or arrangement.
59
SCHEDULE II
VALUATION AND QUALIFYING ACCOUNTS
US LEC CORP. (IN THOUSANDS)
Additions
Balance at Balance at
Beginning of Charged to Charged to End of
Period Costs and Other Period
Description (Dec. 31, 2000) Expenses Accounts Deductions (Dec. 31, 2001)
--------------- -------- -------- ---------- ---------------
Allowance against accounts receivables $53,523 $ 6,586* $ 3,318 $51,164 $12,263
Allowance against deferred tax assets $35,669 $25,376 $ 0 $ 0 $61,045
*Represents the provision for doubtful account reserves recorded during the year
ended December 31, 2001 of $13,628 included in selling, general and
administrative expenses in the accompanying Consolidated Statements of
Operations, net of the recovery of amounts previously reserved for disputed
receivables of $7,042.
60
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: March 29, 2002 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 March 29, 2002
------------------
Richard T. Aab
/s/ Frank J. Jules Chief Executive Officer and Director March 29, 2002
------------------ (Principal Executive Officer)
Frank J. Jules
/s/ Michael K. Robinson Executive Vice President and March 29, 2002
----------------------- Chief Financial Officer
Michael K. Robinson (Principal Financial and Accounting Officer)
/s/ Tansukh V. Ganatra Director March 29, 2002
----------------------
Tansukh V. Ganatra
/s/ David M. Flaum Director March 29, 2002
------------------
David M. Flaum
/s/ Steven L. Schoonover Director March 29, 2002
------------------------
Steven L. Schoonover
/s/ Anthony J. Dinovi Director March 29, 2002
---------------------
Anthony J. Dinovi
/s/ Michael A. Krupka Director March 29, 2002
---------------------
Michael A. Krupka
61