UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549-0001

 

 

FORM 10-Q

 

(MARK ONE)

 

 

For the quarterly period ended September 30, 2004

 

OR

 

 

Commission File Number 000-50706

 

 

ESCHELON TELECOM, INC.

(Exact name of registrant as specified in its charter)

 

 

Registrant’s telephone number, including area code: (612) 376-4400

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to the filing requirements for the past 90 days.  Yes ý     No o

 

Indicate by check mark whether the registrant is an accelerated filer as defined in Rule 12b-2 of the Exchange Act.  Yes o     No ý

 

 

 

 

ESCHELON TELECOM, INC.

INDEX TO FORM 10-Q

 

 

PART I. FINANCIAL INFORMATION		3
Item 1.	Financial Statements:	3
	Consolidated Balance Sheets — December 31, 2003 and September 30, 2004 (Unaudited)	4
	Unaudited Consolidated Statements of Operations — Three months and nine months ended September 30, 2003 and 2004	4
	Unaudited Consolidated Statements of Cash Flows — Nine months ended September 30, 2003 and 2004	5
	Notes to Consolidated Financial Statements	6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	13
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	24
Item 4.	Controls and Procedures	24
PART II. OTHER INFORMATION		25
Item 1.	Legal Proceedings	25
Item 2.	Changes in Securities, Use of Proceeds and Issuer Purchase of Equity Securities	25
Item 3.	Defaults Upon Securities	26
Item 4.	Submission of Matters to a Vote of Security Holders	26
Item 5.	Other Information	26
Item 6.	Exhibits and Reports on Form 8-K	26
	Signature	29

 

2

 

 

 

PART I.  FINANCIAL INFORMATION

 

Item 1.  Financial Statements

 

Eschelon Telecom, Inc.

Consolidated Balance Sheets

(In Thousands, Except Share and Per Share Amounts)

 

		December 31, 2003					September 30, 2004
							(Unaudited)
Assets
Current assets:
Cash and cash equivalents		$			8,606		$	14,408
Restricted cash		—					651
Marketable securities		—					4,362
Accounts receivable, net of allowance for doubtful accounts of $739 and $246, respectively		13,537					12,866
Other receivables		2,097					3,047
Inventories		3,169					3,154
Prepaid expenses		2,046					922
Total current assets		29,455					39,410
Property and equipment, net		86,777					85,137
Other assets		1,269					1,396
Goodwill		7,168					7,168
Intangible assets, net		29,052					29,727
Total assets		$	153,721				$		162,838
Liabilities and stockholders’ deficit
Current liabilities:
Accounts payable		$	4,582				$	4,869
Accrued telecommunication costs		6,939					7,521
Accrued expenses		3,240					4,796
Deferred revenue		3,000					3,762
Accrued compensation expenses		4,261					3,312
Capital lease obligation, current maturities		1,020					311
Total current liabilities		23,042					24,571
Long-term liabilities:
Commitments and contingencies (Note 3)
Capital lease obligation		576					1,979
Notes payable		86,226					85,789
Total liabilities		109,844					112,339
Series A convertible preferred stock, $0.01 par value; 100,000,000 shares authorized; 84,306,677 shares outstanding at December 31, 2003 and September 30, 2004		48,948					51,520
Stockholders’ deficit:
Common stock, $0.01 par value; 160,000,000 shares authorized; 4,457,579 shares issued and outstanding at December 31, 2003; and 4,730,919 shares issued and outstanding at September 30, 2004		45					47
Additional paid-in capital		120,105					117,550
Accumulated other comprehensive income		—					5
Accumulated deficit		(125,167				)	(118,589			)
Deferred compensation		(54				)	(34			)
Total stockholders’ deficit		(5,071				)	(1,021			)
Total liabilities and stockholders’ deficit		$		153,721			$	162,838

 

See accompanying notes.

 

 

3

 

 

Eschelon Telecom, Inc.

Unaudited Consolidated Statements of Operations

(In Thousands, Except Share and Per Share Amounts)

 

		Three months ended September 30,								Nine months ended September 30,
		2003				2004				2003				2004
Revenue:
Network services		$	29,632			$	33,476			$	84,474			$	98,333
Business telephone systems		6,941				7,086				19,418				19,575
Total revenue		36,573				40,562				103,892				117,908
Cost of revenue:
Network services		11,791				11,736				33,640				35,093
Business telephone systems		4,215				4,305				11,771				11,785
Total cost of revenue		16,006				16,041				45,411				46,878
Gross profit:
Network services		17,841				21,740				50,834				63,240
Business telephone systems		2,726				2,781				7,647				7,790
Total gross profit		20,567				24,521				58,481				71,030
Operating expenses:
Sales, general and administrative		17,292				18,423				48,959				51,949
Depreciation and amortization		7,057				7,493				22,762				22,705
Operating loss		(3,782			)	(1,395			)	(13,240			)	(3,624		)
Other income (expense):
Interest income		15				45				162				83
Interest expense		(422			)	(2,837			)	(1,301			)	(7,911		)
Gain on extinguishment of debt		—				—				—				18,195
Other expense		502				(138			)	466				(161		)
Income (loss) before taxes		(3,687			)	(4,325			)	(13,913			)	6,582
Income taxes		(28			)	(4			)	(28			)	(4		)
Net income (loss)		(3,715			)	(4,329			)	(13,941			)	6,578
Less preferred stock dividends		(863			)	(863			)	(2,562			)	(2,572		)
Net income (loss) applicable to common stockholders		$		(4,578	)	$		(5,192	)	$		(16,503	)	$	4,006
Net income (loss) per share:
Basic		$		(1.43	)	$		(1.30	)	$		(5.69	)	$	1.04
Diluted		$		(1.43	)	$		(1.30	)	$		(5.69	)	$	0.11
Weighted average number of shares outstanding:
Basic		3,199,473				3,992,931				2,902,001				3,838,007
Diluted		3,199,473				3,992,931				2,902,001				110,190,030

 

 

See accompanying notes.

 

 

4

 

Eschelon Telecom, Inc.

Unaudited Consolidated Statements of Cash Flows

(In Thousands)

 

 

		Nine months ended  September 30,
		2003			2004
Operating activities
Net income (loss)		$	(13,941	)	$	6,578
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation and amortization expense		22,762			22,705
Other non-cash items		1,050			2,212
Gain on extinguishment of debt		—			(18,195		)
Changes in operating assets and liabilities:
Increase in restricted cash		—			(651		)
Accounts receivable		(4,238		)	171
Inventories		(685		)	15
Other current assets and deposits		1,695			47
Accounts payable and accrued expenses		3,640			2,425
Deferred revenue		665			762
Accrued compensation expense		(742		)	(949		)
Net cash provided by operating activities		10,206			15,120
Investing activities
Purchases of marketable securities		—			(4,357		)
Purchases of property and equipment		(10,856		)	(10,105		)
Cash paid for customer installation costs		(8,907		)	(8,442		)
Net cash used in investing activities		(19,763		)	(22,904		)
Financing activities
Proceeds from issuance of notes payable		—			84,813
Payments made on bank debt and capital lease obligations		(2,081		)	(66,599		)
Proceeds from (fees associated with) issuance of stock		(58		)	7
Increase in debt issuance costs		(58		)	(4,635		)
Net cash provided by (used in) financing activities		(2,197		)	13,586
Net increase (decrease) in cash and cash equivalents		(11,754		)	5,802
Cash and cash equivalents at beginning of period		19,733			8,606
Cash and cash equivalents at end of period		$	7,979		$	14,408
Supplemental cash flow information
Cash paid for interest		$	327		$	6,394
Supplemental noncash activities
Equipment purchases under capital leases		$	1,097		$	1,872
Value of common stock issued to management		$	124		$	14

 

 

See accompanying notes.

 

 

 

5

 

Eschelon Telecom, Inc.

Notes to Consolidated Financial Statements

(In Thousands, Except Share and Per Share Amounts)

(Unaudited)

 

1.)          Summary of Significant Accounting Policies

 

Basis of Presentation

 

The accompanying unaudited consolidated financial statements of Eschelon Telecom, Inc. and its subsidiaries (the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and the instructions to Form 10-Q and Article 10 of Regulation S-X promulgated by the United States Securities and Exchange Commission (the “SEC”).  Accordingly, they do not include all of the information and notes required by accounting principles generally accepted in the United States of America for complete financial statements.  In the opinion of management, all adjustments (consisting of normal and recurring adjustments and accruals) considered necessary for a fair presentation for the periods indicated have been included.  Operating results for the three and nine month periods ended September 30, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004.  The consolidated balance sheet at December 31, 2003 has been derived from the audited consolidated financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.  These financial statements should be read in conjunction with the Company’s audited financial statements and related notes thereto for the year ended December 31, 2003 included in the Eschelon Operating Company Form S-4/A, File No. 333-114437-08, filed with the Securities and Exchange Commission on May 6, 2004.

 

Principles of Consolidation

 

The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries.  All intercompany balances and transactions have been eliminated in consolidation.

 

Property and Equipment

 

Property and equipment, including leasehold improvements, are stated at cost.  All internal costs directly related to the construction of the switches and operating and support systems, including salaries of certain employees, are capitalized.  Depreciation is provided using the straight-line method over the estimated useful lives of the assets.  Leasehold improvements are amortized over the shorter of the related lease term or the estimated useful life of the asset.

 

Property and equipment consist of the following:

 

 

Goodwill and Intangibles

 

Goodwill represents the excess of cost over the fair value of net assets acquired.

 

 

6

 

Intangibles consist of customer installation costs, debt issuance costs and non-compete agreements.  The customer installation costs are being amortized over a period of 48 months, which approximates the average life of a customer contract.  Debt issuance costs are being amortized over the term of the respective debt obligation.  Non-compete agreement costs represent costs associated with various agreements the Company has entered into with existing management of the companies they have acquired.  These costs are being amortized over the terms of the agreements.

 

Intangible assets consist of the following:

 

 

Revenue Recognition

 

Revenues from network services are recognized in the period in which subscribers use the related services.  Revenues from equipment sales and related installation charges are recognized upon delivery, completion of the installation of the related equipment, and acceptance by the customer, at which point legal title passes to the customer.  Revenues for carrier interconnection and access are recognized in the period in which the service is provided.

 

Use of Estimates

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes.  Actual results could differ from those estimates.

 

Stock-Based Compensation

 

The Company accounts for its stock-based employee compensation under the recognition and measurement principles of Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations.  Under APB No. 25, when the exercise price of stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized in the consolidated statement of operations.

 

The following table illustrates the effect on net income (loss) per share if the company had applied the fair value recognition provision of Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation:

 

 

7

 

		Three months ended September 30,							Nine months ended September 30,
		2003			2004				2003				2004
Net income (loss) applicable to common stockholders, as reported		$	(4,578	)	$		(5,192	)	$	(16,503		)	$	4,006
Add: Stock-based employee compensation expense included in reported net income (loss)		—			—				70				20
Deduct: Total stock-based employee compensation expense determined under fair value-based methods for all awards		(1		)	(2			)	(132			)	(49			)
Pro forma net income (loss) applicable to common stockholders		$	(4,579	)	$	(5,194		)	$		(16,565	)	$		3,977
Net income (loss) per share:
Basic — as reported		$	(1.43	)	$	(1.30		)	$		(5.69	)	$		1.04
Basic — pro forma		$	(1.43	)	$	(1.30		)	$		(5.71	)	$		1.04
Diluted — as reported		$	(1.43	)	$	(1.30		)	$		(5.69	)	$		0.11
Diluted — pro forma		$	(1.43	)	$	(1.30		)	$		(5.71	)	$		0.11

 

Pro forma information regarding net income (loss) and net income (loss) per share is required by SFAS No. 123, and has been determined as if the Company had accounted for its employee stock options under the fair value method of SFAS No. 123.  The fair value of these options was estimated at the date of grant using the Black-Scholes option pricing model with the following assumptions for the three months ended September 30, 2003 and 2004:  a risk-free interest rate of 3.25% and 3.47%, respectively; dividend yield of 0% for each period; volatility factor of the expected market price of the Company’s common stock of 25% for each period; and a weighted average life of the options of five years for each period.  The following assumptions were used for the nine months ended September 30, 2003 and 2004:  a risk-free interest rate ranging from 3.25% to 3.88%; dividend yield of 0% for each period; volatility factor of the expected market price of the Company’s common stock of 25% for each period; and a weighted average life of the options of five years for each period.

 

The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable.  In addition, option valuation models require the input of highly subjective assumptions.  Because the Company’s employee stock options have characteristics significantly different from those of traded options and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.

 

Net Income (Loss) Per Share

 

Basic earnings per share is computed based on the weighted average number of common shares outstanding.  Diluted earnings per share is computed based on the weighted average number of common shares outstanding adjusted by the number of additional shares that would have been outstanding had the potentially dilutive common shares been issued.  Potentially dilutive shares of common stock include stock options, unvested restricted stock grants and Series A Convertible Preferred Stock.  During periods in which a net loss is incurred, diluted earnings per share amounts are the same as basic per share amounts because the effect of all options, unvested restricted stock grants and Series A Convertible Preferred Stock is anti-dilutive.

 

The following table presents a reconciliation of the numerators and denominators of basic and diluted earnings per common share:

 

 

8

 

 

		Three months ended September 30,									Nine months ended September 30,
		2003				2004					2003				2004
Numerator:
Net income (loss) applicable to common stockholders, as reported		$		(4,578	)	$		(5,192		)	$	(16,503		)	$	4,006
Add: Cumulative preferred stock dividends		—				—					—				8,698
Deduct: Unrecognized deferred compensation expense		—				—					—				(34		)
Numerator for diluted earnings per share		$	(4,578		)	$			(5,192	)	$		(16,503	)	$	12,670
Denominator:
Weighted average number of common shares outstanding		3,199,473				3,992,931					2,902,001				3,838,007
Effect of dilutive securities:
Restricted stock grants		—				—					—				397,918
Employee stock options		—				—					—				4,521,646
Series A convertible preferred stock		—				—					—				101,432,459
Denominator for diluted earnings per share		3,199,473				3,992,931					2,902,001				110,190,030
Net income (loss) per share:
Basic — as reported		$	(1.43		)	$	(1.30			)	$		(5.69	)	$	1.04
Diluted — as reported		$		(1.43	)	$	(1.30			)	$		(5.69	)	$	0.11

 

New Accounting Pronouncements

 

In May 2003, the Financial Accounting Standards Board issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity.  SFAS No. 150 requires that certain financial instruments, which under previous guidance were accounted for as equity, must now be accounted for as liabilities.  The financial instruments affected include mandatorily redeemable stock, certain financial instruments that require or may require the issuer to buy back some of its shares in exchange for cash or other assets and certain obligations that can be settled with shares of stock.  SFAS No. 150 is effective for all financial instruments entered into or modified after May 31, 2003, and otherwise is effective the beginning of the first interim period after June 15, 2003.  The adoption of SFAS No. 150 did not have a material impact on the Company’s financial statements and did not require the Company to reclassify its Series A Preferred Stock to a liability as the shares are contingently redeemable.

 

Reclassifications

 

Certain prior year amounts have been reclassified to conform to current year presentation.

 

2.)          Restricted Cash

 

On August 2, 2004, a Nevada state court entered a judgment against the Company for intentionally interfering with a former salesperson’s economic relationship with his new employer in the amount of $376 plus costs.  The Company had reason to believe the former employee was violating his non-solicitation agreement with the Company.  On August 30, 2004, the Company appealed the judgment because, among other reasons, the jury was not instructed to consider whether the Company was justified in informing the new employer of the agreement and the intent to enforce it.  During the appeal process, the Company is required to hold an amount equal to one and one-half times the pending judgment, plus accrued interest, as restricted cash.

 

3.)          Marketable Securities

 

Short-term investments are comprised of municipal and United States government debt securities.  In accordance with SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, and based on the Company’s intentions regarding these instruments, all investments in debt securities are classified as available-for-sale and accounted for at fair value.

 

The cost basis, fair value and gross unrealized gains of the investment securities available-for-sale as of September 31, 2004 and December 31, 2003, are as follows:

 

 

9

 

 

		Cost Basis			Fair Value			Gross Unrealized Holding Gains			Gross Unrealized Holding (Losses)
Marketable securities as of September 30, 2004		$	4,357		$	4,362		$	5		$	—
Marketable securities as of December 31, 2003		$	—		$	—		$	—		$	—

 

 

Debt securities as of September 30, 2004 have maturities of six months or less.

 

4.)          Notes Payable

 

In March 2004, the Company completed an offering of $100,000 of 8 3/8% senior second secured notes due 2010 at a discount resulting in a 12% yield.  Proceeds from the offering were used to retire bank debt with a principal balance of $65,421, pay fees related to the offering and provide additional liquidity to the Company.

 

The carrying value of notes payable is comprised of the following:

 

 

5.)          Commitments and Contingencies

 

In April 2003, the Company entered into a five-year agreement with MCI to purchase colocation/LIS transport services.  The agreement requires that the Company maintain monthly minimums as follows:

 

 

The Company will pay an underutilization charge for any amounts billed under the monthly minimum.

 

In 2000, the Company entered into an amendment of an earlier Master Purchase and Service agreement with Nortel Networks, Inc. (Nortel Networks).  Under the amendment, the Company committed to purchase and/or license $100,000 of Nortel Networks’ equipment or services.  However, the Company is confident that, due to Nortel Networks’ discontinuance of certain product lines contemplated in the Amended Master Purchase and Services agreement, neither party will be held to the conditions of the contract.

 

In August 2000, the Company entered into a ten-year agreement with Global Crossing to purchase a total of $100,000 of services.  The agreement does not contain monthly minimums, however a penalty is assessed for early termination upon change in control.  Upon change in control, the remaining early termination penalty is $5,000.

 

6.)          Capital Stock

 

Under the terms of the Series A Convertible Preferred Stock, the holders are entitled to receive, when and if declared by the Board of Directors, cumulative dividends on each share of the Series A Convertible Preferred Stock at a rate of 8% per year which shall accrue daily and, to the extent not paid, shall accumulate quarterly in arrears.  At December 31, 2003 and September 30, 2004, dividends in arrears are $6,127 and $8,698, respectively.

 

 

10

 

 

The shares of Series A Convertible Preferred Stock, plus all accrued and unpaid dividends at the time of conversion, are convertible at any time, at the option of the holder, into shares of the Company’s common stock at the initial conversion price, which is the original issue price of $0.5079.  The conversion price is subject to adjustment in the event of certain events, such as dilutive issuances of additional securities.  The Series A Convertible Preferred Stock will automatically convert into common stock in the event of an initial public offering raising at least $50,000.  The Series A Convertible Preferred Stock may be automatically converted upon the consent of the holders of at least 60% of the then outstanding shares of Series A Convertible Preferred Stock.

 

The shares of Series A Convertible Preferred Stock will be redeemed on the tenth anniversary of the original issuance, if the shares have not previously been redeemed or converted.  The Company may redeem all of the Series A Convertible Preferred Stock upon the effectiveness of an initial public offering.  The redemption price of the Series A Convertible Preferred stock will be the greater of (i) the original issue price plus all accrued and unpaid dividends or (ii) the fair market value of the shares of common stock, as determined by the Board of Directors, that would be received upon conversion of (a) the Series A Convertible Preferred Stock, and (b) any accrued and unpaid dividends on the Series A Convertible Preferred Stock.  Upon a change of control, the holders of 60% of the then outstanding shares of the Series A Convertible Preferred Stock may require the Company to redeem all of or a portion of the Series A Convertible Preferred Stock at a price equal to (1) the liquidation preference (as described below) if the change of control occurs before the fifth anniversary of the original issue date and (2) the redemption price if the change of control occurs after the fifth anniversary of the original issue date.

 

In the event of the Company’s liquidation, the holders of the Series A Convertible Preferred Stock will receive any distribution of corporate assets before any distributions are made to a junior class of equity.  The amount to be distributed to the holders of Series A Convertible Preferred Stock will be the greater of (i) two times the original issue price plus all accrued and unpaid dividends (whether or not yet accumulated) as of the date of distribution, or (ii) the fair market value of the shares of the Company’s common stock, as determined by the Board of Directors, that would be received upon (1) conversion of the Series A Convertible Preferred Stock, (2) any accrued and unpaid dividends and, (3) if the liquidation is prior to the fifth anniversary of the date of issuance of the Series A Convertible Preferred Stock, all additional dividends that would have been accrued through the fifth anniversary date.

 

Stock Options

 

In November 2002, the Board of Directors approved the Eschelon Telecom, Inc. Stock Option Plan of 2002 (the 2002 Plan).  A total of 14,117,647 shares of the Company’s common stock have been reserved for issuance under the 2002 Plan.  At September 30, 2004, the Company had 10,273,030 options outstanding and 2,484,979 shares of restricted common stock issued to certain directors and members of management under the 2002 Plan.

 

Restricted Common Stock

 

In February 2003, the Company granted 2,484,979 shares of restricted common stock to certain directors and members of management.  The fair value per share of this restricted stock was $0.05.  The Company records compensation expense as the restrictions are removed from the stock.  In February 2003, 1,399,902 shares had vested resulting in compensation expense related to restricted common stock of $70.  In February 2004, an additional 405,968 shares had vested resulting in compensation expense of $20.

 

7.)          Subsequent Event

 

On October 13, 2004, the Company entered into an agreement with Advanced TelCom Group, Inc. (ATG), a Delaware corporation and a subsidiary of General Electric Capital Corporation (GECC) providing for the purchase by the Company of 100% of the issued and outstanding shares of capital stock of Advanced TelCom, Inc. (ATI), a Delaware corporation and a wholly owned subsidiary of ATG (the ATI Acquisition), for a purchase price of approximately $45,500.  The ATI Acquisition is currently expected to close on December 31, 2004.  In addition, on October 13, 2004, the Company entered into an agreement with GE Business Productivity Solutions, Inc. (GE BPS), a Georgia corporation and a wholly owned subsidiary of GECC, providing for the purchase of substantially all of the operating assets of GE BPS (the GE BPS Acquisition).  Under the agreement, the Company will purchase the business of GE BPS as a going concern, including substantially all of its operating assets, and the Company will assume certain of its

 

 

11

 

liabilities, for a purchase price of approximately $100.  The GE BPS Acquisition is currently expected to close on, or as soon as possible after, December 31, 2004.

 

 

12

 

 

 

Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Forward-Looking and Cautionary Statements

 

We make “forward-looking statements” throughout this document.  Whenever you read a statement that is not solely a statement of historical fact (such as when we state that we “may,” “will” or “plan to” perform in a certain manner or that we “intend,” “believe,” “expect,” “anticipate,” “estimate” or “project” that an event will occur, or the negative thereof, and other similar statements), you should understand that our expectations may not be correct, although we believe that they are reasonable.  You should also understand that our plans may change.  We do not guarantee that the transactions and events described in this document will happen as described or that any positive trends noted in this document will continue.

 

Forward-looking statements, such as those regarding management’s present plans or expectations for new product offerings, capital expenditures, cost-saving strategies and growth are not guarantees of future performance.  They involve risks and uncertainties relative to return expectations and related allocation of resources, and changing economic or competitive conditions, as well as the negotiation of agreements with third parties and other factors discussed herein, which could cause actual results to differ from present plans or expectations, and such differences could be material.  Similarly, forward-looking statements regarding management’s present expectations for operating results and cash flow involve risks and uncertainties relative to these and other factors, such as the ability to increase revenues and/or to achieve cost reductions and other factors discussed herein, which also would cause actual results to differ from present plans.  Such differences could be material.  All forward-looking statements attributable to us or by any persons acting on our behalf are expressly qualified in their entirety by these cautionary statements.

 

As such, actual results or circumstances may vary materially from such forward-looking statements or expectations.   Readers are also cautioned not to place undue reliance on these forward-looking statements which speak only as of the date these statements were made.  Except as required by law, we will not update these forward-looking statements, even if our situation changes in the future.

 

Company Overview

 

We are a leading facilities-based provider of integrated voice and data communications services to small and medium-sized businesses in 12 markets in the western United States.  Our voice and data services, which we refer to as network services, include local dial tone, long distance, enhanced voice features and dedicated Internet access services.  We also sell, install and maintain business telephone and data systems and equipment, which we call BTS.  We provide these products and services individually or in customized packages to address our customers’ need for an outsourced voice and data network solution.

 

We have increased our annual revenue every year from $41.7 million for the year ended December 31, 1999 to $141.1 million for the year ended December 31, 2003, and we have increased our gross profit from $14.8 million to $80.3 million over the same period.  As of September 30, 2004, we provided service through 237,428 total access lines, an increase of 15.0% from 206,421 total access lines at December 31, 2003.

 

Our goal is to provide services to our customers on our network, or on-net, which will allow us to continue to expand our operating margins and improve profitability.  We have continued to increase the percentage of on-net customers with a strategically deployed and incentivized sales force.  Increasing our on-net percentage improves customer retention, leverages our network, increases profitability and reduces our exposure to regulatory risk.  We selectively provide service via the unbundled network element-platform, or UNE-P, to reach locations outside of our network footprint of on-net customers and to provide Qwest DSL.  For the nine months ended September 30, 2004, 90.8% of our new access lines installed were on-net and as of September 30, 2004, 79.2% of our total access lines in service were on-net.

 

Customer retention is a key metric that we use to measure the success of our business.  We report monthly access line attrition, or churn, as measured by dividing total access lines disconnected for the month by our total access lines at the end of the month.  We believe our low level of churn reflects our high quality of service and the value proposition we provide to new and existing customers.  Due to our focus on improved service levels, competitive pricing and customer credit quality, we have reduced our monthly churn to levels that we believe are industry leading.  For the nine months ended September 30, 2004, our monthly churn averaged 1.54% compared to 1.60% for the year ended December 31, 2003.

 

 

 

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Revenue.  Network services revenue consists primarily of local dial tone, long distance, access charges, and data service.  Revenue from local telephone service consists of charges for basic local service, including dedicated T1 access, and custom-calling features such as call waiting and call forwarding.  Revenue from long distance service consists of per-minute-of-use charges for a full range of traditional switched and dedicated long distance, toll-free calling, international, calling card and operator services.  Revenue from data services consists primarily of monthly usage fees for dedicated Internet access services.

 

Network services revenue is recognized in the month the services are used.  In the case of local service revenue, local services charges are billed in advance but accrued for and recognized on a prorated basis based on length of service in any given month.  Long distance and access charges are billed in arrears but accrued based on monthly average usage per line per day.  We do not receive any revenues from reciprocal compensation due to our bill-and-keep arrangement with Qwest nor do we have any wholesale revenue other than access revenue.  For the nine months ended September 30, 2004, carrier access revenue represented 8.2% of our total revenue.

 

BTS revenue consists of revenue from both the sale of telephone equipment and the servicing of telephone equipment systems.  Telephone equipment revenue is recognized upon delivery and acceptance by the customer.  Service revenue is recognized upon completion of service or, in the case of maintenance agreements, is spread equally over the life of the maintenance contract.

 

Cost of revenue.  Our network services cost consists primarily of the cost of operating and maintaining our network facilities.  The network components for our facilities-based business include the cost of:

 

•   leasing  local loops and digital T1 lines which connect our customers to our network;

•   leasing high capacity digital lines that interconnect our network with ILECs;

•   leasing high capacity digital lines that connect our switching equipment to our colocations;

•   leasing space in ILEC central offices for colocating our equipment;

•   signaling system network connectivity; and

•   leasing our ATM backbone network.

 

The costs to lease local loops, digital T1 lines and high capacity digital interoffice facilities from the ILECs varies by carrier and by state and are regulated under the Telecommunications Act of 1996.  In virtually all areas, we lease local loops, T1 lines and interoffice capacity from the ILECs.  We lease interoffice facilities from carriers other than the ILEC where possible in order to lower costs and improve network redundancy.  However, in most cases, the ILEC is the only source for local loops and T1 lines.  We also purchase, on a wholesale or negotiated basis, UNE-P and customized network element packages, or UNE-E, from Qwest and Centrex services from SBC Communications Inc.  The rates for UNE-P and Centrex are regulated and established by the various state corporation or utility commissions.  As of September 30, 2004 and December 31, 2003, we had 39,590 and 43,107 UNE-P access lines in service, respectively.  As of September 30, 2004 and December 31, 2003, we had 7,913 and 8,493 Centrex access lines in service, respectively.  The rates for UNE-E were negotiated with Qwest under the terms of a five-year contract that expires December 31, 2005.  As of September 30, 2004 and December 31, 2003, we had 1,781 and 1,934 UNE-E access lines in service, respectively.

 

We have entered into wholesale purchasing agreements with long distance and other service providers.  Some of these agreements also contain termination penalties and/or minimum usage volume commitments.  In the event we fail to meet minimum volume commitments, we may be obligated to pay underutilization charges.  We do not anticipate having to pay any underutilization charges in the foreseeable future.

 

We carefully review all of our vendor invoices and frequently dispute inaccurate or inappropriate charges.  Our single largest vendor is Qwest, to whom we paid $25.8 million for the year ended December 31, 2003, and $21.4 million for the nine months ended September 30, 2004.  We frequently short pay vendor invoices in order to pay proper amounts owed.  We use significant estimates to determine the level of success in dispute resolution and consider past historical experience, basis of dispute, financial status and current relationship with vendors and aging of prior disputes in quantifying our estimates.

 

We account for all of our network depreciation in depreciation and amortization expense and do not have any depreciation in cost of revenue.

 

 

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Our most significant BTS costs are the equipment purchased from manufacturers and labor for service and equipment installation.  To take advantage of volume purchase discounts, we purchase equipment primarily from three manufacturers.  For all BTS installations our policy is to require a 30% deposit before ordering the equipment so our risk of excess inventory or inventory obsolescence is low.  BTS cost of revenue also includes salaries and benefits of field technicians as well as vehicle and incidental expenses associated with equipment installation, maintenance and service provisioning.

 

Sales, general and administrative expenses.  Sales, general and administrative expenses are comprised primarily of salaries and benefits, bonuses, commissions, occupancy costs, sales and marketing expenses, bad debt, billing and professional services.

 

Determining our allowance for doubtful accounts receivable requires significant estimates.  We consider a number of factors in determining the proper level of the allowance, including historical collections experience, current economic trends, the aging of the accounts receivable portfolio and changes in the creditworthiness of our customers.  We perform a rigorous credit review process on each new customer that involves reviewing the customer’s current service provider bill and payment history, matching customers with the National Telecommunications Data Exchange database for delinquent customers and, in some cases, requesting credit reviews through Dun and Bradstreet.  For the nine months ended September 30, 2003 and 2004, our bad debt expense as a percentage of revenue was 0.5% and 0.4%, respectively.

 

Depreciation and amortization.  Our depreciation and amortization currently includes depreciation for network related voice and data equipment, back office systems, furniture, fixtures, leasehold improvements, office equipment and computers.  All internal costs directly related to the expansion of our network and operating and support systems, including salaries of certain employees, are capitalized and depreciated over the lives of the switches or systems, as the case may be.  Capitalized customer installation costs are amortized over the approximate average life of a customer.  Detailed annual time studies are used to determine labor capitalization.  These time studies are based on employee time sheets for those engaged in capitalizable activities.

 

Regulatory Overview

 

FCC rules implementing the local competition provisions of the Telecommunications Act permit CLECs to lease UNEs at rates determined by PUCs employing the FCC’s Total Element Long Run Incremental Cost, or TELRIC, forward-looking, cost-based pricing model.  On September 15, 2003, the FCC opened a proceeding re-examining the TELRIC methodology and wholesale pricing rules for communications services made available for resale by ILECs in accordance with the Telecommunications Act.  This proceeding will comprehensively re-examine whether the TELRIC pricing model produces unpredictable pricing inconsistent with appropriate economic signals; fails to adequately reflect the real-world attributes of the routing and topography of an ILEC’s network; and creates disincentives to investment in facilities by understating forward-looking costs in pricing RBOC network facilities and overstating efficiency assumptions.  We have joined a coalition of CLECs to participate in this proceeding.  The application and effect of a revised TELRIC pricing model on the communications industry generally and on certain of our business activities cannot be determined at this time.

 

In its 2003 Triennial Review Order, which we call the TRO, the FCC substantially modified its rules governing access to UNEs by CLECs.  However, on March 2, 2004, the D.C. Circuit vacated certain portions of the TRO and remanded the TRO to the FCC for further proceedings.  Specifically, the Court vacated the FCC’s delegation of decision-making authority to state commissions and several of the FCC’s nation-wide impairment determinations.    The Court also found that the FCC used a flawed methodology when making certain network element unbundling determinations and remanded those determinations back to the FCC for further analysis and justification.

 

The FCC and the Solicitor General have declined to appeal the Court’s order. The National Association of Regulatory Utility Commissioners and a coalition of CLECs, including Eschelon, separately appealed the decision.  The Supreme Court announced in October that it will not take the case.

 

In response to the D.C. Court’s order, the FCC released a standstill order on August 20, 2004, requiring ILECs to continue to provide CLECs with access to UNEs until the FCC issues final UNE rules, or for six months from the effective date of the order, whichever comes first.  This order, the “Interim Order”, proposed that in the event the FCC does not promulgate final rules within the six-month period, CLECs

 

 

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should continue to have access only to their embedded base of UNEs as of the end of the six-month standstill period.  The FCC proposed that CLECs should pay 15% more for those existing UNEs, or in the case of UNE-P lines one dollar more.  As for new orders placed after the standstill period ended, the FCC suggested that CLECs would pay the ILEC’s substantially higher tariffed prices.

 

The FCC’s Interim Order was accompanied by a Notice of Proposed Rulemaking which set out a comment cycle for interested parties to make filings to assist the FCC in developing final UNE rules.  Comments were due on October 4, 2004 and replies on October 19, 2004.  The ILECs interpret the D.C. Court’s decision as requiring the FCC to eliminate unbundled access to switching, transport, high capacity loops and dark fiber.  Verizon, Bell South, SBC and Qwest have all filed comments together with evidence in support of this view.

 

Except for dark fiber, Eschelon uses all of the UNEs at issue in the TRO proceeding.  Eschelon filed reply comments on its own and participated in filing comments with a coalition of CLECs as well as with our trade association ALTS - the Association for Local Telecommunications Services.  These filings provide evidence that CLECs are in many instances impaired without access to UNEs.

 

We do not know when the FCC will issue final UNE rules or what affects those rules will have on Eschelon’s business.  In the event that the FCC does not issue final rules before the six-month standstill expires, we do not know whether CLECs will continue to have access to UNEs or what rates will apply if they do.

 

Several ILECs and their trade association USTA — the United States Telephone Association — filed a petition for mandamus with the D.C. Circuit Court.  The petition requested the Court overturn the Interim Order.  The same parties also appealed the Interim Order to the same Court.  In response to the mandamus petition, the Court has issued an order holding it in abeyance until January 4, 2005.  This ruling will allow the FCC to follow through on its commitment to issue final UNE rules by the end of this year.  In summary, although the mandamus petition and the appeal of the Interim Order remain active proceedings, it now appears that the D.C. Circuit will not act on them until at least January 4, 2005.

 

Although the final state of the law with respect to UNE availability will not be clear for some months, the D.C. Circuit Court’s March order is now final.  The ILECs have stated that they will follow the “change of law” provisions in our interconnection agreements.  In many agreements, these provisions provide that when a party to the agreement believes the governing law has changed its obligations under the agreement, it may request that the other party enter into negotiations to amend the agreement.  If the parties are unable to agree upon an amendment, the dispute is arbitrated either by a neutral arbitrator or by the relevant state commission.  To date, Eschelon has not commenced any negotiations under those of its agreements that contain this kind of provision.

 

Some agreements that Eschelon has have other change of law provisions.  SBC-Nevada has filed a complaint against us and other CLECs alleging that we have not conformed our interconnection agreement with SBC-Nevada consistent with the requirements of that agreement.  We have filed an answer denying SBC’s allegations.  Verizon-Washington petitioned the state commission to undertake an arbitration to change its interconnection agreements with many CLECs, including Eschelon.  The Commission dismissed the petition as to Eschelon and most other CLECs.

 

We do not know whether or when any state commission might order changes to our interconnection agreements or how such changes might affect our business.  Nor do we know whether or when any ILEC may commence change of law negotiations with us, or the ultimate affects of any such negotiations upon our business.

 

The FCC has encouraged ILECs and CLECs to engage in commercial negotiations to provide access to ILEC facilities that may no longer be available as UNEs.  Although a few such agreements have been announced, the great majority of CLECs, including Eschelon, have not succeeded in negotiating new agreements as of this date.

 

As a condition of entering the long distance markets, the Act requires ILECs to provide CLECs with loops, transport, and unbundled switching.  In the TRO, the FCC determined, and the D.C. Circuit Court agreed, that these facilities must be made available to CLECs at “just and reasonable” rates, in contrast to UNEs which are available at TELRIC rates.  We do not know what “just and reasonable” rates would be nor do we know when such rates might be established nor the roles of the FCC or state commissions in

 

 

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establishing such rates.  In addition, Bell South has petitioned the FCC requesting that the FCC forebear from requiring RBOCs to provide an element under the long distance provisions of the Act if the RBOC is no longer required to provide the analogous UNE under the local competition portions of the Act.  The FCC incorporated Bell South’s petition into its Interim Order and Notice of Proposed Rulemaking.  We do not know how the FCC will decide these issues.

 

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Comparison of Financial Results

 

                Overview of Results

 

                Selected consolidated financial and operating data for the three and nine month periods ended September 30, 2003 and 2004 is as follows (dollars in thousands, except per unit amounts):

 

		Three months ended September 30,									Nine months ended September 30,
		2003			2004				% Change		2003			2004			% Change
		(unaudited)			(unaudited)						(unaudited)			(unaudited)
Total revenue		$	36,573		$		40,562		10.9	%	$	103,892		$	117,908		13.5	%
Total gross margin (%)		56.2		%	60.5			%	7.5	%	56.3		%	60.2		%	7.0	%
EBITDA		$	3,275		$		6,098		86.2	%	$	9,592		$	19,102		99.1	%
Capital expenditures		$	6,094		$		6,616		8.6	%	$	20,870		$	20,445		(2.0%	)
Cash and marketable securities		$	7,979		$	19,421			143.4	%	$	7,979		$	19,421		143.4	%
Voice lines in service		150,193			167,263				11.4	%	150,193			167,263			11.4	%
Data lines in service		43,191			70,165				62.5	%	43,191			70,165			62.5	%
Total lines in service		193,384			237,428				22.8	%	193,384			237,428			22.8	%
Lines on-net (%)		71.9		%	79.2			%	10.2	%	71.9		%	79.2		%	10.2	%
Lines sold		23,341			23,076				(1.1	)%	67,207			65,312			(2.8	)%
Average monthly churn (%)		1.51		%	1.54			%	2.0	%	1.67		%	1.54		%	(7.8	)%
Average network revenue per line		$	52.32		$	47.92			(8.4	)%	$	52.90		$	49.10		(7.2	)%
Average total associates		908			936				3.0	%	902			913			1.3	%
Average total sales associates		200			202				0.7	%	194			190			(1.8	)%
Average network sales associates		161			164				2.1	%	156			153			(1.6	)%

 

Three Months Ended September 30, 2004 versus Three Months Ended September 30, 2003

 

                Revenue.  Revenue for the three months ended September 30, 2003 and 2004 is as follows:

 

 

                Network services revenue was $33.5 million for the three months ended September 30, 2004, an increase of 13.0% from $29.7 million in the same period of 2003.  The increase in revenue was primarily due to an increase in the average number of voice and data access lines in service.  Over the past 12 months the number of voice lines increased by 11.4% to 167,263 lines at September 30, 2004 and the number of data lines increased by 62.5% to 70,165 lines at September 30, 2004.  The growth in access lines was partially offset by declines in long distance and access revenue per minute of use and a decline in data revenue per line.  Due to continued high levels of competition, long distance revenue per minute of use declined.  Access revenue per minute of use declined in line with the scheduled FCC reduction of interstate rate levels.  Data revenue per line declined due to a combination of customers purchasing more bandwidth at discounted prices and general pricing pressures for data services in our markets.  We expect all of the above trends in line growth, long distance rates, access rates and data revenue per line to continue for the foreseeable future.  As we continue to grow, our size and churn will begin to limit our access line growth rate on both an absolute and on a percentage basis unless we increase our sales force and geographic territory.

 

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                BTS revenue was $7.1 million for the three months ended September 30, 2004, an increase of 2.1% from $6.9 million in the same period of 2003.  The increase in revenue was primarily due to an increase in revenue from new system sales.  This was partially offset by a decline in revenue from change orders.  We cannot predict future trends in capital spending by small and medium-sized business customers.

 

                Cost of Revenue.  Cost of revenue for the three months ended September 30, 2003 and 2004 is as follows:

 

 

                Network services cost of revenue was $11.7 million for the three months ended September 30, 2004, a decrease of 0.5% from $11.8 million in the same period of 2003.  As a percentage of related revenue, network services cost of revenue for the three months ended September 30, 2004 declined to 35.1% from 39.8% for the same period of 2003.  This improvement was due to the increase in our percentage of access lines on-net to 79.2% as of September 30, 2004 from 71.9% as of September 30, 2003.

 

                BTS cost of revenue was $4.3 million for the three months ended September 30, 2004, an increase of 2.1% from $4.2 million in the same period of 2003.  This increase was due to an increase in materials cost related to the new system sales mentioned previously.  As a percentage of related revenue, BTS cost of revenue for the three months ended September 30, 2004 increased to 60.8% from 60.7% for the same period of 2003.  We do not expect future improvements in BTS cost of revenue as a percentage of related revenue unless we are able to significantly increase BTS revenue and therefore achieve greater volume discounts or economies of scale in our workforce.

 

                Gross Profit.  Gross profit for the three months ended September 30, 2003 and 2004 is as follows:

 

 

                The increase in gross profit for the three months ended September 30, 2004, from the same period of 2003, is due to the increase in revenue mentioned previously.

 

                Sales, General and Administrative Expense.  Sales, general and administrative expenses were $18.4 million for the three months ended September 30, 2004, an increase of 6.5% from $17.3 million in the same period of 2003.  The increase is primarily due to costs associated with the expansion of the agency channel, TRO related costs and legal costs associated with the Qwest litigation in Federal Court.  As a percentage of revenue, sales, general and administrative expenses for the three months ended September 30, 2004 declined to 45.4% from 47.3% in the same period of 2003 due to the improved efficiency of our existing operations resulting from our fixed cost structure supporting a higher level of revenue.  We expect this trend to continue as we add more access lines with only modest increases in our employee base.

 

                EBITDA.  Earnings before interest, taxes, depreciation and amortization (EBITDA) was $6.1 million for the three months ended September 30, 2004, an increase of 86.2% from $3.3 million in the same period of 2003.  This increase was due to increased profit margins and lower sales, general and administrative expenses as a percentage of revenue.

 

EBITDA is a not a measure of financial performance under generally accepted accounting principles (GAAP).  EBITDA is provided because it is a measure of financial performance commonly used as an indicator of a company’s historical ability to service debt.  EBITDA should not be construed as an alternative to operating income, as an indicator of operating performance nor as an alternative to cash flows

 

 

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provided by operating activities as a measure of liquidity determined in accordance with GAAP.  We may calculate EBITDA differently than other companies.  The following is a schedule reconciling EBITDA with reported GAAP net income (loss) for the three months ended September 30, 2003 and 2004 (dollars in thousands):

 

 

                Depreciation and Amortization.  Depreciation and amortization expense was $7.5 million for the three months ended September 30, 2004, an increase of 6.2% from $7.1 million in the same period of 2003.  As a percentage of revenue, depreciation and amortization decreased to 18.5% for the three months ended September 30, 2004 from 19.3% for the same period of 2003.

 

                Interest.  Interest expense was $2.8 million for the three months ended September 30, 2004, an increase of 572.0% from $0.4 million in the same period of 2003.  This increase was primarily due to interest expense on our senior second secured notes.

 

Nine Months Ended September 30, 2004 versus Nine Months Ended September 30, 2003

 

                Revenue.  Revenue for the nine months ended September 30, 2003 and 2004 is as follows:

 

 

                Network services revenue was $98.3 million for the nine months ended September 30, 2004, an increase of 16.4% from $84.5 million in the same period of 2003.  The increase in revenue was primarily due to an increase in the average number of voice and data access lines in service.  Over the past 12 months the number of voice lines increased by 11.4% to 167,263 lines at September 30, 2004, and the number of data lines increased by 62.5% to 70,165 lines at September 30, 2004.  The growth in access lines was partially offset by declines in long distance and access revenue per minute of use and a decline in data revenue per line.  Due to continued high levels of competition, long distance revenue per minute of use declined.  Access revenue per minute of use declined in line with the scheduled FCC reduction of interstate rate levels.  Data revenue per line declined due to a combination of customers purchasing more bandwidth at discounted prices and general pricing pressures for data services in our markets.  We expect all of the above trends in line growth, long distance rates, access rates and data revenue per line to continue for the foreseeable future.  As we continue to grow, our size and churn will begin to limit our access line growth rate on both an absolute and on a percentage basis unless we increase our sales force and geographic territory.

 

                BTS revenue was $19.6 million for the nine months ended September 30, 2004, an increase of 0.8% from $19.4 million in the same period of 2003.  We cannot predict future trends in capital spending by small and medium-sized business customers.

 

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