-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, RDDrCctn98vQKFDda27HppcCHsKuHdXLvV6yB2jM61iaAefjPUZ4O3SZkHgjTchD r4tTONdaoGJ8UamqsBC8YA== 0000950168-99-001009.txt : 19990402 0000950168-99-001009.hdr.sgml : 19990402 ACCESSION NUMBER: 0000950168-99-001009 CONFORMED SUBMISSION TYPE: 10-K405 PUBLIC DOCUMENT COUNT: 5 CONFORMED PERIOD OF REPORT: 19981231 FILED AS OF DATE: 19990331 FILER: COMPANY DATA: COMPANY CONFORMED NAME: US LEC CORP CENTRAL INDEX KEY: 0001054290 STANDARD INDUSTRIAL CLASSIFICATION: TELEPHONE COMMUNICATIONS (NO RADIO TELEPHONE) [4813] IRS NUMBER: 562065535 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K405 SEC ACT: SEC FILE NUMBER: 000-24061 FILM NUMBER: 99581136 BUSINESS ADDRESS: STREET 1: 401 N TRYON ST STREET 2: STE 1000 CITY: CHARLOTTE STATE: NC ZIP: 28251 MAIL ADDRESS: STREET 1: 212 S TRYON ST STREET 2: SUITE 1540 CITY: CHARLOTTE STATE: NC ZIP: 28281 10-K405 1 US LEC CORP. 10-K405 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, 1998 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.) 401 NORTH TRYON STREET, SUITE 1000 CHARLOTTE, NORTH CAROLINA 28202 (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. [X] The aggregate market value of voting stock of the registrant held by non-affiliates of the registrant was $152,153,585 as of March 23, 1999 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 23, 1999, there were 10,351,500 shares of Class A Common Stock and 17,075,270 shares of Class B Common Stock outstanding. DOCUMENTS INCORPORATED BY REFERENCE Portions of the registrant's Annual Report to Stockholders for the year ended December 31, 1998 are incorporated by reference into Part I, Part II and Part IV of this report. Portions of the registrant's Proxy Statement for its Annual Meeting of Stockholders to be held on April 20, 1999 are incorporated by reference into Part III of this report. US LEC CORP. 1998 ANNUAL REPORT ON FORM 10-K TABLE OF CONTENTS
Page ---- PART I Item 1: Business 3 Item 2: Properties 17 Item 3: Legal Proceedings 18 Item 4. Submission of Matters to a Vote of Security Holders 18 PART II Item 5: Market for the Registrant's Common Stock and Related Stockholder Matters 18 Item 6: Selected Consolidated Financial Data 18 Item 7: Management's Discussion and Analysis of Financial Condition and Results of Operations 18 Item 8: Financial Statements and Supplementary Data 18 Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure 18 PART III Item 10: Directors and Executive Officers of the Registrant 19 Item 11: Executive Compensation 19 Item 12: Security Ownership of Certain Beneficial Owners and Management 19 Item 13: Certain Relationships and Related Transactions 19 PART IV Item 14: Exhibits, Financial Statement Schedules and Reports on Form 8-K 20
2 PART I ITEM 1. BUSINESS THE COMPANY US LEC Corp. ("US LEC" or the "Company") is a rapidly growing competitive local exchange carrier ("CLEC") that provides switched local, long distance and enhanced telecommunications services to its customers. The Company primarily serves telecommunication-intensive customers including businesses, universities, financial institutions, hospitals, hotels, Internet Service Providers ("ISPs") and government agencies. The predecessor to US LEC was incorporated in June 1996 after passage of the Telecommunications Act of 1996 ("Telecom Act"), which enhanced the competitive environment for local exchange services. On December 31, 1996, the original corporation was merged into US LEC L.L.C., a limited liability company. On December 31, 1997, in anticipation of an initial public offering, US LEC L.L.C. was merged into US LEC. US LEC initiated service in North Carolina in March 1997, becoming one of the first CLECs in North Carolina to provide switched local exchange services, and now has switches in Charlotte, Raleigh, Greensboro, Atlanta, Memphis, Nashville, Knoxville, Orlando, Miami, Tampa, Jacksonville, and Norfolk/Virginia Beach. US LEC currently plans to establish switch sites in additional markets during 1999, including Richmond, Birmingham, Philadelphia and the Washington D.C. metropolitan area. As of December 31, 1998 the Company had 199,578 Equivalent Access Lines in service. See "Item 7: Management's Discussion and Analysis of Financial Condition and Results of Operations" for a detailed explanation of how the Company calculates Equivalent Access Lines. BUSINESS STRATEGY US LEC's objective is to become a leading telecommunications service provider and the primary provider of telecommunications services to its existing and target customers. The principal elements of US LEC's business strategy include: DEPLOY A CAPITAL-EFFICIENT NETWORK. US LEC utilizes a "smart-build" strategy of purchasing and deploying switching equipment and leasing the required fiber optic transmission capacity from competitive access providers ("CAPs"), other CLECs and incumbent local exchange carriers ("ILECs"). Management believes the Company's switch-based, leased-transport strategy enables it to enter markets and generate revenue and positive cash flow more rapidly than if the Company first constructed its own transmission facilities. By leasing fiber transport, this smart-build strategy also reduces the up-front capital expenditures required to build a network and enter new markets and avoid the risk of "stranded" investment in under-utilized fiber networks. Management also believes that the Company's ability to align its leased transmission costs with customer orders permits a higher return on invested capital. FOCUS ON A REGIONAL CLUSTER 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 and Washington D.C.) and Tier II cities (mid-size metropolitan areas such as Greensboro, Tampa and Nashville) throughout the southeastern and mid-Atlantic United States -- two of the fastest growing regional markets for business telecommunications services in the country. 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. Management believes that the Company's clustered network will enable it to take advantage of regional calling patterns and capture an increasing portion of customer traffic on its network. TARGET TELECOMMUNICATIONS-INTENSIVE CUSTOMERS. The Company focuses its primary sales efforts on telecommunications-intensive customers including businesses, universities, financial institutions, hospitals, hotels, ISPs and government agencies. The volume of usage generated by the Company's target customers allows the Company to efficiently concentrate the telecommunications traffic of its customers. In addition, the Company frequently is able to sell enhanced and long distance services to complement its core local services. This further 3 enhances network utilization and thereby improves margins, as fixed network costs are spread over a larger base of minutes of use. Unlike many other CLECs, the Company does not resell ILEC services. INSTALL A ROBUST TECHNOLOGY PLATFORM. The Company has chosen the 5ESS(R) Any Media(TM) digital switch manufactured by Lucent Technologies, Inc. ("Lucent") to provide a consistent technology platform throughout its network. US LEC currently has twelve Lucent switches active throughout its network. To enhance its service offerings, the Company is in the process of deploying Alcatel MegaHub(R) 600ES ("Alcatel") tandem switches. The Alcatel switches will complement the Lucent switches and improve US LEC's ability to provide enhanced services, including calling cards, toll-free services, operator services and Virtual Private Networks ("VPN"). The Company has also reached the final stages of selection for an Advanced Intelligent Network ("AIN") platform. This AIN platform will position US LEC for many enhanced services as well as allow the Company more reliability for Signaling System No. 7 connectivity. This advanced switching platform allows the Company to (i) deploy features and functions quickly throughout its entire network, (ii) expand switch capacity in a cost effective manner, (iii) achieve direct connectivity to cellular and personal communication system applications in the future and (iv) provide a broader range of product offerings. 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 employed this strategy in building its existing sales forces in North Carolina, Georgia, Tennessee, Florida and Virginia and intends to continue implementing this strategy in other markets. 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 customers to the Company's network. The Company focuses on implementing effective and timely provisioning practices in each of its markets to rapidly and efficiently transition customers from the ILEC or other CLECs to the Company with minimal disruption of the customer's operations. US LEC continues to work with ILECs to streamline its process for migration of customers to US LEC's network. Among other things, US LEC is approved by Lockheed Martin as a provider of Local Number Portability("LNP") for its customers. In addition, the US LEC Network Operations Center ("NOC") houses the tools to monitor and maintain customers' networks at all times. The NOC provides network surveillance, real-time alarm notification, dispatch services, and 24 hour x 7 day a week availability and notification. Management believes that these practices provide the Company with a long-term competitive advantage and enable it to implement services in its markets rapidly and to shorten the time between receipt of the customer order and the generation of revenue. OFFER A BROAD RANGE OF PRODUCTS AND SERVICES. US LEC offers customers a broad range of bundled telecommunication services. Management believes rapid deployment of new technologies, customized services for diverse applications and highly competitive pricing give US LEC customers an exceptional value. Local network access is available in many forms including Integrated Services Digital Network ("ISDN"), Primary Rate Interface ("PRI"), T1 Access and Channel Access ("DSO"). Multiple local access services are also available, including business lines, Private Branch Exchange ("PBX") trunks and Foreign Exchange trunks. US LEC also offers its customers competitively priced long distance service including intrastate, interstate, international and toll-free calls. US LEC's efforts to expand its technology platform will allow the Company to further increase its product offerings. US LEC'S NETWORK During 1998, the Company installed new Lucent 5ESS(R) Any Media(TM) digital switches in eight new cities, bringing the total to eleven switches serving twenty-four markets. During the first quarter of 1999, the Company activated its twelfth Lucent switch in Norfolk/Virginia Beach. The Company has announced plans to activate additional Lucent switches during 1999 in Richmond, Birmingham, Philadelphia and the Washington D.C. metropolitan area. Also during the first quarter of 1999, US LEC installed its first Alcatel switch in Charlotte. 4 US LEC utilizes a "smart build" strategy of purchasing and deploying switching equipment and leasing fiber optic transmission capacity from CAPs, other CLECs and ILECs. Calls originating with a US LEC customer are transported over leased lines to the US LEC switch and can either be terminated directly on the Company's network or routed to a long distance carrier, an ILEC or another CLEC, depending on the location of the call recipient. Similarly, calls originating from the public switched telephone network and destined for a US LEC customer are routed through the US LEC switch and delivered to call recipients via leased transmission facilities. Management believes that this smart-build strategy results in the following competitive advantages: o an increased number of buildings that can be directly connected to the Company's switching network, which should maximize the number of customers to which the Company can offer its services; o a higher volume of telecommunications traffic both originating and terminating on the Company's network, which should result in improved operating margins; and o the ability to leverage its investment in high capacity switching equipment and related electronics. The Company has signed interconnection agreements with various ILECs, including BellSouth, GTE, Sprint, Bell Atlantic and other carriers. These agreements provide the framework for the Company to serve its customers when other local carriers are involved. The agreement with BellSouth covers all states in BellSouth's operating area in which US LEC operates. The Company's interconnection agreement with BellSouth is scheduled to expire in June 1999, but management does not anticipate any interruption of interconnect services. No other interconnection agreements are scheduled to expire in 1999. PRODUCTS AND SERVICES The Company provides local dial-tone services to customers. Local access is available in many different forms including ISDN, PRI, TI Access and Channel Access. Local services and long distance services can be bundled together using the same transport facility. The Company's network is designed to allow a customer to easily increase or decrease capacity and utilize enhanced services as the telecommunications requirements of the customer change. The Company also provides access to third party directory assistance and operator services. US LEC provides domestic and international long distance services for completing intrastate, interstate and international calls. The Company also provides toll-free services. Long distance calls which do not terminate on the Company's network are passed to long distance carriers which route the remaining portion of the call. The Company's ability to bundle local and long distance services allows it to offer its customers more efficient use of transport facilities and allows it to aggregate customers' monthly recurring, local usage and long distance charges on a single, consolidated invoice. In addition to providing typical enhanced services such as voice mail, call transfer and conference calling, US LEC offers additional value-added enhanced services to complement its core local and long distance services. These enhanced service offerings include: o Access to Internet Services -- Enables customers to use their available capacity for access to ISPs. o Data Networking Services -- The Company can provide high-speed, broadband services to use for data and Internet access such as ISDN and PRI. o Specialized Application Services -- The Company can create products and services that are tailored for target industries with special telecommunications needs such as the hospitality industry. These services typically include non-measured rate local calling, expanded local calling area, discounted long distance rates and tailored trunking configurations. 5 SALES AND MARKETING SALES. US LEC is building a highly motivated and experienced direct sales force. The Company recruits salespeople with strong sales backgrounds in its existing and target markets, including salespeople from long distance companies, telecommunications equipment manufacturers, network systems integrators, CLECs and ILECs. The Company expanded its sales force from 23 salespeople at December 31, 1997 to 98 salespeople at December 31, 1998, and management expects to further increase the Company's sales force to over 150 salespeople by the end of 1999. 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. The Company also utilizes independent sales agents to identify and maintain customers. MARKETING. In its existing markets, US LEC seeks to position itself as a high quality alternative to ILECs for local telecommunication services by offering network reliability and superior customer support at competitive prices. The Company is building 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, advertising and promotional efforts. The Company primarily uses three service marks: US LEC, a logo that includes US LEC, and THE COMPETITIVE TELEPHONE COMPANY. These service marks have been registered either on the principal or the supplemental register of the U.S. Patent and Trademark Office for uses related to telecommunications services. The Company also has pending trademark applications for these marks. CUSTOMER SERVICE. Management believes that the Company's ability to provide superior customer service is a key factor in acquiring new customers and reducing churn of existing customers. The Company has developed a customer service strategy that is designed to effectively meet the service requirements of its target customers. The principal salesperson for each customer provides the first line of customer service by identifying and resolving any customer needs. An account development representative is assigned to each customer to supervise all aspects of customer relations, including account collections and complaint resolution, and to provide a single point of contact for all customer service issues. To support this locally-based team, the Company also has a centrally based customer service and NOC team. BILLING. US LEC outsources the preparation of customer bills, which are available in a variety of formats that can be tailored to a customer's specific needs. US LEC offers customers simplicity and convenience by sending one bill for all services, and the bill is sent out within a few days after the billing cycle. SIGNIFICANT CUSTOMER In fiscal 1997 and 1998, BellSouth, the predominant ILEC operating in the Company's existing markets, accounted for 65% and 80%, respectively, of the Company's net revenue (before reduction for the $12 million allowance described in Note 6 to Company's consolidated financial statements). The majority of this revenue for 1998 was generated from reciprocal compensation. Although reciprocal compensation owed to the Company by BellSouth is not a customer relationship in the traditional sense, BellSouth is shown here due to the significant contribution to revenue. At December 31, 1997 and 1998, BellSouth accounted for 67% and 94% of the Company's total accounts receivables before allowance, respectively. The majority of such receivables and revenues have resulted from traffic associated with Metacomm, LLC ("Metacomm"), a customer of the Company and BellSouth, and which became a related party to the Company during 1998 (see Notes 6 and 8 to Company's consolidated financial statements). 6 EMPLOYEES As of December 31, 1998, the Company employed 253 people. The Company expects to employ over 400 people by the end of 1999. The Company considers its employee relations to be very good. 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 49 Chairman of the Board, Chief Executive Officer and Director Tansukh V. Ganatra 55 President, Chief Operating Officer and Director Aaron D. Cowell, Jr. 36 Executive Vice President, General Counsel and Secretary (since June 1998) Michael K. Robinson 42 Executive Vice President and Chief Financial Officer (since July 1998) David C. Conner 41 Executive Vice President -- Engineering and Operations and Chief Technology Officer Gary D. Grefrath 57 Executive Vice President -- Administration Michael K. Simmons 40 Executive Vice President -- Corporate Development Craig K. Simpson 36 Executive Vice President -- Sales
* Except as otherwise indicated, all offices were assumed on January 1, 1998. 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, legislative hearings and administrative proposals which could change, in varying degrees, the manner in which this industry operates. Neither the outcome of these proceedings, nor their impact upon the telecommunications industry or the Company, can be predicted at this time. This section also includes a brief description of regulatory and tariff issues pertaining to the operation of the Company. OVERVIEW. The Company's services are subject to varying degrees of federal, state and local regulation. The Federal Communications Commission (the "FCC") generally exercises jurisdiction over the facilities of, and services offered by, telecommunications common carriers that provide interstate or international communications. The state regulatory commissions (herein "PUC's) 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 is 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 ILECs and other new entrants into the local telephone market. Specifically, the Telecom Act imposes on ILECs certain interconnection obligations, some of which are to be implemented by FCC regulations. The Telecom Act contemplates that states will apply the federal regulations and oversee the 7 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. See "Business -- Forward Looking Statements and Risk Factors -- Uncertainties Related to Reciprocal Compensation" for a discussion of the actions before the North Carolina PUC related to its interconnection agreement with BellSouth. The Telecom Act imposes on ILECs certain interconnection obligations that, taken together, grant competitive entrants such as the Company what is commonly referred to as "co-carrier status." It is anticipated that co-carrier status and the preemption of state and local prohibitions on entry could permit the Company to become a full service provider of switched telecommunications services anywhere in the United States. The Company has historically received a significant portion of its initial revenue in a given market from the ILEC in the form of reciprocal compensation payments due to the Company. Several ILECs have challenged the applicability of the reciprocal compensation related to enhanced service providers ("ESP") and ISP customers receiving more calls than they make. See "Business -- Forward Looking Statements and Risk Factors -- Uncertainties Related to Reciprocal Compensation". 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 ("RBOCs"), other ILECs, long distance carriers and other companies and likely will increase the level of competition the Company faces. See "Business - Competition". In addition, the Telecom Act, as passed, 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. These limitations have been challenged by the RBOC's. See "Business -- Forward Looking Statements and Risk Factors--Regulation". FEDERAL REGULATION AND RELATED PROCEEDINGS. The Telecom Act and the FCC's efforts to initiate reform have resulted in numerous legal challenges. As a result, the regulatory framework in which the Company operates is subject to a great deal of uncertainty. Any changes that result from this uncertainty could have a material adverse effect on the Company. The FCC has adopted orders eliminating tariff filing requirements for non-dominant carriers providing interstate access and domestic interstate long distance services. However, on February 13, 1997, the United States Court of Appeals for the District of Columbia granted motions for stay of the FCC order detariffing domestic interstate long distance service pending judicial review of that order. The result of this stay is that carriers 8 must continue to file tariffs for interstate long distance services. Tariff filing requirements remain in place for international traffic. US LEC has filed federal interstate long distance, interstate access and international tariffs. 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 proposed affording significant new pricing flexibility to ILECs subject to price cap regulation. To the extent such increased pricing flexibility is provided, the Company's ability to compete with ILECs for certain service may be adversely affected. The FCC has taken several actions related to the assignment of telephone numbers, first in July 1995 mandating the responsibility for administering and assigning local telephone numbers be transferred from the RBOCs and a few other ILECs to a neutral entity, and second in July 1996 adopting a regulatory structure under which a wide range of number portability issues would be resolved. In March 1997, the FCC affirmed its number portability rules, but it extended slightly certain deadlines for the implementation of true number portability. The FCC has established cost recovery rules for long-term number portability. On August 8, 1996, the FCC issued an order containing rules providing guidance to the ILECs, CLECs, long distance companies and state 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 has suggested should be in the range of 17%-25%); (ii) availability of unbundled local loops and other unbundled ILEC network elements; (iii) the use of Total Element Long Run Incremental Costs in the pricing of these unbundled network elements; (iv) average default proxy prices for unbundled local loops in each state; (v) mutual compensation proxy rates for termination of ILEC/CLEC local calls; and (vi) the ability of CLECs and other service providers to opt into portions of previously-approved interconnection agreements negotiated by the ILECs with other parties on a most favored nation (or a "pick and choose") basis. See " Regulation -- Eighth Circuit Court of Appeals Decision and Supreme Court Reversal" for a discussion of the Eighth Circuit Court of Appeals decision related to this order. On May 8, 1997, the FCC released an order establishing a significantly expanded federal universal service program which subsidized certain eligible services. For example, the FCC established new subsidies for services provided to qualifying schools and libraries with an annual cap of $2.25 billion and for services provided to rural health care providers with an annual cap of $400 million. The FCC also expanded the federal subsidies to low-income consumers and consumers in high-cost areas. Providers of interstate telecommunications service, such as the Company, as well as certain other entities, must pay for these programs. The Company's share of the schools, libraries and rural health care funds will be 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 will be based on its share of the total interstate telecommunications service and certain defined telecommunications end user revenues. Although the Company has already begun contributing to the fund, the amount of the Company's required contribution changes each quarter. As a result, the Company cannot predict the revenue 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. Several parties have appealed the May 8 order. Such appeals have been consolidated and transferred to the United States Court of Appeals for the Fifth Circuit where they are currently pending. In addition, on July 3, 1997, several ILECs filed a petition for stay of the May 8 order with the FCC. That petition is also pending. 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 9 rules ("price cap LECs") recover through monthly, non-traffic sensitive access charges and substantially decrease the costs that price cap LECs 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 will 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. As part of its overall plan to lower interstate access rates, the FCC also released an order on May 21, 1997, in which the FCC revised its price cap rules. In the May 21 order, the FCC increased the so-called X-Factor (the percentage by which price cap LECs must lower their interstate access charges every year, net of inflation and exogenous cost increases) and made it uniform for all price cap LECs. The results of these rule changes will be both a one-time overall reduction in price cap LEC interstate access charges and an increase in the rate at which those charges will be reduced in the future. Several parties have appealed the May 21 order. Those appeals were consolidated and transferred to the United States Court of Appeals for the Tenth Circuit. They have been subsequently transferred to the United States Court of Appeals for the District of Columbia where they are currently pending. 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 interstate in nature. The FCC has requested comment as to what reciprocal compensation rules should govern this traffic upon expiration of existing interconnection agreements. The FCC also determined that no federal rule existed that governed reciprocal compensation for ISP traffic at the time existing interconnection agreements were negotiated and concluded that it should permit states to determine whether reciprocal compensation should be paid for calls to ISPs under existing interconnection agreements. In light of the FCC order, state commissions which previously addressed this issue and required reciprocal compensation to be paid for ISP traffic may reconsider and may modify their prior rulings. The FCC order has been appealed by several parties. No procedural calendar has been established yet. To date, no PUC in any state where the Company has earned reciprocal compensation has either affirmed or altered its prior position on this issue. The Company anticipates that the FCC will initiate a number of additional proceedings, of its own volition and as a result of requests from CLECs and others, as a result of the Telecom Act. The FCC also requires carriers to file periodic reports concerning carriers interstate circuits and deployment of network facilities. The FCC generally does not exercise direct oversight over cost justification and the level of charges for services of non-dominant carriers, although it has the power to do so. The FCC also imposes prior approval requirements on transfers of control and assignments of operating authorizations. The FCC has the authority to generally condition, modify, cancel, terminate, or revoke operating authority for failure to comply with federal laws or rules, regulations and policies of the FCC. Fines or other penalties also may be imposed for such violations. There can be no assurance that the FCC or third parties will not raise issues with regard to the Company's compliance with applicable 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 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, which is discussed in more detail below). In addition, the Supreme Court affirmed the "pick and choose" rules which allows carriers to choose individual portions of existing interconnection agreements with other 10 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. These challenges will now have to be addressed by the 8th Circuit in light of the Supreme Court's decision. 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. This issue will have to be addressed by the FCC in a new rule-making proceeding that the FCC intends to initiate in the spring of 1999. 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 be able to rely on existing interconnection agreements or have the ability to negotiate acceptable interconnection agreements in the future. STATE REGULATION. The Company is certified by the appropriate state PUCs as follows:
STATE TELECOMMUNICATION SERVICES North Carolina local exchange, exchange access, and intrastate interexchange long distance Georgia local exchange, long distance and intrastate interexchange alternate operator services Virginia intrastate local exchange and exchange access, not required for long distance Tennessee local exchange, exchange access and interexchange South Carolina resale and facilities-based local exchange, exchange access and intrastate interexchange Florida local exchange, long distance Alabama facilities-based and resold local exchange, exchange access and interexchange The Company has applications pending with the following PUC's: Washington D.C. resale and facilities-based local exchange Pennsylvania resale and facilities-based local exchange, exchange access and interexchange (provisional certification granted) Maryland resale and facilities-based local exchange and interexchange Delaware resale and facilities-based local exchange and interexchange New Jersey resale and facilities-based local exchange and interexchange
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. 11 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. State PUCs will implement and enforce most of the Telecom Act's local competition provisions, including those governing the specific charges for local network interconnection. In some states, those charges are being determined by generic cost proceedings and in other states they are being established through arbitration proceedings. Depending on how such charges are ultimately determined, such charges could become a material expense to the Company. COMPETITION As noted above, the regulatory environment in which the Company operates is changing rapidly. The passage of the Telecom Act combined with other actions by the FCC and state regulatory authorities continues to promote competition in the provision of telecommunications services. ILECS. In each market served by its networks, the Company faces, and expects to continue to face, significant competition from the ILECs, which currently dominate their local telecommunications markets as a result of their historic monopoly position. The Company competes with the ILECs in its markets for local exchange services on the basis of product offerings, reliability, state-of-the-art technology, price, route diversity, ease of ordering and customer service. However, the ILECs have long-standing relationships with their customers and provide those customers with various transmission and switching services, a number of which the Company does not currently offer. In addition, ILECs enjoy a competitive advantage due to their vast financial resources. The Company has sought, and will continue to seek, to achieve parity with the ILECs in order to become able to provide a full range of local telecommunications services. See "Business -- Regulation" for additional information concerning the regulatory environment in which the Company operates. Because US LEC leases fiber optic transmission capacity to link its customers with its networks, and uses state-of-the-art technology in its switch platforms, the Company may have cost and service quality advantages over some currently available ILEC networks. 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 CAPs, 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. 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. 12 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, 1998, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and subsequently filed Annual Reports on Form 10-K may include forward looking statements. Other written or oral statements which constitute forward looking statements have been made and may in the future be made by or on behalf of US LEC, including statements regarding future operating performance, share of new and existing markets, short-term and long-term revenue, earnings and cash flow amounts, judicial, statutory and regulatory developments and general industry growth rates and US LEC's performance in relation thereto. These statements are identified by the use of forward-looking terminology such as "believes," "expects," "may," "will," "should," "estimates" or "anticipates" or the negative thereof or other variations thereon or comparable terminology, or by discussions of strategy that involve risks and uncertainties. These forward looking statements are based on a number of assumptions concerning future events, including the outcome of judicial and regulatory proceedings, the adoption of balanced and effective rules and regulations by the FCC and PUCs, and US LEC's ability to successfully execute its strategy. These forward looking statements are also subject to a number of uncertainties and risks, many of which are outside of US LEC's control, that could cause actual results to differ materially from such statements. These risks include, but are not limited to, the following: UNCERTAINTIES RELATED TO RECIPROCAL COMPENSATION The Telecom Act requires ILECs to provide reciprocal compensation to a CLEC for local traffic terminated on such CLEC's network. Notwithstanding this requirement, a number of ILECs have taken the position that traffic terminated to ESPs, including information service providers such as ISPs, is not local traffic. A majority of the Company's revenue is derived from reciprocal compensation amounts due from ILECs, principally BellSouth, a majority of which relates to ISP revenue (approximately $54 million in 1998 before an allowance of $12 million) that is being disputed. Management believes that such revenue has been earned by the Company and payments are due from BellSouth pursuant to the interconnection agreements that BellSouth has with the Company. However, in August 1997, BellSouth notified the Company and other CLECs that it considered ISP traffic interstate (and therefore not subject to reciprocal compensation) and that BellSouth would not pay (or bill) reciprocal compensation under interconnection agreements for traffic terminated to ESPs, including information service providers and ISPs. On February 26, 1998, following a petition by the Company, the NCUC ordered BellSouth to bill and pay for all such traffic. Following motions filed by BellSouth, the NCUC stayed enforcement of its order until June 1, 1998. On April 27, 1998, BellSouth filed a petition for judicial review of the NCUC's order and an action for declaratory judgment and other relief (including a request for an additional stay) with the United States District Court for the Western District of North Carolina (U.S. District Court). This matter was filed against the Company and the NCUC and is currently pending before the U.S. District Court. 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 interstate in nature. The FCC has requested comment as to what reciprocal compensation rules should govern this traffic upon expiration of existing interconnection agreements. The FCC also determined that no federal rule existed that governed reciprocal compensation for ISP traffic at the time existing interconnection agreements were negotiated and concluded that it should permit states to determine whether reciprocal compensation should be paid for calls to ISPs under existing interconnection agreements. In light of the FCC order, state commissions which previously addressed this issue and required reciprocal compensation to be paid for ISP traffic may reconsider and may modify their prior rulings. The FCC order has been appealed by several parties. No procedural calendar has been established yet. To date, no PUC in any state where the Company has earned reciprocal compensation has either affirmed or altered its prior position on this issue. On September 14, 1998, BellSouth filed a complaint with the NCUC seeking to be relieved from an unspecified portion of obligations under its interconnection agreement with the Company to pay reciprocal compensation for traffic related to Metacomm, a customer of BellSouth and the Company, and currently a related party of the Company (see Note 8 to Company's consolidated financial statements). In addition to disputing the traffic due to its ISP nature, BellSouth has also alleged that the traffic related to Metacomm would not qualify for reciprocal compensation, alleging that such traffic does not constitute "telecommunications" subject to reciprocal compensation under the Telecom Act and the existing interconnection agreement. Also, on September 14, 1998, the Company filed a complaint with the NCUC seeking payment of facilities charges, non-ISP based reciprocal compensation and intraLATA toll termination charges. These matters are currently pending before the NCUC. 13 Management believes that the Company will ultimately obtain favorable results in these proceedings; however, BellSouth may elect to initiate additional proceedings (by way of appeal or otherwise) challenging amounts owed to the Company. If a decision adverse to the Company is issued in any of these proceedings by the U.S. District Court, the NCUC or the FCC, or in any appeal or review of a favorable decision by the U.S. District Court, the NCUC, or the FCC, or in any other proceeding affecting these issues in another forum, or if the FCC were to alter its position regarding reciprocal compensation obligations under existing interconnection agreements or if the NCUC were to alter its position on this issue, such an event could have a material adverse effect on the Company's operating results and financial condition. The Company's revenues for the year ended December 31, 1998 and trade accounts receivable as of December 31, 1998 included approximately $54 million (before the $12 million allowance) of earned but unpaid ISP reciprocal compensation, the majority of which was related to Metacomm. The Company's interconnection agreements with BellSouth are scheduled to expire in June 1999 and the Company does not anticipate that BellSouth will willingly agree to renew the agreements in a manner consistent with the Company's existing agreements as they relate to reciprocal compensation. However, the Company intends to pursue consistent agreements vigorously and does not anticipate any interruption in interconnection service. The Company's ultimate ability to obtain such terms will depend on a number of factors, including decisions of the FCC and the PUCs. LIMITED OPERATING HISTORY. US LEC was formed in June 1996 and began generating revenue in March 1997. Accordingly, investors have limited historical operating and financial information upon which to base an evaluation of the Company's performance. Given the Company's limited operating history, there can be no assurance that it will continue to compete successfully in the telecommunications business, sustain profitability or generate sufficient positive cash flow in the future to meet debt service, working capital or other cash requirements. See "Item 7: Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources". RISKS ASSOCIATED WITH IMPLEMENTATION OF GROWTH STRATEGY. The 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, (ii) identify, hire and retain qualified personnel, (iii) lease access to suitable fiber optic transmission facilities, (iv) purchase, 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 expansion effectively depends on the continued development of plans, systems and controls for its operational, financial and management needs. Given the Company's limited operating history, there can be no assurance that the Company will be able to satisfy these requirements or otherwise manage its 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 expansion plans. The Company's growth strategy also involves the following risks: QUALIFIED PERSONNEL. A critical component for US LEC's success is hiring and retaining additional qualified managerial, sales and technical personnel. Since its inception, the Company has experienced significant competition in hiring and retaining personnel possessing necessary skills and telecommunications experience. Although management believes the Company has been successful in hiring and retaining qualified personnel, there can be no assurance that US LEC will be able to do so in the future. SWITCHES AND RELATED EQUIPMENT. An essential element of the Company's current strategy is the provision of switched local service. There can be no assurance that installation of the switches and associated equipment necessary to implement the Company's business plan will be completed on a timely basis or that the Company will not experience technological problems that cannot be resolved in a satisfactory or timely matter. The failure of the Company to install and operate successfully switches and other network equipment could have a material adverse effect on the Company's financial condition and its ability to enter additional markets. 14 INTERCONNECTION AGREEMENTS. The Company has agreements for the interconnection of its networks with the networks of the ILECs covering each market in which US LEC either has or is currently installing a switching platform. US LEC may be required to negotiate new interconnection agreements as it enters new markets in the future. In addition, as its existing interconnection agreements expire, it will be required to negotiate extension or replacement agreements. There can be no assurance that the Company will successfully negotiate such additional agreements for interconnection with the ILECs or renewals of existing interconnection agreements on terms and conditions acceptable to the Company. The Company's interconnection agreement with BellSouth is scheduled to expire in June 1999 but management does not anticipate any interruption of interconnect services. The regulatory environment related to interconnection agreements is not static, and recent decisions may change the rules related to this process. See "Business -- Regulation". The regulatory uncertainty makes negotiating and enforcing such agreements more difficult and possibly more protracted, and could result in the need to renegotiate existing agreements. The failure to negotiate and obtain required interconnection agreements on terms and conditions acceptable to the Company could have a material adverse effect on the Company's ability to rapidly enter a particular market and on its operations in its existing markets. ORDERING, PROVISIONING AND BILLING. The Company has developed processes and procedures and is working with external vendors, including the ILECs, in the implementation of customer orders for services, the provisioning, installation and delivery of such services and monthly billing for those services. The failure to manage effectively processes and systems for these service elements or the failure of the Company's current vendors or the ILECs to deliver ordering, provisioning and billing services on a timely and accurate basis could have a material adverse effect upon the Company's ability to fully execute its strategy. PRODUCTS AND SERVICES. The Company currently focuses its efforts on providing local and long distance telecommunications 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 key executive officers, most notably Richard T. Aab, Chairman and Chief Executive Officer, and Tansukh V. Ganatra, President and Chief Operating Officer. The loss of the services of one or more of these key people, particularly Mr. Aab or Mr. Ganatra, could materially and adversely affect US LEC's business and its prospects. None of the Company's executive officers have employment agreements and the Company does not maintain key man life insurance on any of its officers. The competition for qualified managers in the telecommunications industry is intense. Accordingly, there can be no assurance that US LEC will be able to hire and retain necessary personnel in the future to replace any of its key executive officers, if any of them were to leave US LEC or be otherwise unable to provide services to US LEC. RELIANCE ON LEASED CAPACITY. A key element of US LEC's business and growth strategy is leasing fiber optic transmission capacity instead of constructing its own transport facilities. In implementing this strategy, the Company relies upon its ability to lease capacity from CAPs, other CLECs and 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. Although US LEC enters into agreements with its network providers that are intended to ensure access to adequate capacity and timely processing 15 of provisioning requests and although US LEC's interconnection agreements with ILECs generally provide that the Company's connection and maintenance orders will receive attention at parity with the ILECs and other CLECs and that adequate capacity will be provided, there can be no assurance that the ILECs and other network providers will comply with their contractual (and, in the case of the ILECs, legally required) network provisioning obligations, or that the provisioning process will be completed for the Company's customers on a timely and otherwise satisfactory basis. Furthermore, there can be no assurance that the rates to be charged to US LEC under future interconnection agreements or lease agreements with other providers will allow the Company to offer usage rates low enough to attract a sufficient number of customers and operate its networks at satisfactory margins. COMPETITION. The telecommunications industry is highly competitive. In each of the Company's existing and target markets, the Company competes and will continue to compete principally with the 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". 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 concern 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. As the regulatory environment changes, it is possible that 16 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". FUTURE CAPITAL AND OPERATING REQUIREMENTS. Implementation of the Company's business strategy will require significant capital and operating expenditures during 1999 and future years. In December 1998, the Company entered into a $50 million loan agreement with two lenders (the "Credit Facility"). See "Item 7: Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources". The Company's principal capital expenditures relate to the purchase and installation of its switching platform, related infrastructure and facilities. Management expects to satisfy its capital and operating requirements primarily with current cash balances, borrowings under the Credit Facility and cash flow from operations, although there can be no assurance that the actual expenditures required to implement the Company's business strategy will not exceed amounts available from these sources. In addition, the actual amount and timing of the Company's future expenditures may differ materially from the Company's estimates as a result of, among other things, the ability of the Company to meet its planned expansion schedule, the number of its customers and the services for which they subscribe and regulatory, technological and competitive developments in the Company's industry. Due to the uncertainty of these factors, actual revenues and costs may vary from expected amounts, possibly to a material degree, and such variations are likely to affect the implementation of the Company's business strategy. The Company also will continue to evaluate revenue opportunities in planned and other markets as well as potential acquisitions. The Company expects to obtain the capital required to pursue additional opportunities from the Credit Facility and other borrowings, the sale of additional equity or debt securities or cash generated from operations. There can be no assurance, however, that the Company would be successful in raising sufficient additional capital on acceptable terms or that the Company's operations would produce sufficient positive cash flow to pursue such opportunities should they arise. Failure to raise and generate sufficient funds, or unanticipated increases in capital requirements may require the Company to delay or curtail its expansion plans, which could have a material adverse effect on the Company's growth and its ability to compete in the telecommunications services industry. VARIABILITY OF QUARTERLY OPERATING RESULTS. As a result of the significant expenses associated with the Company's expansion into new markets, the Company's operating results may vary significantly from period to period. CONTROL BY SINGLE STOCKHOLDER. As of March 23, 1999, Richard T. Aab beneficially owns or otherwise controlled 100% of the outstanding shares of Class B Common Stock representing approximately 94% of the Company's total voting power. In addition, holders of Class B Common Stock are entitled to vote as a separate class to elect two members of the Board of Directors and to vote with the holders of Class A Common Stock for the election of other members of the Board of Directors. As a result, Mr. Aab will be able to control the board and all stockholder decisions and, in general, to determine (without the consent of the Company's other stockholders) the outcome of any corporate transaction or other matter submitted to the stockholders for approval, including mergers, consolidations and the sale of all or substantially all of the Company's assets. Mr. Aab also has the power to prevent or cause a change in control of the Company. See "Item 12: Security Ownership of Certain Beneficial Owners and Management". ITEM 2. PROPERTIES The Company's corporate headquarters are located at its principal office at 401 North Tryon Street, Suite 1000, Charlotte, North Carolina 28202. The Company leases all of its administrative and sales offices and its switch sites. The various leases expire in years ranging from 2000 to 2005. 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. 17 ITEM 3. LEGAL PROCEEDINGS US LEC is not currently a party to any material legal proceedings, other than the NCUC and U.S. District Court proceedings related to reciprocal compensation and other amounts due from BellSouth. See "Business--Regulation" and "Forward Looking Statements and Risk Factors" above and Note 6 to the Company's consolidated financial statements for a detailed description of these proceedings. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS No matters were submitted to a vote of security holders during the quarter ending December 31, 1998. PART II ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS The information required to be furnished in response to Item 5 is incorporated by reference to the inside back cover of the Company's 1998 Annual Report to Stockholders (the "Annual Report"). This section of the Annual Report has been included in Exhibit 13 to this report. ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA The information required to be furnished in response to Item 6 is incorporated by reference to the section of the Annual Report that appears under the heading "Selected Financial Data". This section of the Annual Report has been included in Exhibit 13 to this report. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information required to be furnished in response to Item 7 is incorporated by reference to the section of the Annual Report that appears under the heading "Management's Discussion and Analysis of Financial Condition and Results of Operations". This section of the Annual Report has been included in Exhibit 13 to this report. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The information required to be furnished in response to Item 8 is incorporated by reference to the sections of the Annual Report that appear under the headings "Consolidated Balance Sheets," "Consolidated Statements of Operations," "Consolidated Statements of Stockholders' Equity (Deficiency)," "Consolidated Statements of Cash Flows," "Notes to Consolidated Financial Statements" and "Independent Auditors' Report." These sections of the Annual Report have been included in Exhibit 13 to this report. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. 18 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required to be furnished in response to Item 10 with respect to directors is incorporated by reference from the section of the proxy statement for the Company's annual meeting of stockholders to be held April 20, 1999 (the "Proxy Statement") that appears under the heading "Election of Directors". Information relating to the Company's executive officers is contained in Part I of this report under the heading "Executive Officers of the Registrant". 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". 19 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) Financial Statements, Financial Statement Schedules 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, 1997 and 1998 B. Consolidated Statements of Operations for the Period from June 6, 1996 (Inception) to December 31, 1996 and years ended December 31, 1997 and 1998 C. Consolidated Statements of Stockholders' Equity (Deficiency) for the Period from June 6, 1996 (Inception) to December 31, 1996 and years ended December 31, 1997 and 1998 D. Consolidated Statements of Cash Flows for the Period from June 6, 1996 (Inception) to December 31, 1996 and years ended December 31, 1997 and 1998 E. Notes to Consolidated Financial Statements for the Period from June 6, 1996 (Inception) to December 31, 1996 and years ended December 31, 1997 and 1998 F. Independent Auditors' Report (2) Financial Statement Schedules: A. Schedule I - Independent Auditors' Report B. Schedule II -Valuation and Qualifying Accounts (3) List of Exhibits:
No. Exhibit --- ------- 3.1 Form of Restated Certificate of Incorporation of the Company (1) 3.2 Bylaws of the Company (1) 3.3 Amendment No. 1 to Bylaws of the Company (1) 4 Form of Class A Common Stock Certificate (1) 10.1 US LEC Corp. 1998 Omnibus Stock Plan (1) (2) 10.2 Promissory Note, dated January 16, 1998, made by the Company to Melrich Associates, LP (1) 10.3 Security Agreement dated January 16, 1998, by and between the Company and Melrich Associates, L.P. (1) 10.4 Promissory Note, dated January 16, 1998, made by the Company to Tansukh V. Ganatra (1) 10.5 Security Agreement, dated January 16, 1998, by and between the Company and Tansukh V. Ganatra (1) 10.6 Guaranty and Suretyship Agreement, dated January 16, 1998, by and among the Company and Richard T. Aab, Melrich Associates, L.P. and Tansukh V. Ganatra (1) 10.7 Contribution Agreement, dated February 14, 1998, by and between US LEC Corp. and Richard T. Aab (1) 10.8 Form of Non-transferable Warrant, dated August 4, 1997, issued Craig K. Simpson (1) (2)
20
No. Exhibit --- ------- 10.9 Amended and Restated Class B Stockholders Agreement, dated as of January 1, 1998 (1) 10.10 Consulting Agreement, dated December 18, 1997, by and between the Company and RTA Associates, LLC and related termination letter, dated January 1, 1998 (1) 10.11 Consulting Agreement, dated December 18, 1997 by and between the Company and Super STAR Associates Limited Partnership and related termination letter, dated January 1, 1998 (1) 10.12 Loan and Security Agreement, dated as of December 30, 1998, among US LEC Corp., certain operating subsidiaries of US LEC Corp., General Electric Capital Corporation and First Union National Bank (3) 13 Specified portions (pages 13 to 36 and inside back cover) of the Company's Annual Report to Stockholders for the year ended December 31, 1998 21 Subsidiaries of the Registrant 23 Consent of Deloitte & Touche LLP 27 Financial Data Schedule - ----------------------------
(1) Incorporated by reference to Registration Statement from Form S-1 (File No. 333-46341) filed February 13, 1998. (2) Indicates a management contract or compensatory plan or arrangement. (3) Incorporated by reference from the Company's Current Report on Form 8-K filed on January 7, 1999. (b) Reports on Form 8-K. No Current Reports on Form 8-K were filed during the quarter ending December 31, 1998. 21 SCHEDULE I INDEPENDENT AUDITORS' REPORT Board of Directors US LEC Corp. Charlotte, North Carolina We have audited the consolidated financial statements of US LEC Corp. and subsidiaries as of December 31, 1997 and 1998, and for the period from June 6, 1996 (inception) to December 31, 1996 and each of the two years in the period ended December 31, 1998, and have issued our report thereon dated February 6, 1999 (February 26, 1999 as to Note 6), which report includes an emphasis of a matter paragraph as to a significant portion of the Company's accounts receivables and revenues relating to reciprocal compensation currently in dispute; such financial statements and report are included in your 1998 Annual Report to Stockholders and are incorporated herein by reference. Our audits also included the consolidated financial statement schedule of US LEC Corp. and subsidiaries, listed in Item 14. This financial statement schedule is the responsibility of the Corporation's management. Our responsibility is to express an opinion based on our audits. In our opinion, such consolidated 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 as set forth therein. DELOITTE & TOUCHE LLP Charlotte, North Carolina February 26, 1999 22 SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS US LEC CORP. (IN THOUSANDS)
ADDITIONS -------------------------- BALANCE AT BEGINNING OF CHARGED TO CHARGED TO BALANCE AT END PERIOD COSTS AND OTHER OF PERIOD DESCRIPTION (DEC. 31, 1997) EXPENSES ACCOUNTS DEDUCTIONS (DEC. 31, 1998) - --------------------- ----------------- ------------ ------------- --------------- --------------- Allowance against accounts receivables $0 $12,024 $0 $0 $12,024 -- ------- -- -- -------
23 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. US LEC CORP. Date: March 30, 1999 By: /s/ Richard T. Aab ----------------------------- Richard T. Aab Chairman of the Board and Chief Executive Officer 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 of the Board and March 30, 1999 ------------------ Chief Executive Officer Richard T. Aab (Principal Executive Officer) /s/ Tansukh V. Ganatra President, Chief Operating Officer and March 30, 1999 ---------------------- Director Tansukh V. Ganatra /s/ Michael K. Robinson Executive Vice President and March 30, 1999 ----------------------- Chief Financial Officer Michael K. Robinson (Principal Financial and Accounting Officer) /s/ David M. Flaum Director March 30, 1999 ------------------ David M. Flaum /s/Steven L. Schoonover Director March 30, 1999 ----------------------- Steven L. Schoonover
24 EX-13 2 EXHIBIT 13 US LEC o The Competitive Telephone Company Management's Discussion and Analysis of Financial Condition and Results of Operations 13 Except for historical information, this report contains forward-looking statements subject to uncertainties and risks, and as a result, US LEC's actual results may differ materially from those discussed here. These uncertainties and risks include among others, the demand for US LEC's services, the ability of the Company to successfully attract and retain personnel, competition, uncertainties regarding its dealings with incumbent local exchange carriers ("ILECs"), other telecommunications carriers and facility providers, regulatory uncertainties, reliance on leased transmission capacity and the cost of that capacity, the need to finance operations and future capital expenditures, the possibility of an adverse decision related to reciprocal compensation owed to the Company by BellSouth Telecommunications, Inc. ("BellSouth"), as well as the Company's ability to successfully initiate operations in additional markets. These and other applicable risks are described in the Company's Annual Report on Form 10-K for the year ended December 31, 1998 and other filings with the Securities and Exchange Commission. The following discussion and analysis should be read in conjunction with the "Selected Financial Data" on page 12 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 local, long distance and enhanced telecommunications services to its customers. The Company primarily serves telecommunication- intensive customers including businesses, universities, financial institutions, hospitals, hotels and government agencies. 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, and now operates from offices in Charlotte, Raleigh, Greensboro, Atlanta, Memphis, Nashville, Knoxville, Orlando, Miami, Tampa and Jacksonville. US LEC currently plans to establish offices in additional markets during 1999, including Richmond, Norfolk/Virginia Beach, Chattanooga, Birmingham, Philadelphia, and the Washington D.C. metropolitan area. Revenue and Cost of Services US LEC's revenue is comprised of two primary components: (1) fees paid by customers for local, long distance and enhanced services and (2) access charges. Local, long distance 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 lines in service and additional features on those lines. 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 by interexchange carriers ("IXCs") for the origination and termination of interexchange toll and toll-free calls and reciprocal compensation, which is discussed below. US LEC's "core business" revenue is comprised of local, long distance, enhanced service fees and toll and toll-free access charges as described above. The Company does not resell any ILEC services. Reciprocal compensation arises when a local exchange carrier completes a call that originated on another local exchange carrier's network. Reciprocal compensation rates are fixed by an interconnection agreement negotiated between those carriers. The majority of the Company's 1998 revenue was earned from reciprocal compensation and is currently being disputed by BellSouth. This dispute relates to reciprocal compensation charges related to traffic that is terminated to enhanced service providers, including internet service providers. As part of this dispute BellSouth has disputed reciprocal compensation charges related to Metacomm, LLC, a company that is indirectly controlled by Richard T. Aab, the majority stockholder and chief executive officer of the Company. The BellSouth dispute contends that such traffic does not constitute "telecommunications" subject to reciprocal compensation under the Telecom Act and the existing interconnection agreement between BellSouth and the Company. See Note 6 to the consolidated financial statements for a detailed description of these proceedings and uncertainties associated with their outcome. Although the Company has generated a majority of its revenue from reciprocal compensation, 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 1998 has active switches in 11 sites, serving over 550 customers. Management believes this level of growth, achieved in less than two years, is indicative of the markets' acceptance of US LEC's strategy and service offerings in its core business. Management expects the Company's core business revenue to increase and reciprocal compensation to decrease as percentages of total revenue in future periods as US LEC continues to deploy its network and expand its customer base. US LEC o The Competitive Telephone Company Management's Discussion and Analysis of Financial Condition and Results of Operations 14 In order to provide local exchange services, the Company has signed interconnection agreements with various ILECs, including BellSouth, GTE and Sprint. These agreements provide the framework for the Company to serve its customers when other local carriers are involved. The Company's interconnection agreement with BellSouth is scheduled to terminate in June 1999 but management does not anticipate any interruption of interconnect services. While the Company does not anticipate that BellSouth will agree to renew the agreements in a manner consistent with the Company's existing agreements as they relate to reciprocal compensation, it intends to pursue such consistent terms vigorously. The Company's ultimate ability to obtain such terms will depend on a number of factors, including decisions by the Federal Communications Commission and state regulatory authorities. Cost of services is comprised primarily of leased transport charges and commissions payable with respect to reciprocal compensation revenue. The Company's leased transport charges are the lease payments incurred by US LEC for the fiber optic transmission facilities used to connect the Company's customers to its switch and 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 some 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 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. The Company shares revenue in the case of toll-free access and reciprocal compensation revenue. While the majority of the Company's cost of services is comprised of leased transport charges and reciprocal compensation commissions, management expects that over time outbound traffic and other usage sensitive charges will become a major component of cost of services as the Company begins to carry more of its customers' outbound calls. Selling, General and Administrative Expenses; Depreciation and Amortization In addition to the costs of services described above, the Company incurs certain other expenses. The largest component of selling, general and administrative expense ("SG&A") relates to employee salaries, related taxes and benefits, and other incentive-based compensation. Other major categories of SG&A include expenses associated with leasing real estate for the Company's offices and network, 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 $13.3 million in 1997 to $61.3 million in 1998. Depreciation and amortization expense increased from $0.4 million in 1997 to $4.9 million in 1998. As the Company continues to build its network, SG&A, depreciation and amortization expense will continue to grow. Although the Company is currently profitable, there can be no assurance that the Company can continue to maintain its profitability. Results of Operations Comparison of Year Ended December 31, 1998 to Year Ended December 31, 1997 Net revenue increased to $84.7 million for the year ended December 31, 1998 from $6.5 million in 1997. The increase in revenue of $78.2 million resulted from 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. As mentioned above, a majority of the Company's revenue was comprised of reciprocal compensation originated by customers of ILECs. Given that no near term resolution of the reciprocal compensation dispute is expected, the Company recorded a $12.0 million allowance against reciprocal compensation revenue and related receivables during 1998. The results discussed in this report are net of this adjustment. This allowance was made for the uncertainty associated with the current judicial and regulatory proceedings related to this revenue, and does not reflect a change in the Company's commitment to pursue the matter to a successful conclusion. See Note 6 to the consolidated financial statements for a detailed description of these proceedings and uncertainties associated with their outcome. 15 Billable minutes of use were approximately 10.9 billion in 1998 compared to approximately 472 million in 1997. Billable trunks increased to 39,304 at December 31, 1998 from 8,039 at the December 31, 1997. Equivalent Access Lines ("EALs") increased to 199,578 at December 31, 1998, from 49,229 at December 31, 1997. Equivalent Access Lines is a term used by US LEC to quantify the size of its network. During 1998, the Company modified the ratio of lines per trunk used in calculating EALs, which are based on the number of customer lines and trunks and the utilization of those lines and trunks during the "busy hour". The "busy hour" refers to the hour of the day when line usage is at its highest level. The Company calculates its EALs by multiplying the number of its trunks in service by five and adding to the result the number of its separate access lines in service. The decision to use five as the multiplier is based on management's experience, which now indicates that the typical business access line is in use for approximately 400 seconds during the busy hour (or approximately 11.1% of capacity during the busy hour) and a typical business trunk is in use for approximately 2,000 seconds during the busy hour (or approximately 55.6% of capacity during the busy hour) or approximately five times use during the busy hour of a typical business line. Beginning in the third quarter of 1998, as part of its periodic review of this issue, management changed the multiplier that it uses in the calculation of EALs from six to five in order to reflect changes in the usage of its network. Cost of services is comprised primarily of leased transport, facility installation, commissions and usage charges. Cost of services increased from $4.2 million, or 65.1% of revenue, for 1997, to $33.6 million, or 39.7% of revenue, for 1998. This increase was primarily a result of the increase in the size of US LEC's network, increased usage by its customers, and increased commissions due to reciprocal compensation. Selling, general and administrative expenses for 1998 increased to $25.0 million, or 29.5% of revenue, compared to $6.1 million, or 94.7% of revenue, for 1997. This increase was primarily a result of costs associated with developing and expanding the infrastructure of the Company as it expands into new markets, such as expenses associated with personnel, sales and marketing, occupancy, administration and billing as well as legal expenses associated with the BellSouth litigation. Depreciation and amortization for 1998 increased to $4.9 million from $0.4 million in 1997 primarily due to the increase in depreciable assets in service related to US LEC's network expansion. Interest income for 1998 increased by $1.8 million over 1997 to $1.9 million as a result of investing the proceeds from the Company's initial public offering. Interest expense for 1998 decreased from 1997 by $184 thousand to $237 thousand. This decrease was primarily due to the full repayment of $3.3 million in notes payable in June 1998. Provision for income taxes for 1998 was $9.3 million, based on an effective tax rate of 40.9%. As a result of timing differences between book and tax income at December 31, 1998, the Company had a tax net operating loss carryforward of $2.8 million. US LEC was organized as a limited liability company during 1997 and effectively converted to C Corporation status as of January 1, 1998. Accordingly, no provision (benefit) for income taxes was necessary for 1997 since income taxes were the responsibility of the individual limited liability company members. Net earnings after tax for 1998 amounted to $13.4 million, or $.52 per share (diluted), compared to a net loss of $4.7 million, or ($.25) per share (diluted) for 1997. The increase in net earnings and net earnings per share is attributed to the factors discussed above. Earnings before interest, taxes, depreciation and amortization ("EBITDA") for 1998 increased to $26.0 million from a loss of $3.9 million in 1997. EBITDA is a measure commonly used by analysts, investors, and other interested parties in the telecommunications industry and is presented to assist in understanding the Company's operating results. EBITDA is not a measurement of financial performance under generally accepted accounting principles and should not be considered an alternative to net income or loss as a measure of performance or to cash flow as a measure of liquidity. EBITDA is not necessarily comparable with the similarly titled measures for other companies. US LEC o The Competitive Telephone Company Management's Discussion and Analysis of Financial Condition and Results of Operations 16 Comparison of Year Ended December 31, 1997 to the Period from Inception (June 6, 1996) to December 31, 1996 Although the Company began operations on June 6, 1996, it did not generate revenue until March 1997 and, accordingly, any comparison of operating results between 1996 and 1997 would not be meaningful. Selling, general and administrative expenses for 1996 were $942 thousand resulting primarily from payroll costs. The Company's net loss for fiscal 1996 was $963 thousand resulting from operating expenses incurred for the initial development of the Company's business. During fiscal 1996, the Company was organized as an S corporation. Liquidity and Capital Resources US LEC's business is capital intensive and its operations require substantial capital expenditures for the purchase and installation of network switches, related electronic equipment and facilities. The Company's cash capital expenditures were $47.7 million and $5.8 million for the years ended December 31, 1998 and 1997, respectively. The Company anticipates that it will have substantial capital requirements in connection with its planned expansion into additional markets during 1999 and beyond. In February 1998, US LEC registered 6,325,000 shares of its Class A Common Stock for sale to the public. In April and May 1998, the Company completed the public offering of these 6,325,000 shares (the "Equity Offering"). The net proceeds to the Company from the Equity Offering were approximately $87.1 million, after deducting underwriting discounts and commissions of $6.6 million and offering expenses of $1.1 million. At December 31, 1997, US LEC was indebted to Richard T. Aab, the Company's principal stockholder, Chairman and Chief Executive Officer, in the amount of $5.0 million. In February 1998, Mr. Aab exchanged this loan for 480,770 shares of Class B Common Stock. During the first quarter of 1998, Tansukh V. Ganatra, US LEC's President and Chief Operating Officer, and Melrich Associates, L.P. (an entity of which Mr. Aab is a general partner) loaned the Company a total of $3.3 million. The Company repaid these loans in June 1998. In December 1998, the Company entered into a $50.0 million loan agreement with General Electric Capital Corporation and First Union National Bank. The loan agreement was comprised of a $42.5 million one year revolving credit facility which converts to a seven year term loan and a $7.5 million reducing revolving credit facility with a six year term. The amount outstanding at December 31, 1998 was $20.0 million, all of which was borrowed under the $42.5 million one year revolving credit facility. The interest rate for the loan agreement is a floating rate based, at the Company's option, on a base rate or the London Interbank Offered Rate, plus, in each case, a specified margin. Initial advances under the agreement bear an interest rate of approximately 8.6%. This loan is subject to certain financial covenants the most significant of which relate to the levels of maintenance of revenue, earnings and debt ratios. Substantially all of the Company's and its subsidiaries' assets are pledged as collateral to serve amounts borrowed under the loan agreement. Cash used in operating activities was approximately $19.1 million for 1998 compared to $5.6 million in 1997. The increase in cash used in operating activities was primarily due to a $56 million increase related to accounts receivable (net of a $12 million receivable allowance) offset by an increase in net income of $18.1 million, an increase in depreciation of $4.5 million, an increase in deferred taxes of $8.4 million and an increase related to accrued expenses of $10.6 million. The majority of the Company's accounts receivable at December 31, 1998 represented amounts due from BellSouth for reciprocal compensation, facility charges, toll and other charges. Management expects receivables due from BellSouth to continue to increase until the judicial and regulatory proceedings with BellSouth are resolved. The increase in depreciation was due to the increase in depreciable assets in service related to US LEC's network expansion. The increase in deferred taxes was due to timing differences between book and tax income at December 31, 1998. The increase in accrued expenses was primarily the result of an increase in accrued network costs, accrued compensation and other accrued expenses related to the Company's expansion. Cash used in investing activities increased to $48.5 million in 1998 from $6.0 million during 1997. The increase was primarily related to purchases of switching and related telecommunications equipment, office equipment and leasehold improvements associated with the Company's expansion into additional locations and markets during 1998 and, to a lesser extent, an increase in restricted cash which serves as collateral for letters of credit related to certain office leases. 17 Cash provided by financing activities increased to $106.5 million for 1998 from $14.0 million for 1997. The increase was primarily due to the $87.1 million of net proceeds from the Equity Offering and $20.0 million of borrowings under the Company's credit facility, both of which are discussed above. Effect of Recently Issued Accounting Pronouncements In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities". This statement addresses the accounting for derivative instruments, including certain derivative instruments embedded in other contracts and hedging activities. This statement will be effective for the Company's 2000 fiscal year. The Company has not yet completed its analysis of any potential impact of this statement on its financial statements. Year 2000 Compliance Many computer systems will experience difficulty processing dates beyond the year 1999 and will need to be modified prior to the Year 2000. Failure to make such modifications could result in system failures or miscalculations causing a disruption of operations. Most of the Company's information technology purchases were made after March 1997 and, because the Company's systems are relatively new and there were no legacy systems to integrate, management believes the Company's internal software and hardware systems will function properly with respect to dates in the Year 2000 and thereafter. In addition, Year 2000 issues are also addressed as the Company's network and internal systems are upgraded in the normal course of business. As of December 31, 1998, the Company's costs expended towards Year 2000 compliance has been minimal and it does not expect its additional expenditures directly related to Year 2000 compliance cost to exceed $100 thousand. Management continually reassesses the estimated costs and status of the Company's Year 2000 compliance efforts. The Company began conducting verification testing of all its internal information technology and information systems in 1998. The testing is a multi-phased process which includes, but is not limited to, setting the system clocks to simulate several key dates and times in the Year 2000, then performing daily activities. The infrastructure, servers and workstations, as well as software systems are being tested and validated using this process. The final phase of testing is scheduled to be completed in October 1999. While management believes that its hardware and software applications are Year 2000 compliant, there can be no assurance until the Year 2000 occurs that all systems will then function adequately. The Company is monitoring all key vendors and suppliers for Year 2000 compliance by various methods including, but not limited to, gathering information from a detailed survey sent by the Company, public domain websites, public service commission filings, and Securities and Exchange Commission filings. While most of the Company's significant suppliers and vendors have advised the Company that they are or anticipate being Year 2000 compliant, if the software applications of other local exchange carriers, long distance carriers, service providers, competitive access providers, or others on whose services the Company depends are not Year 2000 compliant, a material adverse effect on the Company's financial condition and results of operations could result. The Company is not aware of any significant vendor who may be unable to provide services to the Company as a result of Year 2000 non-compliance. The Company currently has a disaster recovery plan in place which will serve as a foundation for its contingency plan in the event its suppliers and vendors are not Year 2000 compliant. The full contingency plan is currently being developed and will be completed by mid-1999. 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, 1998, investments consisted primarily of institutional money market funds. All of the Company's long-term debt consist 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. US LEC o The Competitive Telephone Company US LEC Corp. and Subsidiaries Consolidated Balance Sheets December 31, 1997 and 1998 (In Thousands) 18
1997 1998 - ------------------------------------------------------------------------------------------ Assets (Note 5) Current Assets: Cash and cash equivalents (Note 2) $ 3,189 $ 41,965 Certificates of deposit and restricted cash (Note 2 and 6) 350 1,167 Accounts receivable, net of allowance of $12,024 for 1998 (Notes 2 and 6) 6,006 66,214 Prepaid expenses and other assets 111 2,838 - ------------------------------------------------------------------------------------------ Total current assets 9,656 112,184 Property and Equipment, Net (Notes 2, 3 and 5) 12,889 56,219 Other Assets 136 1,800 - ------------------------------------------------------------------------------------------ Total Assets $22,681 $ 170,203 ========================================================================================== Liabilities and Stockholders' Equity Current Liabilities: Accounts payable $ 8,201 $ 13,509 Deferred revenue (Note 2) 1,141 829 Accrued network costs (Notes 2 and 8) 1,865 9,866 Accrued interest payable - related party (Note 4) 282 - Deferred income taxes (Notes 2 and 7) - 7,108 Accrued expenses - other 435 4,657 - ------------------------------------------------------------------------------------------ Total current liabilities 11,924 35,969 Notes Payable-Stockholders (Note 4) 5,000 - Deferred Income Taxes (Notes 2 and 7) - 1,259 Long-Term Debt (Note 5) - 20,000 Commitments and Contingencies (Note 6) Stockholders' Equity (Note 10): Common stock - Class A, $.01 par (72,925 authorized shares, 3,855 and 10,345 outstanding at December 31, 1997 and 1998, respectively) 39 103 Common stock - Class B, $.01 par (17,076 authorized shares, 16,595 and 17,076 outstanding at December 31, 1997 and 1998, respectively) 166 171 Additional paid-in capital 11,173 106,800 Retained earnings (deficit) (5,621) 6,556 Unearned compensation - stock options - (655) - ------------------------------------------------------------------------------------------ Total stockholders' equity 5,757 112,975 - ------------------------------------------------------------------------------------------ Total Liabilities and Stockholders' Equity $22,681 $ 170,203 ==========================================================================================
See notes to consolidated financial statements. US LEC o The Competitive Telephone Company US LEC Corp. and Subsidiaries Consolidated Statements of Operations Period from June 6, 1996 (inception) to December 31, 1996 and years ended December 31, 1997 and 1998 (In Thousands, Except Per Share Data) 19
1996 1997 1998 - ---------------------------------------------------------------------------------------- Revenue, Net (Notes 2, 6 and 8) $ - $6,458 $ 84,716 Cost of Services (Note 8) - 4,201 33,646 ------------------------------------- Gross Margin - 2,257 51,070 Selling, General and Administrative (Note 8) 942 6,117 25,020 Depreciation and Amortization 4 443 4,941 ------------------------------------- Earnings (Loss) from Operations (946) (4,303) 21,109 Other (Income) Expense: Interest income - (66) (1,860) Interest expense (Note 4) 17 421 237 -------------------------------------- Earnings (Loss) Before Income Taxes (963) (4,658) 22,732 Provision For Income Taxes (Note 7) - - 9,305 -------------------------------------- Net Earnings (Loss) $ (963) $(4,658) $13,427 ====================================== Net Earnings (Loss) Per Share (Note 11): Basic $ (.06) $ (.25) $ .53 ====================================== Diluted $ (.06) $ (.25) $ .52 ====================================== Weighted Average Shares Outstanding (Note 11): Basic 17,310 18,653 25,295 ====================================== Diluted 17,310 18,653 25,804 ======================================
See notes to consolidated financial statements. US LEC o The Competitive Telephone Company US LEC Corp. and Subsidiaries Consolidated Statements of Stockholders' Equity (Deficiency) Period from June 6, 1996 (inception) to December 31, 1996 and years ended December 31, 1997 and 1998 (Notes 1 and 10) (In Thousands) 20
Common Stock Common Stock Class A Class B Shares Amount Shares Amount - ---------------------------------------------------------------------------------------- Balance, June 6, 1996 (Inception) -- $ -- -- $ -- Issuance of voting shares/units -- -- -- -- Shares/units granted to employees -- -- -- -- Net loss -- -- -- -- ----------------------------------------- Balance (Deficiency), December 31, 1996 -- -- -- -- Issuance of nonvoting units -- -- -- -- Issuance of voting units -- -- -- -- Issuance of warrants -- -- -- -- Contribution to capital -- -- -- -- Exchange of limited liability company units for C Corporation shares 3,855 39 16,595 166 Net loss -- -- -- -- ---------------------------------------- Balance, December 31, 1997 3,855 39 16,595 166 Public stock offering 6,325 63 -- -- Conversion of $5,000 stockholder loans for 481 shares of Class B common stock -- -- 481 5 Dividend (Note 4) -- -- -- -- Issuance of stock warrants -- -- -- -- Unearned compensation-stock options -- -- -- -- Exercise of warrants 165 1 -- -- Tax effect of non-qualified options/warrants exercised -- -- -- -- Net earnings -- -- -- -- ---------------------------------------- Balance, December 31, 1998 10,345 $ 103 17,076 $ 171 ========================================
(1) On December 31, 1996, all S Corporation common shares were converted into limited liability company units based on a one-for-one conversion ratio of units for each share. On December 31, 1997, all limited liability units were converted into C Corporation common shares based upon a conversion ratio of 1,500 shares for each unit. See notes to consolidated financial statements. 21
Common Stock/ Common Stock/ Unearned Voting Units (1) Nonvoting Units (1) Additional Retained Compensation ----------------- ------------------- Paid-in Earnings Stock Shares Amount Shares Amount Capital (Deficit) Options Total - ---------------------------------------------------------------------------------------- -- $ -- -- $ -- $ -- $ -- $ -- $ -- 10 600 -- -- -- -- -- 600 -- -- 2 28 -- -- -- 28 -- -- -- -- -- (963) -- (963) - ---------------------------------------------------------------------------------------- 10 600 2 28 -- (963) -- (335) -- -- 1 4,413 -- -- -- 4,413 1 4,555 -- -- -- -- -- 4,555 -- -- -- -- 70 -- -- 70 -- -- -- -- 1,711 -- -- 1,711 (11) (5,155) (3) (4,441) 9,392 -- -- 1 -- -- -- -- -- (4,658) -- (4,658) - ---------------------------------------------------------------------------------------- -- -- -- -- 11,173 (5,621) -- 5,757 -- -- -- -- 87,079 -- -- 87,142 -- -- -- -- 4,995 -- -- 5,000 -- -- -- -- 1,250 (1,250) -- -- -- -- -- -- 75 -- -- 75 -- -- -- -- 819 -- (655) 164 -- -- -- -- 471 -- -- 472 -- -- -- -- 938 -- -- 938 -- -- -- -- -- 13,427 -- 13,427 - ---------------------------------------------------------------------------------------- -- $ -- -- $ -- $ 106,800 $6,556 $(655) $ 112,975 ========================================================================================
US LEC o The Competitive Telephone Company US LEC Corp. and Subsidiaries Consolidated Statements of Cash Flows Period from June 6, 1996 (inception) to December 31, 1996 and years ended December 31, 1997 and 1998 (In Thousands) 22
1996 1997 1998 - --------------------------------------------------------------------------------------------- Operating Activities: Net earnings (loss) $ (963) $(4,658) $13,427 Adjustments to reconcile net earnings (loss) to net cash used in operating activities: Depreciation and amortization 4 443 4,941 Accounts receivable allowance - - 12,024 Stock compensation 28 71 240 Deferred compensation - - (655) Deferred taxes - - 8,367 Changes in assets and liabilities which provided (used) cash: Accounts receivable - (6,006) (74,177) Prepaid expenses and other assets (141) 31 (579) Other assets (124) (14) (1,271) Accounts payable 34 899 5,769 Deferred revenue - 1,141 (312) Accrued expenses - other 83 634 5,082 Accrued network costs - 1,865 8,001 ---------------------------- Total adjustments (116) (936) (32,570) ---------------------------- Net cash used in operating activities (1,079) (5,594) (19,143) ---------------------------- Investing Activities: Purchase of property and equipment (266) (5,802) (47,721) Purchases of certificates of deposit and restricted cash - (349) (817) (Advances to) repayments from stockholder (200) 200 - ---------------------------- Net cash used in investing activities (466) (5,951) (48,538) ---------------------------- Financing Activities: Issuance of common shares and limited liability company units 600 8,968 471 Proceeds from public stock offering - - 87,142 Contribution of capital - 1,711 - Proceeds from long-term debt - - 20,000 Payment of loan fees - - (1,156) Proceeds from notes payable - stockholders 1,671 4,289 3,289 Repayment of notes payable - stockholders - (960) (3,289) ---------------------------- Net cash provided by financing activities 2,271 14,008 106,457 ---------------------------- Net Increase in Cash and Cash Equivalents 726 2,463 38,776 Cash and Cash Equivalents, Beginning of Period - 726 3,189 ---------------------------- Cash and Cash Equivalents, End of Period $ 726 $ 3,189 $ 41,965 ============================ Supplemental Cash Flows Disclosures Cash paid for: Interest $ - $ 672 $ 505 ---------------------------- Taxes $ - $ - $ 1,860 ----------------------------
Supplemental Noncash Investing and Financing Activities: During 1997, accrued interest of $55 due to stockholders was converted into voting equity. At December 31, 1996, 1997 and 1998, $14, $7,267 and $6,838 respectively, of property and equipment additions are included in outstanding accounts payable. During 1998, the majority stockholder converted $5,000 of loans to the Company for 481 shares of Class B Stock. The dividend resulting from the conversion of the loan was $1,250. See notes to consolidated financial statements. US LEC o The Competitive Telephone Company US LEC Corp. and Subsidiaries Notes to Consolidated Financial Statements Period from June 6, 1996 (inception) to December 31, 1996 and years ended December 31, 1997 and 1998 (In Thousands, Except Per Share Data) 23 1. ORGANIZATION AND NATURE OF BUSINESS The consolidated financial statements include the accounts of US LEC Corp. (the "Company") and its nine wholly owned subsidiaries. All significant intercompany transactions and balances have been eliminated in consolidation. The Company was incorporated in 1996 as an S Corporation. Effective December 31, 1996, US LEC Corp. was converted to a limited liability company ("US LEC L.L.C.") through an exchange of the S Corporation common stock for voting and nonvoting units of US LEC L.L.C. On December 31, 1997, in anticipation of an initial public offering of common stock, the Company became a C Corporation through a merger of US LEC L.L.C. into the Company and the exchange of all of the limited liability company units into shares of Class A or Class B Common Stock. On April 29, 1998, the Company completed the sale of 5,500 shares of Class A Common Stock through an initial public offering. Additionally, on May 12, 1998, the Company issued 825 shares of Class A Common Stock in connection with the underwriters' exercise of their option to cover over-allotments. The total offering resulted in net proceeds of approximately $87,142, after deducting underwriting discounts, commissions and offering expenses. The Company has used and intends to use substantially all of the net proceeds of the initial public offering to further expand and develop its telecommunications network and services. The Company, through its subsidiaries, provides switched local, long distance and enhanced telecommunications services primarily to businesses and other organizations in selected markets in the southeastern United States. The Company was a development stage enterprise from inception until March 1997, when it began generating telecommunications revenues. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Revenue Recognition - The Company normally recognizes revenue on telecommunications and enhanced communications services in the period that the service is provided. Revenue is recorded net of amounts which are rebated to a customer or outside sales agent pursuant to each respective telecommunications service contract. Revenue related to billings in advance of providing services is deferred and recognized when earned. At December 31, 1997, deferred revenue primarily represented billings to incumbent local exchange carriers ("ILECs") relating to internet service provider ("ISP") reciprocal compensation. Reciprocal compensation represents the compensation paid to and by a competitive local exchange carrier ("CLEC") and the ILEC for termination of a local call on the other's network. The Company deferred the recognition of such amounts in 1997 pending a ruling from the North Carolina Utilities Commission ("NCUC"). During 1998, such amounts were subsequently recorded as revenue as a result of the decision by the NCUC on February 26, 1998 in favor of the Company. As a result of this ruling, the Company began recognizing all such ISP reciprocal compensation revenue in the period in which the service was provided. However, due to current regulatory and judicial proceedings related to this type of revenue, the Company established an allowance of $12,000 at December 31, 1998, which has been recorded as a reduction of revenue during the year ended December 31, 1998 (see Note 6). Cash and Cash Equivalents - Cash equivalents consist of highly liquid investments with original maturities of three months or less at the time of purchase. Certificates of Deposit and Restricted Cash - Certificates of deposit were carried at cost. All of these certificates matured during 1998, and served as collateral for letters of credit related to certain office leases. The restricted cash balance as of December 31, 1998 serves as collateral for letters of credit related to certain office leases. Accounts Receivable - The majority of the accounts receivable at December 31, 1998 arose from reciprocal compensation revenue earned in accordance with terms of an interconnection agreement with BellSouth Telecommunications, Inc. ("BellSouth"). The Company established an allowance of $12,000 as of December 31, 1998 to allow for the uncertainty associated with the current judicial and regulatory proceedings related to this revenue (see Note 6). US LEC o The Competitive Telephone Company US LEC Corp. and Subsidiaries Notes to Consolidated Financial Statements Period from June 6, 1996 (inception) to December 31, 1996 and years ended December 31, 1997 and 1998 (In Thousands, Except Per Share Data) 24 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 Long-Lived Assets - The Company reviews the carrying value of its long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying value of these assets may not be recoverable. Measurement of any impairment would include a comparison of estimated undiscounted future operating cash flows anticipated to be generated during the remaining life of the assets with their net carrying value. An impairment loss would be recognized as the amount by which the carrying value of the assets exceeds their fair value. Accrued Network Costs - Accrued network costs include management's estimate of charges for direct access lines, facility charges, outgoing and incoming minutes, reciprocal compensation and other costs of revenue for a given period for which bills have not been received by the Company. Management's estimate is developed from the minutes of use and rates charged by each respective service provider. Subsequent adjustments to this estimate may result when actual costs are billed by the service provider to the Company. However, management does not believe such adjustments will be material to the Company's financial statements. Fair Value of Financial Instruments - Management believes the fair values of the Company's financial instruments, including cash equivalents, certificates of deposit, accounts receivables, accounts payable and notes payable to stockholders approximate their carrying value. In addition, because the long-term debt consists of variable rate instruments, their carrying values approximate fair values. Income Taxes - The Company was organized as an S Corporation for the period from inception to December 31, 1996, and as a limited liability company for the period from January 1, 1997 to December 31, 1997, on which date it was converted to a C Corporation. Accordingly, no provision (benefit) for income taxes was necessary for 1996 and 1997 since income taxes were the responsibility of the individual S Corporation stockholders or limited liability company members. On a pro forma basis, had the Company been structured as a C Corporation since inception, there would have been no change in the net loss or net loss per share for 1996 and 1997. At December 31, 1997, deferred tax assets and liabilities related to the conversion to a C Corporation were not significant. For 1998, 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. Concentration of Risk - The Company is exposed to concentration of credit risk principally from trade accounts receivable. The Company's trade customers are located in the southeastern United States. The Company performs ongoing credit evaluations of its customers but does not require collateral to support customer receivables. Credit risk may be reduced by the fact that the Company's most significant trade receivables are from large, well-established telecommunications entities. However, at December 31, 1997 and 1998, the majority of the accounts receivable balance is due from BellSouth and is currently in dispute (see Note 6). 25 The Company is dependent upon certain suppliers for the provision of telecommunications services to its customers. The Company has executed interconnection agreements for all of its current operating networks, and a number of these agreements expire at various dates in 1999. Management believes that suitable interconnection agreements can be negotiated in the future and, accordingly, does not expect any disruption of services. Use of Estimates - The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements. Actual results could differ from those estimates. Significant estimates relate to the accrual of network costs payable to other telecommunications entities and the estimate for the allowance for receivables due from BellSouth (see Note 6). 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 $22, $137 and $276 for 1996, 1997 and 1998, respectively. Significant Customer - In fiscal 1997 and 1998, BellSouth, operating in the majority of the Company's markets, accounted for 65% and 80%, respectively, of the Company's net revenue (before reduction for the $12,000 allowance described in Note 6). The majority of this revenue for 1998 was generated from reciprocal compensation. Although reciprocal compensation owed to the Company by BellSouth is not a customer relationship in the traditional sense, BellSouth is shown here due to the significant contribution to revenue. At December 31, 1997 and 1998, BellSouth accounted for 67% and 94% of the Company's total accounts receivables before allowance, respectively. The majority of such receivables and revenues have resulted from traffic associated with Metacomm, LLC ("Metacomm"), a customer of the Company and BellSouth, and which became a related party to the Company during 1998 (see Notes 6 and 8). Recent Accounting Pronouncements - In June 1997, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 131, "Disclosures about Segments of an Enterprise and Related Information." This Standard redefines how operating segments are determined and requires disclosure of certain financial and descriptive information about a company's operating segments. This Statement is effective for the Company's current fiscal year end. Management has determined that the adoption of SFAS 131 has no material impact on the Company's current disclosures of its one operating segment, providing telecommunications services. In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." This standard addresses the accounting for derivative instruments, including certain derivative instruments embedded in other contracts and hedging activities. This statement will be effective for the Company's 2000 fiscal year. The Company has not yet completed its analysis of any potential impact of this standard on its financial statements. In March 1998, the American Institute of Certified Public Accountants ("AICPA") issued Statement of Position ("SOP") 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use." Adoption of the SOP is effective for the current fiscal year. Management has concluded that adoption of such guidance had no material effect on the financial statements. Reclassifications - Certain reclassifications have been made to 1996 and 1997 amounts to conform to the 1998 presentation. US LEC o The Competitive Telephone Company US LEC Corp. and Subsidiaries Notes to Consolidated Financial Statements Period from June 6, 1996 (inception) to December 31, 1996 and years ended December 31, 1997 and 1998 (In Thousands, Except Per Share Data) 26 3. PROPERTY AND EQUIPMENT Property and equipment at December 31, 1997 and 1998 is summarized by major class as follows: 1997 1998 - ------------------------------------------------------------------------------ Telecommunications switching and other equipment $11,790 $ 45,334 Office equipment, furniture and other 775 9,158 Leasehold improvements 770 6,785 --------------------- 13,335 61,277 Less accumulated depreciation and amortization (446) (5,058) --------------------- Total $12,889 $ 56,219 ===================== 4. NOTES PAYABLE-STOCKHOLDERS During 1997, the Company's majority stockholder loaned an aggregate of $5,000 to the Company. Interest charged on loaned amounts was at prime plus 2% (10.5% per annum at December 31, 1997). On February 14, 1998, the Company's majority stockholder exchanged the $5,000 loan for 481 shares of Class B Common Stock with a fair value of $10.40 per share. The fair value of the Class B Common Stock issued in the exchange was $1,250 in excess of the carrying value of the debt. Accordingly, the difference between the carrying value of the debt and the fair value of the Class B Common Stock issued in the exchange was recorded as a dividend to the majority stockholder in the first quarter of 1998. In January 1998, an entity controlled by this stockholder loaned an additional $2,289 to the Company with an interest rate of 12%. The Company repaid all the outstanding amounts due under the loan in June 1998. Another stockholder loaned the Company an aggregate of $960 in 1996, with an interest rate of prime plus 2%. These loans were repaid in 1997. In January 1998, this stockholder loaned $1,000 to the Company, with an interest rate of 12%. The Company repaid all the outstanding amounts due under the loan in June 1998. Interest expense to related parties totaled $17, $420 and $223 in 1996, 1997 and 1998, respectively. 5. LONG-TERM DEBT Effective December 30, 1998, the Company entered into a $50,000 loan agreement with General Electric Capital Corporation and First Union National Bank. The loan agreement was comprised of a $42,500 one year revolving credit facility which converts to a seven year term loan and a $7,500 reducing revolving credit facility with a six year term. The amount outstanding at December 31, 1998 was $20,000, all of which was borrowed under the $42,500 one year revolving credit facility. On December 31, 1998, the interest rate on the borrowings was 10.25% (prime plus 2.5%) and the Company had an additional $30,000 available under the loan agreement. On January 5, 1999, the Company converted the $20,000 borrowings under the line to a LIBOR-based loan with an interest rate of 8.56%, based on one month LIBOR plus 3.50%. This loan is subject to certain financial covenants, the most 27 significant of which relate to the maintenance of levels of revenue, earnings and debt ratios. Substantially all of the Company's and its subsidiaries' assets are pledged as collateral to secure amounts borrowed under the loan agreement. Scheduled maturities of long-term debt, assuming conversion to a term loan are as follows: Year ending December 31: 1999 $ - 2000 - 2001 - 2002 3,000 2003 3,000 Thereafter 14,000 -------- Total $ 20,000 ======== 6. COMMITMENTS AND CONTINGENCIES Disputed ISP Revenues - A majority of the Company's revenue is derived from reciprocal compensation amounts due from ILECs, principally BellSouth, a majority of which relates to ISP revenue (approximately $54,000 in 1998 before the $12,000 allowance) that is being disputed. Management believes that such revenue has been earned by the Company and payments are due from BellSouth pursuant to the interconnection agreements that BellSouth has with the Company. However, in August 1997, BellSouth notified the Company and other CLECs that it considered ISP traffic interstate (and therefore not subject to reciprocal compensation) and that BellSouth would not pay (or bill) reciprocal compensation under interconnection agreements for traffic terminated to enhanced service providers ("ESPs"), including information service providers and ISPs. On February 26, 1998, following a petition by the Company, the NCUC ordered BellSouth to bill and pay for all such traffic. Following motions filed by BellSouth, the NCUC stayed enforcement of its order until June 1, 1998. On April 27, 1998, BellSouth filed a petition for judicial review of the NCUC's order and an action for declaratory judgment and other relief (including a request for an additional stay) with the United States District Court for the Western District of North Carolina ("U.S. District Court") pending determination of certain ISP issues by the Federal Communications Commission ("FCC"). This action was filed against the Company and the NCUC. This matter is currently pending before the U.S. District Court. On February 26, 1999, the FCC ruled that Internet traffic represents interstate traffic. However, they further ruled that carriers are bound by their existing interconnection agreements, as interpreted by state utility commissions, and thus are subject to reciprocal compensation obligations to the extent provided by such agreements or as determined by state utility commissions. As noted, the NCUC had ruled on February 26, 1998 in favor of the Company with respect to the Company's existing interconnection agreement with BellSouth. On September 14, 1998, BellSouth filed a complaint with the NCUC seeking to be relieved from an unspecified portion of obligations under its interconnection agreement with the Company to pay reciprocal compensation for traffic related to Metacomm, a customer of BellSouth and the Company, and currently a related party of the Company (see Note 8). In addition to disputing the traffic due to its ISP nature, BellSouth has also alleged that traffic related to Metacomm would not qualify for reciprocal compensation, alleging that such traffic does not constitute "telecommunications" subject to reciprocal compensation under the Telecommunications Act of 1996 and the existing interconnection agreement. On September 14, 1998, the Company filed a complaint with the NCUC seeking payment of facilities charges, non-ISP based reciprocal compensation and intraLATA toll termination charges. These matters are currently pending before the NCUC. US LEC o The Competitive Telephone Company US LEC Corp. and Subsidiaries Notes to Consolidated Financial Statements Period from June 6, 1996 (inception) to December 31, 1996 and years ended December 31, 1997 and 1998 (In Thousands, Except Per Share Data) 28 Management believes that the Company will ultimately obtain favorable results in these proceedings; however, BellSouth may elect to initiate additional proceedings (by way of appeal or otherwise) challenging amounts owed to the Company. If a decision adverse to the Company is issued in any of these proceedings by the U.S. District Court, the NCUC or the FCC, or in any appeal or review of a favorable decision by the U.S. District Court, the NCUC, or the FCC, or in any other proceeding affecting these issues in another forum, or if either the FCC or the NCUC were to alter its view of reciprocal compensation, such an event could have a material adverse effect on the Company's operating results and financial condition. The Company's revenues for the year ended December 31, 1998 and trade accounts receivable as of December 31, 1998 included approximately $54,000 (before the $12,000 allowance) of earned but unpaid ISP reciprocal compensation, the majority of which was generated as a result of traffic related to Metacomm (see Note 8). The Company's interconnection agreements with BellSouth are scheduled to terminate in June 1999 and the Company does not anticipate that BellSouth will agree to renew the agreements in a manner consistent with the Company's existing agreements as they relate to reciprocal compensation. However, the Company intends to pursue such agreements vigorously and does not anticipate any interruption in interconnection service. The Company's ultimate ability to obtain such terms will depend on a number of factors, including the decision of the FCC and state regulatory authorities. Leases - The Company leases office premises in various locations under operating lease arrangements. Total rent expense on these leases amounted to $12, $180 and $1,853 in 1996, 1997 and 1998, respectively. The Company's restricted cash balance as of December 31, 1998 serves as collateral for letters of credit for some of these office leases. Future minimum rental payments under operating leases having initial or remaining noncancelable lease terms in excess of one year are as follows: 1999 $ 2,903 2000 2,886 2001 2,801 2002 2,794 2003 2,003 ---------------- Total $ 13,387 ================ Purchase Commitments - At December 31, 1998, the Company has outstanding commitments to purchase switching equipment with an aggregate cost of $6,154. 7. INCOME TAXES The provision for income taxes in 1998 consists of the following components: Current - Charge equivalent to net tax benefit of stock warrant exercise and issuance of stock options $ 938 Deferred ---------------- Federal 6,702 State 1,665 ---------------- 8,367 ---------------- Total provision for income taxes $ 9,305 ================ 29 The reconciliation of the statutory federal income tax rate to the Company's federal and state overall effective income tax rate is as follows: Statutory federal rate 35.00% State income taxes 5.30 Miscellaneous .63 ------ Effective tax rate 40.93% ====== Deferred income taxes reflect the net tax effects of the temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for tax purposes. Significant components of the Company's deferred tax assets and liabilities as of December 31, 1998 are as follows: Deferred tax assets: Net operating loss carryforward $ 1,192 Deferred state taxes and other 584 Accrued expenses 328 --------- Total deferred tax assets 2,104 --------- Deferred tax liabilities: Net deferred revenues 7,834 Depreciation and amortization 2,591 Other 46 --------- Total deferred tax liabilities 10,471 --------- Net deferred tax liability $ 8,367 ========= At December 31, 1998 the Company has federal and state net operating loss carryforwards of approximately $2,771 expiring at the end of 2018 and 2003, respectively. 8. RELATED PARTIES In 1996, the Company advanced $200 to its majority stockholder. The amount was repaid in January 1997. During 1997, the Company received services under consulting agreements with two entities controlled by Company stockholders. Under these agreements in fiscal 1997, the Company expensed $175 which is included in selling, general and administrative expenses in the accompanying financial statements. No such consulting agreements existed during the year ended December 31, 1998. During 1998, the Company's majority stockholder acquired an indirect controlling interest in Metacomm. Metacomm is engaged in the business of developing and operating a high-speed data network in North Carolina, and is a customer of the Company and BellSouth. During 1998, the Company recorded $6,239 in revenue earned from services provided to Metacomm (which did not include revenue from reciprocal compensation due from BellSouth, see Note 6). Metacomm also earns commissions from the Company for reciprocal compensation revenue relating to Metacomm's network. The Company recorded $19,759 in reciprocal compensation commission expense earned by Metacomm, which is included in cost of services in the accompanying financial statements. As of December 31, 1998, the Company had a liability to Metacomm in the amount of $5,345, which is recorded in accrued network costs in the accompanying financial statements. The Company and Metacomm are parties to agreements by US LEC o The Competitive Telephone Company US LEC Corp. and Subsidiaries Notes to Consolidated Financial Statements Period from June 6, 1996 (inception) to December 31, 1996 and years ended December 31, 1997 and 1998 (In Thousands, Except Per Share Data) 30 which commissions earned by Metacomm related to reciprocal compensation would not be paid to Metacomm until the related reciprocal compensation is collected from the ILEC. However, in 1998, the Company paid Metacomm $8,256 prior to collecting the earned reciprocal compensation from BellSouth. These payments are subject to a repayment agreement if the related reciprocal compensation is ultimately determined not to be collectible from BellSouth. During 1998, the Company incurred $35 in expenses for chartered aircraft services provided by the majority stockholder. During 1998, the Company acquired $471 in software from Global Vista Communications, LLC ("Global Vista"), a company controlled by the Company's majority stockholder. In addition, the Company incurred $89 in expenses for consulting services provided by Global Vista. As of December 31, 1998, a liability totaling $6 was recorded in the Company's financial statements, relating to software and consulting services purchased from Global Vista. Company management believes that all of the above transactions were under terms no less favorable to the Company than could be arranged with unrelated parties. 9. EMPLOYEE BENEFIT PLAN The Company has a 401(k) profit-sharing plan under which employees can contribute up to 15% of their annual salary. For 1998, the Company made matching contributions to the plan totaling $41 based on 50% of the first 6% of an employee's contribution to the plan. There were no matching contributions made in 1997. 10. STOCKHOLDERS' EQUITY Common Stock - The Company has authorized two classes of common stock, Class A and Class B. The rights of holders of the Class A Common Stock and the Class B Common Stock are substantially identical, except that (i) holders of the Class A Common Stock are entitled to one vote per share and holders of the Class B Common Stock are entitled to ten votes per share; (ii) holders of the Class B Common Stock vote as a separate class to elect two members of the Company's Board of Directors in addition to voting with the holders of Class A Common Stock in the election of the other members of the Board of Directors; and (iii) the Class B Common Stock is fully convertible at any time into Class A Common Stock, at the option of the holder, or automatically upon transfer to certain third persons, on a one-for-one basis. Pursuant to an agreement among the Class B stockholders, if a Class B stockholder proposes to sell or transfer Class B Common Stock to anyone other than a permitted transferee (as defined in the agreement), the other Class B stockholders who are parties to the agreement would have a right to acquire the Class B Common Stock that is proposed to be sold or transferred. Preferred Stock - The Company is authorized to issue 10,000 shares of preferred stock ($.01 par value) in one or more series without stockholder approval, subject to any limitations prescribed by law. Each series of preferred stock shall have such rights and preferences as shall be determined by the Company's Board of Directors. No shares of preferred stock have been issued. Capital Contribution - During 1997, the Company's majority stockholder contributed an aggregate of $1,711 to additional paid-in capital. In addition, during 1998, this stockholder exchanged a $5,000 loan for 481 shares of Class B Common Stock (see Note 4). Employee Stock Grants - In 1996, as part of the Company's organizational activities, an aggregate of one thousand, five hundred and forty non-voting limited liability company units were issued to encourage certain employees to 31 join the Company. The Company recorded compensation expense of $28 in 1996 for these units, based on the estimated fair value at the time the units were issued. Warrants - During 1997, the Company issued warrants to three employees to purchase an aggregate of 345 shares of Class A Common Stock and a warrant to an outside sales agent to purchase 99 shares of Class A Common Stock. All of these warrants are fully vested and are exercisable at $2.86 per share for a three-year period from the date of issuance. Management believes that these employee warrants issued through October 1997 are noncompensatory based upon an internal valuation of their fair value. For the warrant issued in 1997 to the outside sales agent, the fair value charged to expense was $24. The exercise price of those warrants is the same as the issuance price in 1997 of shares to numerous outside investors. In November 1997, the Company granted to an employee a warrant to purchase 15 shares of Class A Common Stock at an exercise price of $2.86 per share. This warrant was fully vested at date of grant and exercisable over three years. Management estimated the fair value of the warrant granted in November to be $6.00 per share. As a result, compensation of $47 was charged to expense relating to the difference between the fair value and the exercise price of the warrant on the date of grant. In January 1998, the Company issued a warrant to a consultant to purchase 25 shares of Class A Common Stock at $10 per share, exercisable at any time through January 1, 2001. These warrants are fully vested and exercisable over three years. The Company recorded compensation expense of $75 in 1998 associated with the warrant issued in January 1998. In June 1998, a former executive officer of the Company exercised a warrant to purchase 165 shares of Class A Common Stock for $2.86 per share. Stock Option Plan - In January 1998, the Company adopted the US LEC Corp. 1998 Omnibus Stock Plan (the "Stock Plan"). In August 1998, the Company filed a registration statement to register (i) 1,300 shares of Class A Common Stock reserved for issuance under the Stock Plan and (ii) 180 shares of Class A Common Stock reserved for issuance upon the exercise of nontransferable warrants granted by the Company to employees. Under the Stock Plan, 1,300 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. During 1998, the Company amortized $105 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. During 1998, the Company amortized $60 to compensation expense relating to these options. Also, during 1998, 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 outside directors. These options vested immediately upon grant. US LEC o The Competitive Telephone Company US LEC Corp. and Subsidiaries Notes to Consolidated Financial Statements Period from June 6, 1996 (inception) to December 31, 1996 and years ended December 31, 1997 and 1998 (In Thousands, Except Per Share Data) 32 Effective September 18, 1998, the Company repriced 744 options outstanding to the fair value on such date of $7.31 per share. As a condition to the repricing, these options (other than the directors' options) will now vest over four years beginning at the repricing date. 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, December 31, 1996 Granted at fair market value 429 $ 2.86 $ 2.86 Granted at less than fair market value 15 2.86 6.00 ----- Balance, December 31, 1997 (all exercisable) 444 2.86 Granted at fair market value* 1,324 $ 10.27 $ 3.95 Granted at less than fair market value 575 11.88 6.89 25 10.00 $ 13.00 Exercised - (165) 2.86 Forfeited or cancelled* (817) 14.41 - - ---- ----- Balance, December 31, 1998 1,082 $ 8.00 304 $ 3.45 ===== ====== === ========
* Includes 744 options repriced 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: 1997 1998 ----------------------- --------------------- As Reported Proforma As Reported Proforma - ---------------------------------------------------------------------------- Net earnings (loss) $ (4,658) $(4,737) $13,427 $12,832 Earnings (loss) per share: Basic (.25) (.25) .53 .51 Diluted (.25) (.25) .52 .50 33 The Company estimated the fair value for both the stock options and the warrants using the Black-Scholes model assuming no dividend yield in 1997 and 1998; volatility of 0% and 40% for 1997 and 1998, respectively, a risk-free interest rate of 6.0% and 5.0% for 1997 and 1998, respectively, an expected life of 18 months for the warrants and 5.8 years for the stock options. The weighted average remaining contractual life of warrants and stock options outstanding at December 31, 1998 was 20 months and 9.7 years, respectively. A summary of the range of exercise prices and weighted average remaining lives for options and warrants outstanding at December 31, 1998 is as follows:
Options Outstanding ----------------------------------------------- Weighted Average Weighted Range of Number of Remaining Average Exercise Options Contractual Exercise Price Outstanding Life Price - ---------------------------------------------------------------------------------------------- Options granted at fair market value $7.31 917 9.7 years $ 7.31 9.50 11 9.8 years 9.50 11.25 25 9.9 years 11.25 12.38 115 10.0 years 12.38 --------- 7.31 - 12.38 1,068 9.7 years 7.97 Options granted at less than fair market --------- value 10.00 14 9.1 years 10.00 -------- Total options outstanding at December 31, 1998 $7.31 - $12.38 1,082 9.7 years $ 8.00 ======== Warrants Outstanding ------------------------------------------ Weighted Average Weighted Range of Number of Remaining Average Exercise Warrants Contractual Exercise Price Outstanding Life Price - --------------------------------------------------------------------------------------------------- Warrants granted at fair market value $2.86 264 19.1 months $ 2.86 Warrants granted at less than fair market value 2.86 15 22.4 months 2.86 10.00 25 24.1 months 10.00 --------- 2.86 - 10.00 40 23.4 months 7.32 Total warrants outstanding at --------- December 31, 1998 $2.86 - $10.00 304 19.7 months $ 3.45
A summary of the number of options and warrants exercisable and the weighted average exercise price at December 31, 1998 is as follows: Weighted Average Options Exercise Exercisable Price - ------------------------------------------------------------------------------- Options granted at fair market value 10 $7.31 Options granted at less than fair market value - - ------------------- Total options exercisable at December 31, 1998 10 $7.31 =================== US LEC o The Competitive Telephone Company US LEC Corp. and Subsidiaries Notes to Consolidated Financial Statements Period from June 6, 1996 (inception) to December 31, 1996 and years ended December 31, 1997 and 1998 (In Thousands, Except Per Share Data) 34 Weighted Average Warrants Exercise Exercisable Price - ------------------------------------------------------------------------------ Warrants granted at fair market value 264 $ 2.86 Warrants granted at less than fair market value 40 7.32 --------------------- Total warrants exercisable at December 31, 1998 304 $ 3.45 ===================== 11. EARNINGS (LOSS) PER SHARE Earnings (loss) per common and common equivalent share have been calculated in accordance with SFAS 128, "Earnings Per Share," and are based on net income (loss) divided by the weighted average shares outstanding during the period. The weighted average shares outstanding used in the calculation has been determined by giving retroactive effect to the merger of the predecessor limited liability company into the Company, which occurred on December 31, 1997 (based on the share conversion ratios utilized in the merger). Outstanding options and warrants are included in the calculation of diluted earnings per common share to the extent they are dilutive. Securities and Exchange Commission Staff Accounting Bulletin No. 98 requires that equity instruments granted at nominal amounts for periods prior to the filing of the registration statement be included in the calculation of per share data as if outstanding for all periods presented. Accordingly, the weighted average shares used in the calculation of basic and diluted earnings (loss) per share includes two thousand, three hundred and ten shares (two limited liability company units) granted in 1996 to employees, as if such shares were outstanding for the entire period. Following is the reconciliation of earnings (loss) per share for 1996, 1997 and 1998: 1996 1997 1998 - ------------------------------------------------------------------------------ Basic earnings (loss) per share: Net earnings (loss) $ (963) $(4,658) $13,427 Weighted average shares outstanding 17,310 18,653 25,295 ------------------------------ Basic earnings (loss) per share $ (.06) $ (.25) $ .53 ============================== Diluted earnings (loss) per share: Net earnings (loss) $ (963) $(4,658) $13,427 ============================== Weighted average shares outstanding 17,310 18,653 25,295 Dilutive effect of stock options - - 214 Dilutive effect of warrants - - 295 ------------------------------ Weighted average shares, adjusted 17,310 18,653 25,804 ============================== Diluted earnings (loss) per share $ (.06) $ (.25) $ .52 =============================== 35 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 1997 and 1998. Amounts below exclude per share data for periods prior to the completion of the Company's initial public offering: Quarter Ended ------------------------------------------ March 31, June 30, Sept. 30, Dec. 31, 1998 1998 1998 1998 - -------------------------------------------------------------------------------- Year ended December 31, 1998: Revenue, Net $ 13,630 $18,348 $22,291 $30,447 Cost of Services 6,473 7,537 7,296 12,340 ------------------------------------------- Gross Margin 7,157 10,811 14,995 18,107 Selling, General and Administrative 4,426 5,747 6,690 8,157 Depreciation and Amortization 442 925 1,547 2,027 ------------------------------------------- Earnings from Operations 2,289 4,139 6,758 7,923 Interest Income (Expense), Net (90) 596 704 413 ------------------------------------------- Earnings Before Income Taxes 2,199 4,735 7,462 8,336 Provision for Income Taxes 880 1,905 2,999 3,521 ------------------------------------------- Net Earnings $ 1,319 $2,830 $4,463 $ 4,815 ==========================================- Net Earnings per Share: Basic $ .11 $ .16 $ .18 ============================== Diluted $ .11 $ .16 $ .17 ============================== Weighted Average Shares Outstanding: Basic 25,548 27,420 27,420 ============================== Diluted 26,082 27,905 28,016 ============================== Quarter Ended ----------------------------------------- March 31, June 30, Sept. 30, Dec. 31, 1997 1997 1997 1997 - -------------------------------------------------------------------------------- Year ended December 31, 1997: Revenue $ 1 $ 229 $ 1,530 $ 4,698 Cost of Services 423 315 1,075 2,388 ------------------------------------------ Gross Margin (loss) (422) (86) 455 2,310 Selling, General and Administrative 1,049 1,048 1,294 2,726 Depreciation and Amortization 14 88 125 216 ------------------------------------------ Loss from Operations (1,485) (1,222) (964) (632) Interest Expense, Net 67 108 102 78 ------------------------------------------ Net Loss $(1,552) $(1,330) $(1,066) $ (710) =========================================== US LEC o The Competitive Telephone Company Independent Auditors' Report 36 Board of Directors US LEC Corp. Charlotte, North Carolina We have audited the accompanying consolidated balance sheets of US LEC Corp. (the "Company") and subsidiaries as of December 31, 1997 and 1998, and the related consolidated statements of operations, stockholders' equity (deficiency), and cash flows for the period from June 6, 1996 (inception) to December 31, 1996 and the years ended December 31, 1997 and 1998. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. 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 financial statements present fairly, in all material respects, the financial position of US LEC Corp. and subsidiaries as of December 31, 1997 and 1998, and the results of their operations and their cash flows for the period from June 6, 1996 (inception) to December 31, 1996 and the years ended December 31, 1997 and 1998 in conformity with generally accepted accounting principles. As discussed in Note 6 to the financial statements, a significant portion of the Company's accounts receivable and revenues relate to reciprocal compensation which is currently in dispute. /s/ DELOITTE & TOUCHE, LLP ----------------------- February 6, 1999 (February 26, 1999 as to Note 6) Charlotte, North Carolina Board of Directors - -------------------------------------------------------------------------------- Richard T. Aab David M. Flaum (1)(2) Chairman of the Board and President Chief Executive Officer Flaum Management US LEC Corp. Company, Inc. Tansukh V. Ganatra Steven L. Schoonover (1)(2) President and Chief President and Chief Operating Officer Executive Officer US LEC Corp. CellXion, Inc. (1) Member of Audit Committee (2) Member of Compensation Committee Executive Officers - -------------------------------------------------------------------------------- Richard T. Aab Chairman of the Board and Chief Executive Officer Tansukh V. Ganatra President and Chief Operating Officer Michael K. Robinson Executive Vice President - Chief Financial Officer Gary D. Grefrath Executive Vice President - Administration David C. Conner Executive Vice President - Engineering and Operations and Chief Technology Officer Michael K. Simmons Executive Vice President - Corporate Development Aaron D. Cowell, Jr. Executive Vice President, General Counsel and Secretary Craig K. Simpson Executive Vice President - Sales Corporate Information - -------------------------------------------------------------------------------- Form 10-K/Investor Contact A copy of the Company's Annual Report on Form 10-K, filed with the Securities and Exchange Commission, may be obtained from the Company at no charge. Requests for the Annual Report on Form 10-K and other investor contacts should be directed to Michael K. Robinson, Executive Vice President and Chief Financial Officer, at the Company's corporate office. Common Stock and Dividend Information The Company's common stock trades on The Nasdaq National Market under the symbol CLEC. As of March 8, 1999, US LEC Corp. had approximately 6,744 beneficial holders of its common stock. Of that total, 148 were stockholders of record. To date, the Company has not paid cash dividends on its common stock. The Company currently intends to retain earnings to support operations and finance expansion and therefore does not anticipate paying cash dividends in the foreseeable future. The following table sets forth the high and low sales price information as reported by Nasdaq during the period indicated since the Company's 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 *No public market for the stock prior to April 24, 1998 Annual Stockholders' Meeting The annual meeting of stockholders will be held on Tuesday, April 20, 1999, at 10:00 a.m. local time at the Company's corporate office. Corporate Office US LEC Corp. Transamerica Square 401 North Tryon Street, Suite 1000 Charlotte, North Carolina 28202 704-319-1000 Internet Address http://www.uslec.com Registrar and Transfer Agent First Union National Bank Charlotte, North Carolina Independent Auditors Deloitte & Touche LLP Charlotte, North Carolina Legal Counsel Moore & Van Allen, PLLC Charlotte, North Carolina Swidler Berlin Shereff Friedman, LLP Washington, D.C. EX-21 3 EXHIBIT 21 EXHIBIT 21 SUBSIDIARIES OF REGISTRANT US LEC of North Carolina Inc. (North Carolina Corporation) US LEC of Georgia Inc. (Delaware Corporation) US LEC of Tennessee Inc. (Delaware Corporation) US LEC of Florida Inc. (North Carolina Corporation) US LEC of South Carolina Inc. (Delaware Corporation) US LEC of Alabama Inc. (North Carolina Corporation) US LEC of Maryland Inc. (North Carolina Corporation) US LEC of Pennsylvania Inc. (North Carolina Corporation) US LEC of Virginia L.L.C. (Delaware Limited Liability Company) EX-23 4 EXHIBIT 23 EXHIBIT 23 INDEPENDENT AUDITORS' CONSENT US LEC Corp. We consent to the incorporation by reference in Registration Statement No. 333-6167 of US LEC Corp. and subsidiaries on Form S-8 of our report dated February 6, 1999 (February 26, 1999 as to Note 6), which report includes an emphasis of a matter paragraph as to a significant portion of the Company's accounts receivables and revenues relating to reciprocal compensation currently in dispute; incorporated by reference in this annual Report on Form 10-K of US LEC Corp. and subsidiaries for the year ended December 31, 1998. DELOITTE & TOUCHE LLP Charlotte, North Carolina March 30, 1999 EX-27 5 FDS -- US LEC
5 12-MOS DEC-31-1998 JAN-01-1998 DEC-31-1998 0 0 78,238 12,024 0 112,184 61,277 5,058 170,203 35,969 0 0 0 274 112,701 170,203 0 84,716 0 33,646 0 0 237 22,732 9,305 0 0 0 0 13,427 0.53 0.52
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