-----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, WdH8wadZoWD3vX7VYbzpOj1Lf28kIkSwRehiprD01R5ZHDAMjQYNd+iYMcmL+M8b dleCuSVmFAe8xUniJ3h3RA== 0000794323-99-000046.txt : 19990811 0000794323-99-000046.hdr.sgml : 19990811 ACCESSION NUMBER: 0000794323-99-000046 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 19990630 FILED AS OF DATE: 19990810 FILER: COMPANY DATA: COMPANY CONFORMED NAME: LEVEL 3 COMMUNICATIONS INC CENTRAL INDEX KEY: 0000794323 STANDARD INDUSTRIAL CLASSIFICATION: TELEPHONE & TELEGRAPH APPARATUS [3661] IRS NUMBER: 470210602 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: SEC FILE NUMBER: 000-15658 FILM NUMBER: 99683144 BUSINESS ADDRESS: STREET 1: 1025 ELDORADO BOULEVARD STREET 2: 14TH FLOOR CITY: BROOMFIELD STATE: CO ZIP: 80021 BUSINESS PHONE: 3039263000 MAIL ADDRESS: STREET 1: 1000 KIEWIT PLAZA STREET 2: 14TH FL CITY: OMAHA STATE: NE ZIP: 68131 FORMER COMPANY: FORMER CONFORMED NAME: KIEWIT PETER SONS INC DATE OF NAME CHANGE: 19920703 10-Q 1 FORM 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Quarterly Period Ended June 30, 1999 or [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period______ to ______ Commission file number 0-15658 LEVEL 3 COMMUNICATIONS, INC. (Exact name of registrant as specified in its charter) Delaware 47-0210602 (State of Incorporation) (I.R.S. Employer Identification No.) 1025 Eldorado Blvd., Broomfield, CO 80021 (Address of principal executive offices) (Zip Code) (720) 888-1000 (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports(s)), and (2) has been subject to such filing requirements for the past 90 days. Yes X No The number of shares outstanding of each class of the issuer's common stock, as of July 30, 1999: Common Stock 339,885,905 shares LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES Part I - Financial Information Item 1. Financial Statements: Consolidated Condensed Statements of Operations Consolidated Condensed Balance Sheets Consolidated Condensed Statements of Cash Flows Consolidated Statement of Changes in Stockholders' Equity Consolidated Statements of Comprehensive Income Notes to Consolidated Condensed Financial Statements Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Part II - Other Information Item 4. Submission of Matters to a Vote of Security Holders Item 6. Exhibits and Reports on Form 8-K Signatures Index to Exhibits LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES Consolidated Condensed Statements of Operations (unaudited) Three Months Ended Six Months Ended June 30, June 30, (dollars in millions,except share data) 1999 1998 1999 1998 - -------------------------------------------------------------------------------- Revenue $ 106 $ 103 $ 208 $ 190 Costs and Expenses: Cost of revenue 81 49 143 91 Depreciation and amortization 51 10 92 16 Selling, general and administrative expenses 157 55 282 103 Write-off of in-process research & development - 30 - 30 ----- ----- ---- ----- Total costs and expenses 289 144 517 240 ----- ----- ---- ----- Loss from Operations (183) (41) (309) (50) Other Income (Expense): Interest income 57 45 107 71 Interest expense, net (45) (36) (98) (40) Gain on equity investee stock transactions 111 21 111 21 Other, net (7) (25) (30) (47) ----- ----- ---- ----- Total other income 116 5 90 5 ----- ----- ---- ----- Loss Before Income Taxes and Discontinued Operations (67) (36) (219) (45) Income Tax Benefit 23 2 70 5 ----- ----- ---- ----- Loss from Continuing Operations (44) (34) (149) (40) Discontinued Operations: Gain on split-off of Construction Group - - - 608 Gain on disposition of energy business, net of income tax expense of $175 - - - 324 ----- ----- ---- ----- Earnings from discontinued operations - - - 932 ----- ----- ---- ----- Net Earnings (Loss) $ (44) $ (34) $(149) $ 892 ===== ===== ===== ===== Earnings(Loss)Per Share (Basic and Diluted): Continuing operations $(.13) $(.11) $(.45) $(.14) ===== ===== ===== ===== Discontinued operations $ - $ - $ - $3.14 ===== ===== ===== ===== Net earnings (loss) $(.13) $(.11) $(.45) $3.00 ===== ===== ===== ===== Net earnings (loss), excluding gain on split-off of Construction Group $(.13) $(.11) $(.45) $0.96 ===== ===== ===== ===== - ------------------------------------------------------------------------------- See accompanying notes to consolidated condensed financial statements.
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES Consolidated Condensed Balance Sheets (unaudited) June 30, December 31, (dollars in millions, except share data) 1999 1998 - -------------------------------------------------------------------------------- Assets Current Assets Cash and cash equivalents $ 795 $ 842 Marketable securities 3,383 2,863 Restricted securities 34 32 Accounts receivable, net 111 57 Income taxes receivable 89 54 Other 42 29 ------ ------ Total Current Assets 4,454 3,877 Property, Plant and Equipment, net 2,185 1,061 Investments 387 323 Other Assets, net 324 264 ------ ------ $7,350 $5,525 ====== ====== - --------------------------------------------------------------------------- See accompanying notes to consolidated condensed financial statements.
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES Consolidated Condensed Balance Sheets (unaudited) June 30, December 31, (dollars in millions, except share data) 1999 1998 - -------------------------------------------------------------------------------- Liabilities and Stockholders' Equity Current Liabilities: Accounts payable $ 478 $ 276 Current portion of long-term debt 6 5 Accrued payroll and employee benefits 39 16 Accrued interest 33 33 Deferred revenue 56 1 Other 44 39 ------ ------ Total Current Liabilities 656 370 Long-Term Debt, less current portion 2,667 2,641 Deferred Income Taxes 57 86 Accrued Reclamation Costs 95 96 Other Liabilities 266 167 Commitments and Contingencies Stockholders' Equity: Preferred stock, $.01 par value, authorized 10,000,000 shares; no shares outstanding in 1999 and 1998 - - Common Stock: Common Stock,$.01 par value, authorized 1,500,000,000 shares; 339,616,599 shares outstanding in 1999 and 307,874,706 outstanding in 1998 3 3 Class R, $.01 par value, authorized 8,500,000 shares, no shares outstanding in 1999 and 1998 - - Additional paid-in capital 2,372 765 Accumulated other comprehensive (loss) income (10) 4 Retained earnings 1,244 1,393 ------ ------ Total Stockholders' Equity 3,609 2,165 ------ ------ $7,350 $5,525 ====== ====== - ---------------------------------------------------------------------------- See accompanying notes to consolidated condensed financial statements.
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES Consolidated Condensed Statements of Cash Flows (unaudited) Six Months Ended June 30, (dollars in millions) 1999 1998 - -------------------------------------------------------------------------------- Cash flows from continuing operations: Net cash provided by (used in)continuing operations $ 159 $ (62) Cash flows from investing activities: Proceeds from sales and maturities of marketable securities 2,769 2,484 Purchases of marketable securities (3,275) (4,713) Investments (3) (22) Proceeds from sale of property, plant and equipment and other investments 11 26 Capital expenditures (1,215) (144) Other 1 - ------ ------ Net cash used in investing activities (1,712) (2,369) Cash flows from financing activities: Payments on long-term debt including current portion (4) (5) Issuance of long-term debt 1 1,937 Issuances of common stock 1,496 21 Proceeds from exercise of stock options 13 7 Exchange of Class C Stock for Common Stock, net - 122 ------ ------ Net cash provided by financing activities 1,506 2,082 Cash flows from discontinued operations: Proceeds from sale of energy operations, net of income tax payments of $96 million - 1,063 ------ ------ Net cash provided by discontinued operations - 1,063 ------ ------ Net change in cash and cash equivalents (47) 714 Cash and cash equivalents at beginning of year 842 87 ------ ------ Cash and cash equivalents at end of period $ 795 $ 801 ====== ======
The activities of the Construction & Mining Group have been removed from the consolidated condensed statements of cash flows in 1998. The Construction Group had cash flows of ($62) million for the three months ended March 31, 1998. - ------------------------------------------------------------------------------- See accompanying notes to consolidated condensed financial statements. LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES Consolidated Statement of Changes in Stockholders' Equity For the six months ended June 30, 1999 (unaudited) Accumulated Additional Other Common Paid-in Comprehensive Retained (dollars in millions) Stock Capital Income (Loss) Earnings Total - -------------------------------------------------------------------------------- Balance at December 31, 1998 $ 3 $ 765 $ 4 $ 1,393 $ 2,165 Common Stock: Issuances, net - 1,503 - - 1,503 Stock options exercised - 13 - - 13 Stock option grants - 49 - - 49 Income tax benefit from exercise of options - 42 - - 42 Net Loss - - - (149) (149) Other Comprehensive Loss - - (14) - (14) ------ ------ ------ ------ ------ Balance at June 30, 1999 $ 3 $2,372 $ (10) $ 1,244 $ 3,609 ====== ====== ====== ======= ======= - ------------------------------------------------------------------------------- See accompanying notes to consolidated condensed financial statements.
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES Consolidated Statements of Comprehensive Income (Loss) (unaudited) Three Months Ended Six Months Ended June 30, June 30, (dollars in millions) 1999 1998 1999 1998 - -------------------------------------------------------------------------------- Net (Loss) Earnings $ (44) $ (34) $ (149) $ 892 Other Comprehensive (Loss) Income Before Tax: Foreign currency translation adjustments (6) - (8) 1 Unrealized holding (loss) gain arising during period 1 (5) (2) 3 Reclassification adjustment for losses (gains) included in net earnings (loss) (14) (3) (12) (8) ------ ------ ------ ------ Other Comprehensive (Loss) Before Tax (19) (8) (22) (4) Income Tax Benefit Related to Items of Other Comprehensive (Loss) 7 3 8 2 ------ ------ ------ ------ Other Comprehensive (Loss) Net of Taxes (12) (5) (14) (2) ------ ------ ------ ------ Comprehensive (Loss) Income $ (56) $ (39) $ (163) $ 890 ====== ====== ====== ====== - ------------------------------------------------------------------------------- See accompanying notes to consolidated condensed financial statements.
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES Notes to Consolidated Condensed Financial Statements 1. Basis of Presentation The consolidated condensed balance sheet of Level 3 Communications, Inc. and subsidiaries ("Level 3" or the "Company"), at December 31, 1998 has been condensed from the Company's audited balance sheet as of that date. All other financial statements contained herein are unaudited and, in the opinion of management, contain all adjustments (consisting only of normal recurring accruals) necessary for a fair presentation of financial position, results of operations and cash flows for the periods presented. The Company's accounting policies and certain other disclosures are set forth in the notes to the consolidated financial statements contained in the Company's Annual Report on Form 10-K, for the year ended December 31, 1998. These financial statements should be read in conjunction with the Company's audited consolidated financial statements and notes thereto. The preparation of the consolidated condensed financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities and the reported amount of revenue and expenses during the reported period. Actual results could differ from these estimates. The Company has embarked on a plan to become a facilities-based provider (that is, a provider that owns or leases a substantial portion of the property, plant and equipment necessary to provide its services) of a broad range of integrated communications services in the United States, Europe and Asia. To reach this goal, the Company is expanding substantially the business of its PKS Information Services, Inc. subsidiary and creating, through a combination of construction, purchase and leasing of facilities and other assets, an international, end-to-end, facilities-based communications network (the "Business Plan"). The Company is building the network based on Internet Protocol ("IP") technology in order to leverage the efficiencies of this technology to provide lower cost communications services. In 1997, the Company agreed to sell its energy assets to MidAmerican Energy Holding Company, Inc. (f/k/a CalEnergy Company, Inc.) ("MidAmerican") and to separate the construction operations ("Construction Group") from the Company. On January 2, 1998, the Company completed the sale of its energy assets to MidAmerican. On March 31, 1998, the Company completed the split-off of the Construction Group to stockholders that held Class C Stock. Therefore, the results of operations of both businesses have been classified as discontinued operations on the consolidated condensed statements of operations for 1998. On May 1, 1998, the Company's Board of Directors changed Level 3's fiscal year end from the last Saturday in December to a calendar year end. The additional four days for the period ending June 30 1998, were not material to the overall results of operations and cash flows. The results of operations for the six months ended June 30, 1999, are not necessarily indicative of the results expected for the full year. Where appropriate, items within the consolidated condensed financial statements have been reclassified from the previous periods to conform to current period presentation. 2. Reorganization - Discontinued Construction Operations Prior to March 31, 1998, the Company had a two-class capital structure. The Company's Class C Stock reflected the performance of the Construction Group and the Class D Stock reflected the performance of the other businesses, including communications, information services and coal mining. In 1997 the Board of Directors of Level 3 approved a proposal for the separation of the Construction Group from the other operations of the Company through a split-off of the Construction Group (the "Split-off"). In December 1997, the Company's stockholders approved the Split-off and on March 5, 1998 the Company received a ruling from the Internal Revenue Service that stated the Split-off would be tax-free to U.S. stockholders. The Split-off was effected on March 31, 1998. As a result of the Split-off, the Company no longer owns any interest in the Construction Group. Accordingly, the separate financial statements and management's discussion and analysis of financial condition and results of operations of Peter Kiewit Sons', Inc. should be obtained to review the results of operations of the Construction Group for the three months ended March 31, 1998. On March 31, 1998, the Company reflected the fair value of the Construction Group as a distribution to the Class C stockholders because the distribution was considered non-pro rata as compared to the Company's previous two-class capital stock structure. The Company recognized a gain of $608 million within discontinued operations, equal to the difference between the carrying value of the Construction Group and its fair value in accordance with Financial Accounting Standards Board Emerging Issues Task Force Issue 96-4, "Accounting for Reorganizations Involving a Non-Pro Rata Split-off of Certain Nonmonetary Assets to Owners". No taxes were provided on this gain due to the tax-free nature of the Split-off. In connection with the Split-off, the Class D Stock became the common stock of Level 3 Communications, Inc. ("Common Stock"), and shortly thereafter, began trading on the Nasdaq National Market on April 1, 1998, under the symbol "LVLT". 3. Discontinued Energy Operations On January 2, 1998, the Company completed the sale of its energy assets to MidAmerican. These assets included approximately 20.2 million shares of MidAmerican common stock (assuming the exercise of 1 million options held by Level 3), Level 3's 30% interest in CE Electric and Level 3's investments in international power projects in Indonesia and the Philippines. Level 3 recognized an after-tax gain on the disposition of $324 million and the after-tax proceeds of approximately $967 million from the transaction are being used in part to fund the Business Plan. Results of operations for the period through January 2, 1998 were not considered significant and the gain on disposition was calculated using the carrying amount of the energy assets as of December 27, 1997. 4. Earnings (Loss) Per Share Basic earnings (loss) per share have been computed using the weighted average number of shares during each period. The Company had a loss from continuing operations for the three and six month periods ended June 30, 1999 and 1998. Therefore, the 21,868,537 options and warrants outstanding at June 30, 1999 and 19,718,014 options and warrants outstanding at June 30, 1998 have not been included in the computation of diluted earnings (loss) per share because the resulting computation would have been anti-dilutive. Effective August 10, 1998, the Company issued a dividend of one share of Level 3 Common Stock for each share of Level 3 Common Stock outstanding. All share information and per share data have been restated to reflect the stock dividend. The following details the earnings (loss) per share calculations for Level 3 Common Stock: Three Months Ended Six Months Ended June 30, June 30, 1999 1998 1999 1998 - -------------------------------------------------------------------------------- Loss From Continuing Operations (in millions) $ (44) $ (34) $ (149) $ (40) Discontinued Operations: Gain on Split-off of Construction Group - - - 608 Earnings from Discontinued Energy Operations - - - 324 ----- ----- ----- ----- Net earnings (loss) $ (44) $ (34) $(149) $ 892 ===== ===== ===== ===== Total Number of Weighted Average Shares Outstanding Used to Compute Basic and Diluted Earnings Per Share (in thousands) 339,266 301,786 327,840 296,986 ======= ======= ======= ======= Earnings (Loss) Per Share (Basic and Diluted): Continuing operations $ (.13) $ (.11) $ (.45) $ (.14) ======= ======= ======= ======= Discontinued operations $ - $ - $ - $ 3.14 ======= ======= ======= ======= Net earnings (loss) $ (.13) $ (.11) $ (.45) $ 3.00 ======= ======= ======= ======= Net earnings (loss), excluding gain on Split-off of Construction Group $ (.13) $ (.11) $ (.45) $ .96 ======= ======= ======= ======= - -------------------------------------------------------------------------------
5. Acquisitions On January 5, 1999, Level 3 acquired BusinessNet Ltd. ("BusinessNet"), a leading London-based internet service provider in a largely stock-for-stock transaction valued at $12 million and accounted for as a purchase. After completion of certain adjustments, the Company agreed to issue approximately 400,000 shares of Common Stock and paid $1 million in cash in exchange for all of the issued and outstanding shares of BusinessNet's capital stock. Of the approximately 400,000 shares Level 3 agreed to issue in connection with the acquisition, approximately 150,000 shares of Level 3 Common Stock have been pledged to Level 3 to secure certain indemnification obligations of the former BusinessNet stockholders. The pledge of these shares will terminate in approximately 18 months from the acquisition date, unless otherwise extended pursuant to the terms of the acquisition agreement. Liabilities exceeded assets acquired, and goodwill of $16 million was recognized from the transaction which is being amortized over five years. On April 23, 1998, the Company acquired XCOM Technologies, Inc. ("XCOM"), a privately held company that has developed technology which the Company believes will provide certain key components necessary for the Company to develop an interface between its IP-based network and the existing public switched telephone network. The Company issued approximately 5.3 million shares of Level 3 Common Stock and 0.7 million options and warrants to purchase Level 3 Common Stock in exchange for all the stock, options and warrants of XCOM. The Company accounted for this transaction, valued at $154 million, as a purchase. Of the total purchase price, $115 million was originally allocated to in-process research and development and was taken as a nondeductible charge to earnings in the second quarter of 1998. The purchase price exceeded the fair value of the net assets acquired by $30 million which was recognized as goodwill. In October 1998, the Securities and Exchange Commission ("SEC") issued new guidelines for valuing acquired research and development which are applied retroactively. The Company believes its accounting for the acquisition was made in accordance with generally accepted accounting principles and established appraisal practices at the time of the acquisition. However, due to the significance of the charge relative to the total value of the acquisition, the Company reviewed the facts with the SEC. Consequently, using the revised guidelines and assumptions, the Company reduced the charge for in-process research and development from $115 to $30 million, and increased the related goodwill by $85 million. The goodwill associated with the XCOM transaction is being amortized over a five year period. The results for the three and six months ended June 30, 1998 have been restated to reflect the reduced charge for in-process research and development and increased amortization expense. The Company believes that its resulting charge for acquired research and development conforms to the SEC's expressed guidelines and methodologies. However, no assurances can be given that the SEC will not require additional adjustments. The cumulative operating results of BusinessNet, XCOM and other 1998 acquisitions were not significant relative to the Company's 1999 and 1998 results. For the Company's acquisitions, the excess purchase price over the fair market value of the underlying assets was allocated to goodwill and other intangible assets and property based upon preliminary estimates of fair value. The final purchase price allocation for XCOM did not vary significantly from preliminary estimates. The Company does not believe that the final purchase price allocation will vary significantly from the preliminary estimates for the entities acquired after June 30, 1998. 6. Property, Plant and Equipment, net Construction in Progress The Company is currently constructing its communications network. Costs associated directly with the uncompleted network and interest expense incurred during construction are capitalized based on the weighted average accumulated construction expenditures and the interest rates related to borrowings associated with the construction. Certain gateway facilities, local networks and operating equipment have been placed in service during 1999. These assets are being depreciated over their useful lives, primarily ranging from 3-20 years. As other segments of the network are placed in service, the assets will be depreciated over their useful lives. The Company is currently developing business support systems required for its Business Plan. The external direct costs of software, materials and services, payroll and payroll related expenses for employees directly associated with the project and interest costs incurred when developing the business support systems are capitalized. Upon completion of the projects, the total cost of the business support systems are amortized over their useful lives of 3 years. For the six months ended June 30, 1999, the Company invested $1,118 million in its communications business, including $429 million on the U.S. intercity network, $207 million on international networks, $85 million on transoceanic networks and $284 million on gateway facilities and local networks. Capitalized business support systems and network construction costs that have not been placed in service have been classified as construction-in-progress within Property, Plant and Equipment below. Accumulated Book (dollars in millions) Cost Depreciation Value - -------------------------------------------------------------------------------- June 30, 1999 Land and Mineral Properties $ 35 $ (11) $ 24 Facility and Leasehold Improvements: Communications 114 (2) 112 Information Services 26 (2) 24 Coal Mining 18 (15) 3 CPTC 91 (8) 83 Operating Equipment: Communications 294 (43) 251 Information Services 58 (34) 24 Coal Mining 176 (155) 21 CPTC 17 (6) 11 Network Construction Equipment 79 (4) 75 Furniture and Office Equipment 90 (26) 64 Other 75 (15) 60 Construction-in-Progress 1,433 - 1,433 ------ ------ ------ $2,506 $ (321) $2,185 ====== ====== ====== December 31, 1998 Land and Mineral Properties $ 32 $ (11) $ 21 Facility and Leasehold Improvements: Communications 80 (1) 79 Information Services 24 (2) 22 Coal Mining 18 (15) 3 CPTC 91 (5) 86 Operating Equipment: Communications 245 (18) 227 Information Services 53 (30) 23 Coal Mining 180 (155) 25 CPTC 17 (4) 13 Network Construction Equipment 46 (1) 45 Furniture and Office Equipment 67 (10) 57 Other 72 (2) 70 Construction-in-Progress 390 - 390 ------ ------ ------ $1,315 $ (254) $1,061 ====== ====== ====== - -------------------------------------------------------------------------------
7. Investments The Company holds significant equity positions in two publicly traded companies; RCN Corporation ("RCN") and Commonwealth Telephone Enterprises, Inc. ("Commonwealth Telephone"). RCN is a facilities-based provider of communications services to the residential market primarily in the northeastern United States and California. RCN provides local and long distance phone, cable television and Internet services in several markets; including Boston, New York, Washington, D.C., and California's San Francisco to San Diego corridor. Commonwealth Telephone holds Commonwealth Telephone Company, an incumbent local exchange carrier operating in various rural Pennsylvania markets, and CTSI, Inc., a competitive local exchange carrier which commenced operations in 1997. On June 30, 1999, Level 3 owned approximately 35% and 48% of the outstanding shares of RCN and Commonwealth Telephone, respectively, and accounts for each entity using the equity method. The market value of the Company's investment in the two entities was $1,109 million and $431 million, respectively, on June 30, 1999. The Company recognizes gains from the sale, issuance and repurchase of stock by its subsidiaries and equity method investees in its statement of operations. During 1999, RCN issued stock in a public offering and for certain transactions which diluted the Company's ownership of RCN from 41% at December 31, 1998 to 35% at June 30, 1999. The increase in the Company's proportionate share of RCN's net assets as a result of these transactions resulted in a pre-tax gain of $111 million for the Company in the second quarter of 1999. The Company also recognized a gain of $21 million in the second quarter of 1998 related to stock transactions of RCN. The following is summarized financial information of RCN and Commonwealth Telephone for the three and six months ended June 30, 1999 and 1998, and as of June 30, 1999 and December 31, 1998 (in millions): Three Months Ended Six Months Ended June 30, June 30, Operations 1999 1998 1999 1998 - -------------------------------------------------------------------------------- RCN Corporation: Revenue $ 67 $ 50 $ 134 $ 90 Net loss available to common shareholders (68) (49) (136) (117) Level 3's share: Net loss (25) (22) (52) (53) Goodwill amortization (1) - (1) - ------- ------ ------ ----- Equity in net loss $ (26) $ (22) $ (53) $ (53) ======= ====== ====== ===== Commonwealth Telephone Enterprises: Revenue $ 63 $ 56 $ 124 $ 109 Net income available to common shareholders 6 5 11 9 Level 3's share: Net income 3 2 5 4 Goodwill amortization - - (1) (1) ------- ------ ----- ----- Equity in net income $ 3 $ 2 $ 4 $ 3 ======= ====== ===== =====
Commonwealth RCN Telephone Corporation Enterprises Financial Position 1999 1998 1999 1998 - -------------------------------------------------------------------------------- Current assets $ 1,837 $ 1,093 $ 78 $ 79 Other assets 1,023 815 387 354 ------- ------- ----- ----- Total assets 2,860 1,908 465 433 Current liabilities 174 178 85 85 Other liabilities 1,741 1,282 245 223 Minority interest 103 77 - - Preferred stock 244 - - - ------ ------ ----- ----- Total liabilities and preferred stock 2,262 1,537 330 308 ------ ------ ----- ----- Common Equity $ 598 $ 371 $ 135 $ 125 ====== ====== ===== ===== Level 3's share: Equity in net assets $ 214 $ 150 $ 65 $ 60 Goodwill 28 34 55 56 ------ ------ ----- ----- $ 242 $ 184 $ 120 $ 116 ====== ====== ===== ===== - -------------------------------------------------------------------------------- Investments at June 30, 1999 and December 31, 1998 also include $23 million for the Company's investment in the Pavilion Towers office buildings in Aurora, Colorado.
8. Other Assets, net At June 30, 1999 and December 31, 1998 other assets consisted of the following: (in millions) 1999 1998 - -------------------------------------------------------------------------------- Goodwill: XCOM, net of accumulated amortization of $26 and $15 $ 86 $ 100 GeoNet, net of accumulated amortization of $3 and $1 18 20 BusinessNet, net of accumulated amortization of $2 and $- 14 - Other, net of accumulated amortization of $4 and $1 16 19 Prepaid Network Assets 77 - Deferred Debt Issuance Costs 63 67 Deferred Development and Financing Costs 15 15 Unrecovered Mine Development Costs 15 15 Leases 7 9 Timberlands 6 6 Other 7 13 ----- ------ Total other assets $ 324 $ 264 ===== ====== - --------------------------------------------------------------------------------
9. Long-Term Debt 9.125% Senior Notes On April 28, 1998, the Company received $1.94 billion of net proceeds from an offering of $2 billion aggregate principal amount 9.125% Senior Notes Due 2008 ("Senior Notes"). Interest on the notes accrues at 9.125% per year and is payable on May 1 and November 1 each year in cash. Debt issuance costs of $65 million were capitalized and are being amortized as interest expense over the term of the Senior Notes. 10.5% Senior Discount Notes On December 2, 1998, the Company sold $834 million aggregate principal amount at maturity of 10.5% Senior Discount Notes Due 2008 ("Senior Discount Notes"). The sales proceeds of $500 million, excluding debt issuance costs, were recorded as long term debt. Interest on Senior Discount Notes accretes at a rate of 10.5% per annum, compounded semiannually, to an aggregate principal amount of $834 million by December 1, 2003. Cash interest will not accrue on the Senior Discount Notes prior to December 1, 2003; however, the Company may elect to commence the accrual of cash interest on all outstanding Senior Discount Notes on or after December 1, 2001. Accrued interest expense for the six months ended June 30, 1999 on the Senior Discount Notes of $27 million was added to long-term debt. Debt issuance costs of $14 million have been capitalized and are being amortized as interest expense over the term of the Senior Discount Notes. The Company capitalized $20 and $31 million of interest expense and amortized debt issuance costs related to network construction and business systems development projects for the three and six months ended June 30, 1999 and $1 million for the three and six months ended June 30, 1998. 10. Employee Benefit Plans The Company adopted the recognition provisions of SFAS No. 123, "Accounting for Stock Based Compensation" ("SFAS No. 123") in 1998. Under SFAS No. 123, the fair value of an option (as computed in accordance with accepted option valuation models) on the date of grant is amortized over the vesting periods of the options. The recognition provisions of SFAS No. 123 are applied prospectively upon adoption. As a result, the recognition provisions are applied to all stock awards granted in the year of adoption and are not applied to awards granted in previous years unless those awards are modified or settled in cash after adoption of the recognition provisions. Although the recognition of the value of the stock awards results in compensation or professional expenses in an entity's financial statements, the expense differs from other compensation and professional expenses in that these charges will not be settled in cash, but rather, generally, through issuance of common stock. The Company believes that the adoption of SFAS No. 123 will result in material non-cash charges to operations in 1999 and thereafter. The amount of the non-cash charges will be dependent upon a number of factors, including the number of grants and the fair value of each grant estimated at the time of its award. Non-Qualified Stock Options and Warrants The Company granted 55,100 nonqualified stock options with a fair value of $1 million ("NQSO") to employees during the six months ended June 30, 1999. The expense recognized for the three and six months ended June 30, 1999 for NQSOs and warrants outstanding at June 30, 1999 in accordance with SFAS No. 123 was $4 million and $2 million, respectively. In addition to the expense recognized, the Company capitalized $- and $1 million of non-cash compensation costs for the three and six months ended June 30, 1999, respectively related to NQSOs and warrants for employees directly involved in the construction of the IP network and the development of the business support systems. The Company recognized $4 million and $6 million of expense for the three and six months ended June 30, 1998 for NQSOs and warrants granted during the six months ended June 30, 1998. Outperform Stock Option Plan In April 1998, the Company adopted an outperform stock option ("OSO") program that was designed so that the Company's stockholders would receive a market return on their investment before OSO holders receive any return on their options. The Company believes that the OSO program aligns directly management's and stockholders' interests by basing stock option value on the Company's ability to outperform the market in general, as measured by the Standard & Poor's ("S&P") 500 Index. Participants in the OSO program do not realize any value from awards unless the Common Stock price outperforms the S&P 500 Index. When the stock price gain is greater than the corresponding gain on the S&P 500 Index, the value received for awards under the OSO plan is based on a formula involving a multiplier related to the level by which the Common Stock outperforms the S&P 500 Index. To the extent that the Common Stock outperforms the S&P 500, the value of OSOs to a holder may exceed the value of non-qualified stock options. OSO grants are made quarterly to participants employed on the date of the grant. Each award vests in equal quarterly installments over two years and has a four-year life. Each award typically has a two-year moratorium on exercising from the date of grant. As a result, once a participant is 100% vested in the grant, the two year moratorium expires. Therefore, each grant has an exercise window of two years. The fair value recognized under SFAS No. 123 for the 1,525,702 OSOs granted to employees and consultants for services performed for the six months ended June 30, 1999 was $96 million. The Company recognized $25 million and $39 million of compensation expense for the three and six months ended June 30, 1999 for OSOs granted in 1999 and 1998. In addition to the expense recognized, $2 million and $3 million of non-cash compensation was capitalized for the three and six months ended June 30, 1999 for employees directly involved in the construction of the IP network and development of business support systems. The Company recognized $5 million of expense for the three and six months ended June 30, 1998 for OSOs outstanding at June 30, 1998. Shareworks and Restricted Stock The Company recorded $2 million and $4 million of non-cash compensation expense for the three and six months ended June 30, 1999 related to the shareworks and restricted stock programs adopted in the third quarter of 1998. 11. Stockholders' Equity On March 9, 1999 the Company closed the offering of 28,750,000 shares of its Common Stock through an underwritten public offering. The net proceeds from the offering of approximately $1.5 billion after underwriting discounts and offering expenses will be used for working capital, capital expenditures, acquisitions and other general corporate purposes in connection with the implementation of the Company's Business Plan. 12. Industry Data In 1998, the Company adopted SFAS No. 131 "Disclosures about Segments of an Enterprise and Related Information". SFAS No. 131 establishes standards for reporting information about operating segments in annual financial statements and requires selected information about operating segments in interim financial reports issued to stockholders. Operating segments are components of an enterprise for which separate financial information is available and which is evaluated regularly by the Company's chief operating decision maker, or decision making group, in deciding how to allocate resources and assess performance. Operating segments are managed separately and represent strategic business units that offer different products and serve different markets. The Company's reportable segments include: communications and information services (including communications, computer outsourcing and systems integration segments), and coal mining. Other primarily includes California Private Transportation Company L.P. ("CPTC"), a privately owned tollroad in southern California, equity investments and other corporate assets and overhead not attributable to a specific segment. Industry data for the Company's discontinued construction and energy operations are not included. EBITDA, as defined by the Company, consists of earnings (loss) before interest, income taxes, depreciation, amortization, non-cash operating expenses (including stock-based compensation and in- process research and development charges) and other non-operating income or expense. The Company excludes noncash compensation due to its adoption of the expense recognition provisions of SFAS No. 123. EBITDA is commonly used in the communications industry to analyze companies on the basis of operating performance. EBITDA is not intended to represent cash flow for the periods. The information presented in the table below includes information for the three and six months periods ended June 30, 1999 and 1998 for all income statement and cash flow information presented and as of June 30, 1999 and December 31, 1998 for all balance sheet information presented. Communications & Information Services ------------------------------------- Computer Systems Coal (dollars in millions) Communications Outsourcing Integration Mining Other Total - --------------------------------------------------------------------------------------------------- 1999 - ---- Three Months Ended June 30, 1999 Revenue $ 18 $ 18 $ 17 $ 47 $ 6 $ 106 EBITDA (99) 3 - 19 (26) (103) Capital Expenditures 744 2 1 - 61 808 Depreciation and Amortization 35 2 2 1 11 51 Six Months Ended June 30, 1999 - ------------------------------ Revenue $ 33 $ 34 $ 32 $ 98 $ 11 $ 208 EBITDA (167) 7 (3) 39 (46) (170) Capital Expenditures 1,118 5 1 - 91 1,215 Depreciation and Amortization 60 4 3 2 23 92 1998 - ---- Three Months Ended June 30, 1998 - -------------------------------- Revenue $ 6 $ 15 $ 15 $ 62 $ 5 $ 103 EBITDA (29) 4 (3) 26 10 8 Capital Expenditures 97 4 1 1 23 126 Depreciation and Amortization 5 2 - 2 1 10 Six Months Ended June 30, 1998 - ------------------------------ Revenue $ 6 $ 30 $ 29 $ 115 $ 10 $ 190 EBITDA (29) 8 (3) 46 (15) 7 Capital Expenditures 107 9 3 1 24 144 Depreciation and Amortization 5 4 1 3 3 16 Identifiable Assets - ------------------- June 30, 1999 $2,292 $ 57 $ 48 $ 348 $4,605 $ 7,350 December 31, 1998 1,072 59 42 362 3,990 5,525 - ------------------------------------------------------------------------------------------------------
The following information provides a reconciliation of EBITDA to loss from continuing operations for the three and six months ended June 30, 1999 and 1998: Three Months Ended Six Months Ended June 30, June 30, (in millions) 1999 1998 1999 1998 - -------------------------------------------------------------------------------- EBITDA $ (103) $ 8 $ (170) $ 7 Depreciation and Amortization Expense (51) (10) (92) (16) Non-Cash Compensation Expense (29) (9) (47) (11) Write-off of In-Process Research and Development - (30) - (30) ------ ------ ----- ----- Loss from Operations (183) (41) (309) (50) Other Income 116 5 90 5 Income Tax Benefit 23 2 70 5 ------ ----- ----- ----- Loss from Continuing Operations $ (44) $ (34) $(149) $ (40) ====== ====== ===== ===== - --------------------------------------------------------------------------------
13. Related Party Transactions Peter Kiewit Sons', Inc. ("Kiewit") acted as the general contractor on several significant projects for the Company in 1999 and 1998. These projects include the intercity network, local loops and gateway sites, the Company's new corporate headquarters in Colorado and a new data center in Tempe, Arizona. Kiewit provided approximately $490 million and $8 million of construction services related to these projects in the first half of 1999 and 1998, respectively. In 1999, the Company entered into an agreement with RCN whereby RCN will lease cross country capacity on Level 3's nationwide network. Revenue attributable to this agreement was less than $1 million for the six months ended June 30, 1999. Also in 1999, the Company and RCN announced that it had reached joint construction agreements in several RCN markets, through which the companies will share the cost of constructing their respective fiber optic networks. Level 3 also receives certain mine management services from Kiewit. The expense for these services was $7 million and $14 million for the three and six months ended June 30, 1999, respectively and $9 million and $17 million for the three and six months ended June 30, 1998, respectively, and is recorded in selling, general and administrative expenses. 14. Other Matters Prior to the Split-off, as of January 1 of each year, holders of Class C Stock had the right to convert Class C Stock into Class D Stock, subject to certain conditions. In January 1998, holders of Class C Stock converted 2.3 million shares, with a redemption value of $122 million, into 21 million shares of Class D Stock (now known as Common Stock). The Company is involved in various lawsuits, claims and regulatory proceedings incidental to its business. Management believes that any resulting liability for legal proceedings beyond that provided should not materially affect the Company's financial position, future results of operations or future cash flows. Level 3 filed with the Securities and Exchange Commission a "universal" shelf registration statement covering up to $3.5 billion of common stock, preferred stock, debt securities and depositary shares that became effective February 17, 1999. On March 9, 1999 the Company sold 28.75 million shares, or $1.5 billion of the $3.5 billion available under the "universal" shelf registration statement, through a public offering. LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES Management's Discussion and Analysis of Financial Condition and Results of Operations The following discussion should be read in conjunction with the Company's consolidated condensed financial statements (including the notes thereto), included elsewhere herein. This document contains forward looking statements and information that are based on the beliefs of management as well as assumptions made by and information currently available to the Company. When used in this document, the words "anticipate", "believe", "estimate" and "expect" and similar expressions, as they relate to the Company or its management, are intended to identify forward-looking statements. Such statements reflect the current views of the Company with respect to future events and are subject to certain risks, uncertainties and assumptions. Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those described in this document. For a more detailed description for these risks and factors, please see the Company's additional filings with the Securities and Exchange Commission. Recent Developments BusinessNet Ltd. Acquisition On January 5, 1999, Level 3 acquired BusinessNet Ltd., a leading London-based internet service provider in a largely stock-for-stock transaction valued at $12 million and accounted for as a purchase. After completion of certain adjustments, the Company agreed to issue approximately 400,000 shares of Common Stock and paid $1 million in cash in exchange for all of the issued and outstanding shares of BusinessNet's capital stock. Of the approximately 400,000 shares Level 3 agreed to issue in connection with the acquisition, approximately 150,000 shares of Level 3 Common Stock have been pledged to Level 3 to secure certain indemnification obligations of the former BusinessNet stockholders. The pledge of these shares will terminate in approximately 18 months. Liabilities exceeded assets acquired, and goodwill of $16 million was recognized from the transaction which is being amortized over five years. Common Stock Offering Level 3 filed a "universal" shelf registration statement covering up to $3.5 billion of common stock, preferred stock, debt securities and depository shares that became effective February 17, 1999. On March 9, 1999 the Company closed the offering of 28,750,000 shares of its Common Stock through a public offering. The net proceeds from the offering of approximately $1.5 billion, after underwriting discounts and offering expenses, will be used for working capital, capital expenditures, acquisitions and other general corporate purposes in connection with the implementation of the Company's Business Plan. Increase in Authorized Shares Outstanding On February 25, 1999, the Board of Directors approved an increase in the number of authorized shares of Common Stock from 500 million to 1 billion. On April 12, 1999, the Board of Directors approved a further increase in the number of authorized shares of Common Stock by 500 million to 1.5 billion. The Company's stockholders approved the increase in authorized shares at the Company's 1999 Annual Meeting held on May 27, 1999. Transatlantic Cable On April 23, 1999, Level 3 announced that it had contracted with Tyco Submarine Systems Ltd. to design and build a transatlantic terabit cable system from Long Island, New York to North Cornwall, UK. The cable system is expected to be in service by September 2000 and is expected to cost between $600 to $800 million. The total cost will depend on how the cable is upgraded over time. Level 3 has prefunded the purchase of significant amounts of undersea capacity as part of the Business Plan, but may require additional funding depending on the cable's ultimate structure, pre-construction sales and ownership. European Network Level 3 announced on April 29, 1999 that it had finalized contracts relating to construction of Ring 1 of its European Network in France, Belgium, the Netherlands, Germany and the United Kingdom. Ring 1, which is approximately 2,000 miles, will connect Paris, Frankfurt, Amsterdam, Brussels and London. The network is expected to be ready for service by September 2000. Ring 1 is part of the approximate 3,500 mile intercity network that will ultimately connect a minimum of 13 local city networks in Europe. This European network will be linked to the Level 3 U.S. network by the Level 3 transatlantic terabit cable system currently under development, also expected to be ready for service by September 2000. On July 26, 1999, the Company announced two important developments of its European network build with an agreement with Eurotunnel and Alcatel. Eurotunnel will provide Level 3 with multiple cross-Channel cables between the United Kingdom and continental Europe. Eurotunnel will install and supply Level 3 with multiple cross-Channel cables between the United Kingdom and France through the high-security service tunnel. The first of these cables will be completed by the first quarter of 2000. Subsequent cables will be installed to upgrade and expand the network as and when required or when new fiber technology becomes available. Alcatel will provide Level 3 with a cross-Channel undersea cable link between the United Kingdom and Belgium. In the agreement Alcatel will design, develop, and install an undersea cable to link the Level 3 network between the United Kingdom and Belgium. The cable system is already under development and will be complete by the end of this year. Colt Cost Sharing Agreement On May 4, 1999, Level 3 and Colt Telecom Group plc ("Colt") announced an agreement to share costs for the construction of European networks. The agreement calls for Level 3 to share construction costs of Colt's planned 1,600 mile intercity German network linking Berlin, Cologne, Dusseldorf, Frankfurt, Hamburg, Munich and Stuttgart. In return, Colt will share construction costs of Level 3's planned European network. Lucent Agreement On June 23, 1999 Level 3 announced a minimum four year, $250 million strategic agreement with Lucent Technologies to purchase Lucent systems, including breakthrough software switches or "softswitches." The minimum purchase commitment is subject to certain conditions and has the potential to grow to $1 billion over five years. Under the agreement, Lucent will provide Level 3 its Lucent Technologies Softswitch, a software switch for IP networks that combines the reliability and features that customers expect from the public telephone network with the cost effectiveness and flexibility of IP technology. With the Lucent Softswitch, Level 3 expects to provide a full range of IP-based communications services indistinguishable in quality and ease of use from services on traditional circuit voice networks. In addition, the companies also agreed to collaborate on future enhancements of softswitches and gateway products to support next-generation broadband services for business and consumers that will combine high-quality voice and video communications with Internet-style Web data services. Results of Operations In late 1997, the Company announced a plan to increase substantially its information services business and to expand the range of services it offers by building an advanced, international, facilities-based communications network based on Internet Protocol ("IP") technology. Since the Business Plan represents a significant expansion of the Company's communications and information services business, the Company does not believe that the Company's financial condition and results of operations for prior periods will serve as a meaningful indication of the Company's future financial condition or results of operations. The Company expects to incur substantial net operating losses for the foreseeable future, and there can be no assurance that the Company will be able to achieve or sustain operating profitability in the future. Second Quarter 1999 vs. Second Quarter 1998 Revenue for the quarters ended June 30, is summarized as follows (in millions): 1999 1998 Communications and Information Services $ 53 $ 36 Coal Mining 47 62 Other 6 5 ------ ------- $ 106 $ 103 ====== =======
Communications and information services revenue for the three months ended June 30, 1999 increased 47% compared to the same period in 1998. New IP-related products which the Company began offering in late 1998 and early 1999, including private line, colocation and managed modem services, provided $18 million of revenue for the communications segment in 1999. The Company's purchase of XCOM Technologies, Inc. in April, 1998 provided $6 million of communications revenue in the second quarter of 1998 subsequent to the acquisition. A significant portion of XCOM's revenue is attributable to reciprocal compensation agreements with Bell Atlantic ("Bell Atlantic"). These agreements require the company originating a call to compensate the company terminating the call. The Federal Communication Commission ("FCC") has been considering whether local carriers are obligated to pay compensation to each other for the transport and termination of calls to Internet service providers when a local call is placed from an end user of one carrier to an Internet service provider served by the competing local exchange carrier. Recently, the FCC determined that it had no rule addressing inter-carrier compensation for these calls. The FCC also released for comment alternative federal rules to govern compensation for these calls in the future. If state commissions, the FCC or the courts determine that inter-carrier compensation does not apply, carriers may be unable to recover their costs or will be compensated at a significantly lower rate. In May, 1999 the Massachusetts Department of Public Utilities ruled that Bell Atlantic was no longer required to pay the established reciprocal compensation rates for certain services. As a result Level 3 has elected, effective at the beginning of the second quarter, not to recognize this revenue source until these uncertainties are resolved. Bell Atlantic has also notified the Company that it will be escrowing all amounts due the Company under the reciprocal compensation agreements until the issue is resolved. An unfavorable resolution to this matter may have a material adverse effect to the Company. Revenues for the computer outsourcing and systems integration businesses increased 12% and 21% to $18 million and $17 million, respectively. Revenue attributable to new customers is primarily responsible for the increase for both the computer outsourcing and systems integration businesses. Coal mining revenue decreased $15 million, or 24% in the second quarter of 1999 compared to the same period in 1998. The decrease was partially due to timing of shipments taken by Commonwealth Edison Company ("Commonwealth"). Commonwealth is obligated to purchase annually, minimum amounts of coal; however, it is Commonwealth's option as to when the coal will be purchased. Due to expiration of certain long-term coal contracts in 1998, 1999 coal revenue is expected to decline approximately 10% from 1998 levels. If current market conditions continue, the Company will experience a significant decline in coal revenue and earnings beginning in 2001 as delivery requirements under long-term contracts decline as additional long-term contracts begin to expire. Other revenue was consistent with 1998, and is primarily attributable to CPTC, a privately owned tollroad in southern California. Cost of Revenue increased 65% in 1999 to $81 million from $49 million in 1998 primarily as a result of the increase in network expenses of $36 million in 1999 related to the communications business as compared to the same period in 1998. Cost of revenue for the communications business is expected to increase substantially in the future as the Company continues to increase the number of markets in which it offers services and the products available in each of those markets. The cost of revenue for the information services business was consistent with the corresponding increase in revenue. The cost of revenue for the coal business, as a percentage of revenue, increased approximately 7% due to the expiration of the high margin long-term contract in 1998. Depreciation and Amortization expense increased to $51 million in 1999 from $10 million in 1998. The commencement of operations in 21 U.S. and 4 European markets and the completion of the initial installation of 11 local networks in the second half of 1998 and the first half of 1999 resulted in the higher depreciation expense in 1999. In addition, the amortization of goodwill attributable to the acquisitions of XCOM, BusinessNet and others contributed to the higher depreciation and amortization expense in 1999. Selling, General and Administrative expenses increased significantly in 1999 to $157 million from $55 million in 1998 primarily due to the cost of activities associated with the expanding communications business. The Company incurred incremental compensation and travel costs for the substantial number of new employees that have been hired to implement the Business Plan. The total number of employees of the Company increased to over 3,200 at June 30, 1999. Professional fees, including legal costs associated with obtaining licenses, agreements and technical facilities and other development costs associated with the Company's plans to expand services offered in U.S. and European cities, and consulting fees to develop and implement the Company's business support systems, also increased selling general and administrative expenses. In addition to the costs to expand the communications and information services businesses, the Company recorded $29 million of non-cash compensation expense in the second quarter of 1999 under SFAS No. 123 related to grants of stock options and warrants. General and administrative costs are expected to increase significantly in future periods as the Company continues to implement the Business Plan. Write-off of In-Process Research and Development was $30 million in 1998. The in-process research and development costs were the portion of the purchase price allocated to the telephone network-to-IP network bridge technology acquired by the Company in the XCOM transaction and were estimated through formal valuation, at $30 million. In accordance with generally accepted accounting principles, the $30 million was taken as a nondeductible charge against earnings in the second quarter of 1998. EBITDA, as defined by the Company, consists of earnings (losses) before interest, income taxes, depreciation, amortization, non-cash operating expenses (including stock-based compensation and in- process research and development charges) and other non-operating income or expenses. EBITDA was $8 million in 1998 and $(103) million in 1999. The primary reason for the decrease between periods is the significant increase in general and administrative expenses, described above, incurred in connection with the implementation of the Company's Business Plan. EBITDA is commonly used in the communications industry to analyze companies on the basis of operating performance. EBITDA, however, should not be considered an alternative to operating or net income as an indicator of the performance of the Company's businesses, or as an alternative to cash flows from operating activities as a measure of liquidity, in each case determined in accordance with generally accepted accounting principles. See Consolidated Condensed Statements of Cash Flows. Interest Income increased 27% in 1999 to $57 million from $45 million in 1998 as the Company's average cash, cash equivalents and marketable securities balance increased from approximately $3.2 billion during the second quarter of 1998 to approximately $4.6 billion during the second quarter of 1999. Pending utilization of the cash equivalents and marketable securities in implementing the Business Plan, the Company intends to invest the funds primarily in government and governmental agency securities. This investment strategy will provide lower yields on the funds, but is expected to reduce the risk to principal in the short term prior to using the funds in implementing the Business Plan. Interest Expense, net increased significantly from $36 million in 1998 to $45 million in 1999. Interest expense increased substantially due to the completion of the offering of $2 billion aggregate principal amount of 9.125% Senior Notes Due 2008 issued in April 1998 and $834 million aggregate principal amount at maturity of 10.5% Senior Discount Notes Due 2008 issued in December 1998. The amortization of debt issuance costs associated with the Senior Notes and Senior Discount Notes also increased interest expense in 1999. The Company capitalized $20 million and $1 million of interest expense on network construction and business support systems in the second quarter of 1999 and 1998, respectively. Gain on Equity Investee Stock Transactions increased to $111 million in 1999 from $21 million in 1998. In the second quarter of 1999 RCN issued stock in a public offering and for certain transactions which diluted the Company's ownership of RCN from 40% at March 31, 1999 to 35% at June 30, 1999 but increased its proportionate share of RCN's net assets. The increase in the Company's proportionate share of RCN's net assets resulted in a pre-tax gain of $111 million for the Company in the second quarter of 1999. In 1998, the Company recognized a $21 million gain related to RCN stock activity. Other Expense, net decreased in 1999 to $(7) million from $(25) million. Other expense consists primarily of the Company's share of losses incurred by the Company's equity method investees, principally RCN. RCN is incurring significant costs in developing its business plan including the acquisitions of several internet service providers. The Company recorded $26 million of equity losses attributable to RCN in the second quarter of 1999, as compared to $22 million in the second quarter of 1998. During the second quarter of 1999, the Company sold its equity position in Burlington Resources, which resulted in a pre-tax gain of $17 million. Also included in other expense are equity earnings in Commonwealth Telephone Enterprises, Inc., and realized gains and losses on the sale of other assets each not individually significant to the Company's results of operations. Income Tax Benefit in 1999 differs from the statutory rate of 35% primarily due to losses incurred by the Company's international subsidiaries which cannot be included in the consolidated U.S. federal return, nondeductible goodwill amortization expense and state income taxes. The income tax benefit differs from the statutory rate in 1998 primarily due to the $30 million nondeductible write-off of the research and development costs acquired in the XCOM acquisition. Six Months 1999 vs. Six Months 1998 Revenue for the six months ended June 30, is summarized as follows (in millions) 1999 1998 Communications and Information Services $ 99 $ 65 Coal Mining 98 115 Other 11 10 ------ ------ $ 208 $ 190 ====== ======
Communications and information services revenue increased from $65 million for the six months ended June 30, 1998 to $99 million for the six months ended June 30, 1999. In May, 1999 the Massachusetts Department of Public Utilities ruled that Bell Atlantic was no longer required to pay the established reciprocal compensation rates for certain services. As a result, Level 3 has elected not to recognize additional revenue, beginning in the second quarter, from these agreements until the uncertainties are resolved. An unfavorable resolution to this matter may have a material adverse effect to the Company. Systems integration revenue increased 10% to $32 million in 1999. Revenue for the computer outsourcing business increased from $30 million in 1998 to $34 million in 1999. Revenue attributable to new customers led to the increase in computer outsourcing and systems integration revenue. Mining revenue in 1999 decreased to $98 million from $115 million in 1998 due to timing of shipments taken by Commonwealth Edison Company ("Commonwealth"). The purchase agreement with Commonwealth requires that minimum amounts of coal must be purchased, however, does not stipulate when the coal must be purchased. In addition, the expiration of a long-term contract in late 1998 will result in an approximate 10% decline in 1999 coal sales from 1998 levels. Other revenue, was consistent with 1998, and is primarily attributable to CPTC, a privately owned tollroad in southern California. Cost of Revenue increased $52 million or 57% to $143 million in 1999 as a result of the expanding communications business. In 1999 network expenses were $54 million as compared to $1 million in the prior year. The increase in costs is primarily attributable to the XCOM and GeoNet acquisitions, the costs associated with the Frontier and IXC Communications leases and costs attributable to the products the Company began offering in late 1998 and 1999. The cost of revenue, as a percentage of revenue, for the information services business increased slightly for the six months ended June 30, 1999 compared to the same period in 1998. The increase is primarily due to the costs incurred by the systems integration segment to transition from Year 2000 services to systems and software reengineering for IP related applications. The cost of revenue for the coal business as a percentage of revenue, increased due to the expiration of the high margin long-term contract in 1998. Depreciation Expense increased from $12 million in 1998 to $76 million in 1999. The significant increase in the amount of assets placed in service during the last half of 1998 and first half of 1999 for the communications business resulted in the increase in depreciation expense. The acquisitions of XCOM, Geonet and BusinessNet in 1998 and 1999 resulted in goodwill amortization increasing from $4 million in 1998 to $16 million in 1999. Selling, General and Administrative expenses increased significantly to $282 million in 1999 from $103 million in 1998 primarily due to the cost of activities associated with the expanding communications business. Compensation, travel and facilities costs increased substantially due to the additional employees that have been hired to implement the Business Plan. The total number of employees of the Company increased to over 3,200 at June 30, 1999. Professional fees, including legal costs associated with obtaining licenses, agreements and technical facilities and other development costs associated with the Company's plans to expand services offered in U.S. and European cities and consulting fees incurred to develop and implement the Company's business support systems contributed to higher selling general and administrative expenses. In addition, the Company recorded $47 million of non-cash compensation in the first half of 1999 for expenses recognized under SFAS No. 123 related to grants of stock options and warrants, up from $11 million in 1998. As the Company continues to implement the Business Plan, general and administrative costs are expected to continue to increase significantly. Write-off of In-Process Research and Development of $30 million in 1998 was the portion of the purchase price allocated to the telephone network-to-IP network bridge technology acquired by the Company in the XCOM transaction and was estimated through formal valuation. In accordance with generally accepted accounting principles, the $30 million was taken as a nondeductible charge against earnings in the second quarter of 1998. EBITDA decreased from $7 million in 1998 to $(170) million in 1999. The primary reason for the decrease between periods is the significant increase in general and administrative expenses, described above, incurred in connection with the implementation of the Company's Business Plan. Interest Income increased substantially from $71 million in 1998 to $107 million in 1999 primarily as a function of the Company's increasing average cash, cash equivalents and marketable securities balances. The average cash balance increased from approximately $2.6 billion during the first half of 1998 to approximately $4.2 billion during the first half of 1999. Pending utilization of the cash equivalents and marketable securities in implementing the Business Plan, the Company intends to invest the funds primarily in government and governmental agency securities. This investment strategy will provide lower yields on the funds, but is expected to reduce the risk to principal in the short term prior to using the funds in implementing the Business Plan. Interest Expense, net increased $58 million to $98 million in 1999 due to the completion of the offering of $2 billion aggregate principal amount of 9.125% Senior Notes Due 2008 in April, 1998 and $834 million aggregate principal amount at maturity of 10.5% Senior Discount Notes Due 2008 in the fourth quarter of 1998. The amortization of the related debt issuance costs also contributed to the increased interest expense in 1999. The Company capitalized $31 million and $1 million of interest expense on network construction and business support systems in the first half of 1999 and 1998, respectively. Gain on Equity Investee Stock Transactions increased to $111 million during the first half of 1999. RCN issued stock in a public offering and for certain transactions which diluted the Company's ownership of RCN from 41% at December 31, 1998 to 35% at June 30, 1999. The increase in the Company's proportionate share of RCN's net assets as a result of these transactions resulted in a pre-tax gain of $111 million from subsidiary stock sales for the Company in the first half of 1999. The Company recognized $21 million of gains for similar stock transactions of RCN in 1998. Other Expense, net decreased to $(30) million in 1999 from $(47) million in 1998. Other expense consists of the Company's share of losses incurred by the Company's equity method investees, primarily RCN. RCN is incurring significant costs in developing its business plan including the acquisitions of several internet service providers. The Company recorded $53 million of equity losses attributable to RCN in the first half of 1999, as compared to $53 million in the first half of 1998. The Company also sold 1.2 million shares of Burlington Resources common stock, resulting in a pre-tax gain of $17 million for the Company in 1999. Equity earnings of Commonwealth Telephone Enterprises, Inc. and gains on the disposition of other assets were not individually significant in the first half of 1999 or 1998. Income Tax Benefit in 1999 differs from the statutory rate of 35% primarily due to losses incurred by the Company's international subsidiaries which cannot be included in the consolidated U.S. federal return, nondeductible goodwill amortization expense and state income taxes. The income tax benefit in 1999 differs from the statutory rate in 1998 primarily due to the $30 million nondeductible write-off of the research and development costs acquired in the XCOM acquisition. Discontinued Operations includes the one-time gain of $608 million recognized upon the distribution of the Construction Group to former Class C stockholder on March 31, 1998. Also included in discontinued operations is the gain, net of tax, of $324 million from the Company's sale of its energy assets to MidAmerican on January 2, 1998. Financial Condition-June 30, 1999 The Company's working capital increased $291 million during 1999 from $3.5 billion at December 31, 1998 to $3.8 billion at June 30, 1999 primarily due to the $1.5 billion equity offering completed in March 1999, offset by capital expenditures for the communications network. Cash (used in) provided by continuing operations increased from $(62) million in 1998 to $159 million in 1999 primarily due to the changes in components of working capital and an increase in interest income. Interest income increased in 1999 as a result of the proceeds received from the Senior Notes, Senior Discount Notes and the March 9, 1999 equity offering. The increase in cash provided by interest income was partially offset by the decrease in cash provided by operations for the semi-annual payment of interest on the Senior Notes. Interest payments on the Senior Discount Notes are deferred until 2004. An increase in the costs paid to implement the Business Plan also reduced cash provided by continuing operations. Investing activities include the purchase of $3,275 million of marketable securities offset by the sales and maturities of securities of $2,769 million. The Company also incurred costs of $1,215 million for capital expenditures, primarily for the expanding communications business. In addition, the Company realized $11 million of proceeds from the sale of property, plant and equipment. Financing sources in the first six months of 1999 consisted primarily of the net proceeds of $1.5 billion from the issuance of 28,750,000 shares of Common Stock, and the exercise of the Company's stock options for $13 million. The Company also repaid long-term debt of $4 million during the first half of 1999. Liquidity and Capital Resources Since late 1997, the Company has substantially increased the emphasis it places on and the resources devoted to its communications and information services business. The Company has commenced the implementation of a plan to become a facilities-based provider (that is, a provider that owns or leases a substantial portion of the property, plant and equipment necessary to provide its services) of a broad range of integrated communications services. To reach this goal, the Company is expanding substantially the business of its subsidiary, PKS Information Services, Inc., ("PKSIS") to create, through a combination of construction, purchase and leasing of facilities and other assets, an international, end-to-end, facilities- based communications network. The Company is designing its network based on IP technology in order to leverage the efficiencies of this technology to provide lower cost communications services. The development of the Business Plan will require significant capital expenditures, a substantial portion of which will be incurred before any significant related revenues from the Business Plan are expected to be realized. These expenditures, together with the associated early operating expenses, will result in substantial negative operating cash flow and substantial net operating losses for the Company for the foreseeable future. Although the Company believes that its cost estimates and build-out schedule are reasonable, there can be no assurance that the actual construction costs or the timing of the expenditures will not deviate from current estimates. The Company estimates that its capital expenditures in connection with the Business Plan will approximate $2.5 billion in 1999. The Company's current liquidity and the cost sharing agreement with INTERNEXT should be sufficient to fund the currently committed portions of the Business Plan. The Company currently estimates that the implementation of the Business Plan, as currently contemplated, will require between $9 and $11 billion over the next 10 years. The Company's ability to implement the Business Plan and meet its projected growth is dependent upon its ability to secure substantial additional financing in the future. The Company expects to meet its additional capital needs with the proceeds from credit facilities and other borrowings, sales or issuance of additional equity securities, or additional debt securities. The Senior Notes and Senior Discount Notes were issued under an indenture which permits the Company and its subsidiaries to incur substantial amounts of debt. The Company also has approximately $2 billion of unissued securities available under the "universal" shelf registration statement that was declared effective by the Securities and Exchange Commission in February, 1999. In addition, the Company may sell or dispose of existing businesses or investments to fund portions of the Business Plan. The Company may also sell or lease fiber optic capacity, or access to its conduits. There can be no assurance that the Company will be successful in producing sufficient cash flow, raising sufficient debt or equity capital on terms that it will consider acceptable, or selling or leasing fiber optic capacity or access to its conduits, or that proceeds from dispositions of the Company's assets will reflect the assets' intrinsic value. Further, there can be no assurance that expenses will not exceed the Company's estimates or that the financing needed will not likewise be higher than estimated. Failure to generate sufficient funds may require the Company to delay or abandon some of its future expansion or expenditures, which could have a material adverse effect on the implementation of the Business Plan. There can be no assurance that the Company will be able to obtain such financing if and when it is needed or that, if available, such financing will be on terms acceptable to the Company. If the Company is unable to obtain additional financing when needed, it may be required to scale back significantly its Business Plan and, depending upon cash flow from its existing businesses, reduce the scope of its plans and operations. In connection with implementing the Business Plan, management will continue reviewing the existing businesses of the Company to determine how those businesses will complement the Company's focus on communications and information services. If it is decided that an existing business is not compatible with the communications and information services business and if a suitable buyer can be found, the Company may dispose of that business. Year 2000 General The Company's wholly owned subsidiary, Level 3 Communications, LLC is a new Company that is implementing new technologies to provide Internet Protocol (IP) technology-based communications services to its customers. The Company has adopted a strategy to select technology vendors and suppliers that provide products that are represented by such vendors and suppliers to be Year 2000 compliant. In negotiating its vendor and supplier contracts, the Company secures Year 2000 warranties that address the Year 2000 compliance of the applicable product(s). As part of the Company's Year 2000 compliance program, plans will be put into place to test these products to confirm they are Year 2000 ready. PKS Systems Integration LLC ("PKS Systems"), a subsidiary of PKSIS, provides a wide variety of information technology services to its customers. In fiscal year 1998, approximately 57% of the revenue generated by PKS Systems related to projects involving Year 2000 assessment and renovation services performed by PKS Systems for its customers. These contracts generally require PKS Systems to identify date affected fields in certain application software of its customers and, in many cases, PKS Systems undertakes efforts to remediate those date-affected fields so that Year 2000 data may be processed. Thus, Year 2000 issues affect many of the services PKS Systems provides to its customers. This exposes PKS Systems to potential risks that may include problems with services provided by PKS Systems to its customers and the potential for claims arising under PKS Systems' customer contracts. PKS Systems attempts to contractually limit its exposure to liability for Year 2000 compliance issues. However, there can be no assurance as to the effectiveness of these contractual limitations. Outlined below is additional information with respect to the Year 2000 compliance programs that are being pursued by Level 3 Communications, LLC and PKSIS. Level 3 Communications, LLC ("Level 3") Level 3 Communications, LLC, uses software and related technologies throughout its business that may be affected by the date change in the Year 2000. The inability of systems to appropriately recognize the Year 2000 could result in a disruption of Level 3's operations. Level 3 has one main line of business: delivery of communications services to commercial clients over fiber optic cable. The delivery of service will be over Level 3 owned cable when the network construction is complete. In the interim, services will be delivered over both owned and leased lines. Level 3 faces two primary Year 2000 issues with respect to its business. First, Level 3 must assess the readiness of its systems that are required to provide its customer's communications services ("Service Delivery Systems"). Second, Level 3 must evaluate the Year 2000 readiness of its internal business support systems ("Internal Business Support Systems"). Level 3 must also verify the readiness of the providers of the leased lines currently in use. Level 3 has designated a full-time Year 2000 director in addition to establishing a program office staffed in part by experienced Year 2000 consultants. Level 3 is progressing through a comprehensive program to evaluate and address the effect of the Year 2000 on its Internal Business Support Systems, and the Service Delivery Systems. The plans' focus upon Year 2000 issues consists of the following phases: Phase (I) Assessment - Awareness, commitment, and evaluation which includes a detailed inventory of systems and services that the Year 2000 may impact. (II) Detailed Plan - Establishment of priorities, development of specific action steps and allocation of resources to address the issues as outlined in Phase I. (III)Implementation - Completion of the necessary changes as delineated in Phase II. (IV) Verification - Determining whether the conversions implemented in Phase III have resolved the Year 2000 problem so that date related calculations will function properly, both as individual units and on an integrated basis. This will culminate in an end-to-end system test to ensure that the customer services being delivered by Level 3 will function properly and that all support services necessary to business operations will be Year 2000 compliant. (V) Contingency Plans - Establishment of alternative plans should any of the services or suppliers that Level 3 requires to do business fail to be Year 2000 ready. With respect to its Year 2000 plans, Level 3 currently has activities underway in each of the five phases above. The current stage of activities varies based upon the type of component, system, and/or customer service at issue. Business Functions Operational Effect Current Status - -------------------------------------------------------------------------------- Customer Delivery Systems Inability to deliver Phases I to Phase V* Customer Services Internal Business Support Systems Failures of Internal Phases I to Phase V* Support Services and Customer Billing
* Level 3 anticipates this range of activity to continue through 1999 as it adds new equipment and services while building its infrastructure. Additionally, the upgrading of service delivery through its proprietary systems will require that the delivery systems go through verification with each new innovation. The expenses associated with this project by Level 3, as well as the related potential effect on Level 3's earnings, are not expected to have a material effect on the future operating results or financial condition of Level 3. There can be no assurance, however, that the Year 2000 problem, and any loss incurred by any customers of Level 3 as a result of the Year 2000 problem, will not have a material adverse effect on Level 3's financial condition and results of operations. Level 3 has significant relationships and dependencies with regard to systems and technology provided and supported by third party vendors and service providers. In particular, the customer delivery systems for the communications business of Level 3 are dependent upon third parties who provide telecommunication services while the infrastructure continues to be built. As part of its Year 2000 program, Level 3 has sought to obtain formal Year 2000 compliance representation from vendors who provide products and services to Level 3. The vendor compliance process is being performed concurrently with the Company's ongoing Year 2000 validation activities. This compliance process consists of obtaining information from disclosures made publicly available on company websites, reviewing test plans and results made available from suppliers, and following up with letters and phone calls to any vendors who have not made such information available to Level 3 as yet. Because of the aforementioned reliance placed on third party vendors, Level 3's estimate of costs to be incurred could change substantially should one or more of the vendors be unable to timely deliver Year 2000 compliant products. Level 3 does not own the proprietary hardware technology or third party software source code utilized in its business and therefore, Level 3 cannot actually renovate the hardware or third party software identified as having Year 2000 support issues. The standard components supplied by vendors for the customer delivery systems have been tested in laboratory settings and certified as to their compliance. With respect to the contingency plans for Level 3, such plans generally fall into two categories. Concerning the customer delivery systems of Level 3, Level 3 has certain redundant and backup facilities, such as on-site generators. With respect to systems obtained from third party vendors, contingency plans are developed by Level 3 on a case by case basis where deemed appropriate. PKSIS PKSIS and its subsidiaries use software and related technologies throughout its business that may be affected by the date change in the Year 2000. The inability of systems to appropriately recognize the Year 2000 could result in a disruption of PKSIS operations. PKSIS has two main lines of business: computer outsourcing and systems integration. The computer outsourcing business is managed by PKS Computer Services LLC ("PKSCS"). The systems integration is managed by PKS Systems Integration LLC ("PKSSI"). PKSCS generally faces two primary Year 2000 issues with respect to its business. First, PKSCS must evaluate the Year 2000 readiness of its internal support systems. Second, PKSCS must assess and, if necessary, upgrade the operating systems which PKSCS provides for its outsourcing customers. PKSCS outsourcing customers are responsible for their own application code remediation. PKSCS established a corporate-wide Year 2000 program in 1997, which in relation to other business projects and objectives has been assigned a high priority, including the designation of a full-time year 2000 director. PKSCS is progressing through a comprehensive program to evaluate and address the effect of the Year 2000 on its internal operations and support systems, and the operating systems which PKSCS is responsible for providing to its outsourcing customers. Due to the nature of its business, PKSCS has developed and is administering approximately twenty separate Year 2000 project plans. Approximately eighteen of these plans are devoted to the specific operating systems software upgrades to be undertaken by PKSCS for its outsourcing customers according to software vendor specifications. The remaining plans focus upon Year 2000 issues relating to PKSCS internal support systems. PKSCS is utilizing both internal and external resources in implementing these plans. These PKSCS plans generally consist of the following phases: Phase (I) Assessment - Awareness, commitment, and evaluation, which includes a detailed inventory of systems and services that the Year 2000 may impact. (II) Detailed Plan - Establishment of priorities, development of specific action steps and allocation of resources to address the issues as outlined in Phase I. (III)Implementation - Completion of the necessary changes per vendor specifications,(that is, replacement or retirement) as outlined in Phase II. (IV) Verification - With respect to PKSCS' internal support systems, determining whether the conversions implemented in Phase III have resolved the Year 2000 problem so that date related calculations will function properly, both as individual units and on an integrated basis. (V) Completion - The final rollout of components into an operational unit. With respect to its Year 2000 plans, PKSCS currently has activities underway in each of phases III through V. The current stage of activities varies based upon the type of component, system, and/or customer service at issue. Some PKSCS customers have delayed or postponed operating system upgrades to be performed by PKSCS as a result of the customer's delay in its application code remediation schedule. PKSSI generally faces two primary Year 2000 issues with respect to its business. First, PKSSI provides a wide variety of information technology services to its customers which could potentially expose PKSIS to contractual liability for Year 2000 related risks if services are not performed in a timely or satisfactory manner. Second, PKSSI must evaluate and, if necessary, upgrade or replace its internal business support systems which may have date dependencies. PKSSI believes the primary internal systems affected by the Year 2000 issue which could have an impact on its business are desktop and network hardware and software. PKSSI previously completed its Year 2000 assessment of desktop hardware and software, and, based on vendor representations, determined that material upgrades or replacements were not required. PKSIS is continuing to validate these findings and currently plans to do so throughout the remainder of 1999. PKSSI is also in the process of communicating with its vendors to assess its servers and communications hardware for Year 2000 readiness. In fiscal year 1998, approximately 57% of the revenue generated by PKSSI related to projects involving Year 2000 assessment and renovation services performed by PKSSI for its customers. This is a reduction from 80% in 1997. Some of these contracts require PKSSI to identify date affected fields in certain application software of its customers and, in many cases, PKSSI undertakes efforts to remediate those date-affected fields so that Year 2000 data may be processed. Thus, Year 2000 issues affect certain services PKSSI provides to its customers. This exposes PKSSI to potential risks that may include problems with services provided by PKSSI to its customers and the potential for claims arising under PKSSI's customer contracts. In some cases PKSSI has contractual warranties which could require PKSSI to perform Year 2000 related services after the year 2000. PKSSI attempts to contractually limit its exposure to liability for Year 2000 compliance issues. However, there can be no assurance as to the effectiveness of such contractual limitations. The following chart describes the status of PKSIS' Year 2000 program with respect to Computer Outsourcing Services and Systems Integration Services. Business Current Areas of Functions Focus Operational Impact Current Status - ------------------------------------------------------------------------------------------------ Computer Large & Mid-Range Inability to continue Mid Phase III to Phase V Outsourcing Service CPU critical processing of OEM Software customer's systemss OS Systems Network Equipment Support Facilities Internal Support Failures of critical Mid Phase III to Phase V Systems & Business Internal Support Processes Services Systems Integration Internal Support Failures of critical Assessment of desktop Services Systems & Business Internal Support hardware and software has Processes Services been completed and is validated Assessment of services and communications hardware is expected to be completed by the end of the third quarter of 1999.
PKSIS has significant relationships and dependencies with regard to systems and technology provided and supported by third party vendors and service providers. In particular, the computer outsourcing business of PKSCS is dependent upon third parties who provide telecommunication service, electrical utilities and mainframe and midrange hardware and software providers. As part of its Year 2000 program, PKSIS has sought to obtain formal Year 2000 compliance representation from vendors who provide products and services to PKSIS. The vendor compliance process is being performed concurrently with the Company's ongoing Year 2000 remediation activities. PKSCS is also working with its outsourcing customers to inform them of certain dependencies which exist which may affect PKSIS' Year 2000 efforts and certain critical actions which PKSIS believes must be undertaken by the customer in order to allow PKSIS to implement its Year 2000 efforts concerning the operating software system provided by PKSCS for its customers. To date, PKSCS has received written responses from approximately 40% of the vendors from whom it has sought Year 2000 compliance statements. With respect to those key third party vendors and suppliers who have failed to respond in writing, PKSIS is following up directly with such vendors and suppliers and obtaining information from other sources, such as disclosures made publicly available on company websites. Because of this reliance on third party vendors, PKSIS' estimate of costs to be incurred could change substantially should one or more of the vendors be unable to timely deliver Year 2000 compliant products. PKSCS does not own the proprietary hardware technology or third party software source code utilized in its business and therefore, PKSCS cannot actually renovate the hardware or software identified as having Year 2000 support issues. The expenses associated with PKSIS' Year 2000 efforts, as well as the related potential effect on PKSIS' earnings, are not expected to have a material effect on the future operating results or financial condition of Level 3. There can be no assurance,however,that the Year 2000 problem, and any loss incurred by any customers of PKS as a result of the Year 2000 problem, will not have a material adverse effect on Level 3's financial condition and results of operations. With respect to the contingency plans for PKSCS, such plans generally fall into two categories. Concerning the internal support systems of PKSCS, PKSCS has certain redundant and backup facilities, such as on-site generators, water supply and pumps. PKSCS has undertaken contingency plans with respect to these internal systems by performing due diligence with the vendors of these systems in order to investigate the Year 2000 compliance status of these systems, and such systems are tested on a monthly basis. With respect to the operating systems obtained from third party vendors and maintained by PKSCS for its outsourcing customers,contingency plans are developed by PKSCS and its customers on a case by case basis as requested, contracted and paid for by PKSCS' customers. However, there is no contingency plan for the failure of operating system software to properly handle Year 2000 date processing. If the operating system software provided to PKSIS by third party vendors fails at the PKSCS Data Center, such vendor supplied software is expected to fail everywhere and no immediate work around could be supplied by PKSCS. In the event computer hardware supplied by PKSCS for its outsourcing customer fails, some customers have contracted for contingency plans through disaster recovery arrangements with a third party which supplies disaster recovery services. Costs of Year 2000 Issues Level 3 currently expects to incur approximately $12.5 million of costs in aggregate, through the end of 1999. These costs primarily arise from direct costs of Level 3 employees verifying equipment and software as Year 2000 ready. However, Level 3 does not separately track the internal employee costs incurred for its Year 2000 projects. Level 3 does track all material costs incurred for its Year 2000 projects as well as all costs incurred by the Year 2000 program office. Level 3 has estimated the time and effort expended by its employees on Year 2000 projects based on an analysis of Year 2000 project plans. PKSIS incurred approximately $4.2 million of costs to implement its Year 2000 program through 1998, and currently expects to incur an additional approximately $3.6 million of costs in aggregate, through the end of 1999. These costs primarily arise from direct costs of PKSCS employees working on upgrades per vendor specifications of operating system software for PKSCS outsourcing customers and the cost of vendor supplied operating systems software upgrades and the cost of additional hardware. However, PKSIS does not separately track the internal costs incurred for its Year 2000 projects and does not track the cost and time its employees spend on Year 2000 projects. PKSCS has estimated the time and effort expended by its employees on Year 2000 projects based on an analysis of Year 2000 project plans. Labor costs for PKSCS' Year 2000 projects were estimated to be $2.1 million for 1998 and are estimated to be approximately one million dollars for 1999 through September 1999, when such projects are currently scheduled for completion. These labor costs will necessarily increase if such projects take longer to complete. Costs for software upgrades, additional equipment costs and a test system for PKSCS' Year 2000 projects were estimated to be $2.1 million for 1998 and are estimated to be $2.5 million for 1999. Such costs are not available for PKSSI but are not believed to be material. Year 2000 costs for PKSSI are believed to be substantially less than PKSCS and focus primarily on the cost of evaluating and, if necessary, upgrading network and desktop hardware and software. The costs incurred by PKSSI for performing Year 2000 services for its customers are included within PKSSI's pricing for such services. Risks Associated with Year 2000 Issues Due to the complexity of the issues presented by the Year 2000 date change and the proposed solutions, and the interdependence of external vendor support services, it is difficult to assess with any degree of accuracy the future effect of a failure in any one aspect or combination of aspects of the Company's Year 2000 activities. The Company cannot provide assurance that actual results will not differ from management's estimates due to the complexity of upgrading the systems and related technologies surrounding the Year 2000 issue. Failure by the Company to complete its Year 2000 activities in a timely or complete manner, within its estimate of projected costs, or failure by third parties, such as financial institutions and related networks, software providers, local telephone companies, long distance providers and electricity providers among others, to correct their systems, with which the Company's systems interconnect, could have a material effect on the Company's future results of operations and financial position. Other factors which might cause a material difference from management's estimate would include, but not be limited to, the availability and cost of personnel with appropriate skills and abilities to locate and upgrade relevant computer systems and similar uncertainties, as well as the related effects on the Company of the Year 2000 problem on the economy in general, or on the Company's business partners and customers in particular. Market Risk Level 3 is subject to market risks arising from changes in interest rates, equity prices and foreign exchange rates. The Company's exposure to and policies regarding interest rate risk has not changed significantly from December 31, 1998. Level 3 continues to hold positions in certain publicly traded entities, primarily Commonwealth Telephone and RCN. The Company accounts for these two investments using the equity method. The market value of these investments is $1,540 million as of June 30, 1999, which is significantly higher than their carrying value of $362 million. The Company does not currently have plans to dispose of these investments, however, if any such transaction occurred, the value received for the investments would be affected by the market value of the underlying stock at the time of any such transaction. A 20% decrease in the price of Commonwealth Telephone and RCN stock would result in approximately a $308 million decrease in fair value of these investments. The Company does not currently utilize financial instruments to minimize its exposure to price fluctuations in equity securities. The Company's Business Plan includes developing and constructing networks in Europe and Asia. As of June 30, 1999, the Company has invested significant amounts of capital in Europe and will continue to expand its presence in Europe and Asia in the second half of 1999. To date, the Company has not utilized financial instruments to minimize its exposure to foreign currency fluctuations. The Company will continue to analyze risk management strategies to reduce foreign currency exchange risk in the future. The change in equity security prices is based on hypothetical movements and are not necessarily indicative of the actual results that may occur. Future earnings and losses will be affected by actual fluctuations in interest rates, equity prices and foreign currency rates. LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES PART II - OTHER INFORMATION Item 4. Submission of Matters to a Vote of Security Holders At the annual meeting of stockholders held on May 27, 1999, the following matters were submitted to a vote: 1. To reelect the four Class II Directors to the Board of Directors of Level 3 for a three-year term until the 2002 Annual Meeting of Stockholders: In Favor Withheld William L. Grewcock 248,198,886 463,213 Richard R. Jaros 248,172,548 489,551 Robert E. Julian 248,157,374 504,725 David C. McCourt 247,883,555 778,544
2. To adopt an amendment to Level 3's Restated Certificate of Incorporation to increase the number of authorized shares of common stock from 500 million to 1.5 billion. Affirmative votes: 239,480,594 Negative votes: 8,756,054 Abstentions: 425,451
Item 6. Exhibits and Reports on Form 8-K (a) Exhibits filed as part of this report are listed below. Exhibit Number 27 Financial Data Schedule. (b) The Company filed a Form 8-K on May 17, 1999, disclosing an open letter to stockholders from James Q. Crowe, Level 3's President and Chief Executive Officer. In the letter Mr. Crowe detailed a plan to sell 4,000 shares of Level 3 Common Stock each day for 250 consecutive days, for an aggregate total of 1,000,000 shares. The Company also filed a Form 8-K on June 3, 1999, reporting that on May 27, 1999, the Board of Directors had approved an amendment and restatement of the Company's By-laws and to reflect the approval by the Company's stockholders to increase the number of authorized shares of common stock, par value $.01 per share, from 500 million to 1.5 billion. SIGNATURES Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. LEVEL 3 COMMUNICATIONS, INC. Dated: August 10, 1999 \s\ Eric J. Mortensen Eric J. Mortensen Controller and Principal Accounting Officer LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES INDEX TO EXHIBITS Exhibit No. 27 Financial Data Schedule. EX-27 2 FDS --
5 This schedule contains summary financial information extracted from the Form 10-Q for the period ending June 30, 1999 and is qualified in its entirety by reference to such financial statements. 1,000,000 6-mos Dec-31-1999 Jan-01-1999 Jun-30-1999 795 3,417 115 4 4 4,454 2,506 321 7,350 656 2,667 0 0 3 3,606 7,350 98 208 46 143 374 0 98 (219) (70) (149) 0 0 0 (149) (.45) (.45)
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