FORM 10-K
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
(Mark One)
X ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the fiscal year ended December 31, 1998
OR
_ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ________ to ___________
Commission file number: 0-15658
Level 3 Communications, Inc.
(Exact name of Registrant as specified in its charter)
Delaware 47-0210602
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
3555 Farnam Street, Omaha, Nebraska 68131
(Address of principal executive offices) (Zip code)
402-536-3677
(Registrant's telephone number including area code)
Securities registered pursuant to Section
12(b) of the Act:
None
Securities registered pursuant to section 12(g) of the Act:
Common Stock, par value $.01 per share
Rights to Purchase Series A Junior Participating Preferred Stock,
par value $.01 per share
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No ____
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. X
(Cover continued on next page)
(Cover continued from prior page)
Indicate the number of shares outstanding of each of the registrant's
classes of common stock, as of the latest practicable date.
Title Outstanding
Common Stock, par value $.01 per share 337,845,001 as of March 9, 1999
DOCUMENTS INCORPORATED BY REFERENCE
List hereunder the following documents if incorporated by reference and the Part
of the Form 10-K (e.g., Part I, Part II, etc.) into which the document is
incorporated: (1) Any annual report to security holders; (2) Any proxy or
information statement; and (3) Any prospectus filed pursuant to Rule 424(b) or
(c) under the Securities Act of 1933. The listed documents should be clearly
described for identification purposes (e.g., annual report to security holders
for fiscal year ended December 24, 1980).
Portions of the Company's Definitive Proxy Statement for the 1999
Annual Meeting of Stockholders are incorporated by reference into Part
III of this Form 10-K
(End of cover)
ITEM 1. BUSINESS
Level 3 Communications, Inc. ("Level 3" or the "Company") engages in the
information services, communications and coal mining businesses through
ownership of operating subsidiaries and substantial equity positions in public
companies. In late 1997, the Company announced a business plan (the "Business
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 IP technology. For definitions
of certain terms used in this description of Level 3's business, please see "--
Glossary" below.
History
The Company was incorporated as Peter Kiewit Sons', Inc. in Delaware in
1941 to continue a construction business founded in Omaha, Nebraska in 1884. In
subsequent years, the Company invested a portion of the cash flow generated by
its construction activities in a variety of other businesses. The Company
entered the coal mining business in 1943, the telecommunications business
(consisting of MFS Communications Company, Inc. ("MFS") and, more recently, an
investment in C-TEC Corporation and its successors RCN Corporation ("RCN"),
Commonwealth Telephone Enterprises, Inc. ("Commonwealth Telephone") and Cable
Michigan, Inc. ("Cable Michigan") in 1988, the information services business in
1990 and the alternative energy business, through MidAmerican Energy Holdings
Company (f/k/a CalEnergy Company, Inc.) ("MidAmerican"), in 1991. Level 3 also
has made investments in several development-stage ventures.
In the last three years, the Company has distributed to its stockholders a
portion of its telecommunications business, split off its construction business
and sold its investments in the alternative energy sector.
In December 1997, the Company's stockholders ratified the decision of the
Board of Directors (the "Board") to effect a transaction to separate the
Company's construction business from the diversified portion of the Company's
business (the "Split-off"). As a result of the Split-off, which was completed on
March 31, 1998, the Company no longer owns any interest in the construction
portion of its former business (the "Construction Group"). In conjunction with
the Split-off, the Company changed its name to "Level 3 Communications, Inc.,"
and the Construction Group changed its name to "Peter Kiewit Sons', Inc." See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations."
In January 1998, the Company completed the sale to MidAmerican of its
energy investments, consisting primarily of a 24% equity interest in
MidAmerican. The Company received proceeds of approximately $1.16 billion from
this sale, and as a result recognized an after-tax gain of approximately $324
million in 1998.
On November 6, 1998, Avalon Cable of Michigan, Inc. acquired all the
outstanding stock of Cable Michigan. Level 3 received approximately $129 million
in cash for its interest in Cable Michigan and recognized a pre-tax gain of
approximately $90 million.
Industry Background
History and Industry Development
Telecommunications Industry. Prior to its court-ordered breakup in 1984
(the "Divestiture"), AT&T Corp. ("AT&T") largely monopolized the
telecommunications services in the United States even though technological
developments had begun to make it economically possible for companies (primarily
entrepreneurial enterprises) to compete for segments of the communications
business.
The present structure of the U.S. telecommunications market is largely the
result of the Divestiture. As part of the Divestiture, seven local exchange
holding companies were created to offer services in geographically defined areas
called LATAs. The RBOCs were separated from the long distance provider, AT&T,
resulting in the creation of two distinct market segments: local exchange and
long distance. The Divestiture provided for direct, open competition in the long
distance segment.
The Divestiture did not provide for competition in the local exchange
market. However, several factors served to promote competition in the local
exchange market, including: (i) customer desire for an alternative to the RBOCs,
also referred to as the ILECs; (ii) technological advances in the transmission
of data and video requiring greater capacity and reliability than ILEC networks
were able to accommodate; (iii) a monopoly position and rate of return-based
pricing structure which provided little incentive for the ILECs to upgrade their
networks; and (iv) the significant fees, called "access charges," that long
distance carriers were required to pay to the ILECs to access the ILECs'
networks.
The first competitors in the local exchange market, designated as CAPs by
the FCC, were established in the mid-1980s. Most of the early CAPs were
entrepreneurial enterprises that operated limited networks in the central
business districts of major cities in the United States where the highest
concentration of voice and data traffic is found. Since most states prohibited
competition for local switched services, early CAP services primarily consisted
of providing dedicated, unswitched connections to long distance carriers and
large businesses. These connections allowed high-volume users to avoid the
relatively high prices charged by ILECs for dedicated, unswitched connections.
As CAPs proliferated during the latter part of the 1980s, certain federal
and state regulators issued rulings which favored competition and promised to
open local markets to new entrants. These rulings allowed CAPs to offer a number
of new services, including, in certain states, a broad range of local exchange
services, including local switched services. Companies providing a combination
of CAP and switched local services are sometimes referred to as CLECs. This
pro-competitive trend continued with the passage of the Telecommunications Act
of 1996 (the "Telecom Act"), which provided a legal framework for introducing
competition to local telecommunications services throughout the United States.
Over the last three years, several significant transactions have been
announced representing consolidation of the U.S. telecom industry. Among the
ILECs, Bell Atlantic Corporation and NYNEX Corporation merged in August 1997,
Pacific Telesis Group and SBC Communications Inc. merged in April 1997, SBC
Communications Inc. and Ameritech Corporation have proposed a merger and GTE
Corporation and Bell Atlantic Corporation have proposed a merger. Major long
distance providers have sought to enhance their positions in local markets,
through transactions such as AT&T's acquisition of Teleport Communications Group
and Tele-Communications, Inc. and WorldCom, Inc.'s mergers with MFS
Communications Company, Inc. ("MFS") and Brooks Fiber Properties. They have also
sought to otherwise improve their competitive positions, through transactions
such as WorldCom's merger with MCI.
Many international markets resemble that of the United States prior to the
Divestiture. In many countries, traditional telecommunications services have
been provided through a monopoly provider, frequently controlled by the national
government, such as a Post, Telegraph and Telephone Company. In recent years,
there has been a trend toward liberalization of many of these markets,
particularly in Europe. Led by the introduction of competition in the United
Kingdom, the European Union mandated open competition as of January 1998.
Similar trends are emerging, albeit more slowly, in Asia.
Internet Industry. The Internet is a global collection of interconnected
computer networks that allows commercial organizations, educational
institutions, government agencies and individuals to communicate electronically,
access and share information and conduct business. The Internet originated with
the ARPAnet, a restricted network that was created in 1969 by the United States
Department of Defense Advanced Research Projects Agency to provide efficient and
reliable long distance data communications among the disparate computer systems
used by government-funded researchers and academic organizations. The networks
that comprise the Internet are connected in a variety of ways, including by the
public switched telephone network and by high speed, dedicated leased lines.
Communications on the Internet are enabled by IP, an inter-networking standard
that enables communication across the Internet regardless of the hardware and
software used.
Over time, as businesses have begun to utilize e-mail, file transfer and,
more recently, intranet and extranet services, commercial usage has become a
major component of Internet traffic. In 1989, the U.S. government effectively
ceased directly funding any part of the Internet backbone. In the mid-1990s,
contemporaneous with the increase in commercial usage of the Internet, a new
type of provider called an ISP became more prevalent. ISPs offer access, e-mail,
customized content and other specialized services and products aimed at allowing
both commercial and residential customers to obtain information from, transmit
information to, and utilize resources available on the Internet.
ISPs generally operate networks composed of dedicated lines leased from
ILECs, CLECs and ISPs using IP-based switching and routing equipment and
server-based applications and databases. Customers are connected to the ISP's
POP by facilities obtained by the customer or the ISP from either ILECs or CLECs
through a dedicated access line or the placement of a circuit-switched local
telephone call to the ISP.
IP Communications Technology. There are two widely used switching
technologies in currently deployed communications networks: circuit-switching
systems and packet-switching systems. Circuit-switch based communications
systems establish a dedicated channel for each communication (such as a
telephone call for voice or fax), maintain the channel for the duration of the
call, and disconnect the channel at the conclusion of the call. Packet-switch
based communications systems format the information to be transmitted, such as
e-mail, voice, fax and data into a series of shorter digital messages called
"packets." Each packet consists of a portion of the complete message plus the
addressing information to identify the destination and return address.
Packet-switch based systems offer several advantages over circuit-switch
based systems, particularly the ability to commingle packets from several
communications sources together simultaneously onto a single channel. For most
communications, particularly those with bursts of information followed by
periods of "silence," the ability to commingle packets provides for superior
network utilization and efficiency, resulting in more information being
transmitted through a given communication channel. There are, however, certain
disadvantages to packet-switch based systems as currently implemented. Rapidly
increasing demands for data, in part driven by the Internet traffic volumes, are
straining capacity and contributing to latency (delays) and interruptions in
communications transmissions. In addition, there are concerns about the adequacy
of the security and reliability of packet-switch based systems as currently
implemented.
Initiatives are under way to develop technology to address these
disadvantages of packet-switch based systems. The Company believes that the
evolving IP standard, which is a market based standard broadly adopted in the
Internet and elsewhere, will remain a primary focus of these development
efforts. The Company expects the benefits of these efforts to be improved
communications throughout, reduced latency and declining networking hardware
costs.
Telecommunications Services Market
Overview of U.S. Market. The traditional U.S. market for telecommunications
services can be divided into three basic sectors: long distance services, local
exchange services and Internet access services. In 1997, it is estimated that
local exchange services accounted for revenues of $92.4 billion, long distance
services generated revenues of $104.6 billion and Internet services revenues
totaled $6.3 billion. Revenues for both local exchange and long distance
services include amounts charged by long distance carriers and subsequently paid
to ILECs (or, where applicable, CLECs) for long distance access.
Long Distance Services. A long distance telephone call can be envisioned as
consisting of three segments. Starting with the originating customer, the call
travels along an ILEC or CLEC network to a long distance carrier's POP. At the
POP, the call is combined with other calls and sent along a long distance
network to a POP on the long distance carrier's network near where the call will
terminate. The call is then sent from this POP along an ILEC or CLEC network to
the terminating customer. Long distance carriers provide only the connection
between the two local networks, and pay access charges to LECs for originating
and terminating calls.
Local Exchange Services. A local call is one that does not require the
services of a long distance carrier. In general, the local exchange carrier does
provide the local portion of most long distance calls.
Internet Service. Internet services are generally provided in at least two
distinct segments. A local network connection is required from the ISP customer
to the ISP's local facilities. For large, communication-intensive users and for
content providers, these connections are typically unswitched, dedicated
connections provided by ILECs or CLECs, either as independent service providers
or, in some cases, by a company which is both a CLEC and an ISP. For residential
and small/medium business users, these connections are generally PSTN
connections obtained on a dial-up access basis as a local exchange telephone
call. Once a local connection is made to the ISP's local facilities, information
can be transmitted and obtained over a packet-switched IP data network, which
may consist of segments provided by many interconnected networks operated by a
number of ISPs. This collection of interconnected networks makes up the
Internet. A key feature of Internet architecture and packet-switching is that a
single dedicated channel between communication points is never established,
which distinguishes Internet-based services from the PSTN.
Overview of International Market. The traditional market for
telecommunications services outside of the United States can also be divided
into three basic sectors: long distance services, local exchange services and
Internet access services. In 1997, it is estimated that local exchange services
accounted for revenues of $116.6 billion, long distance services generated
revenues of $193.7 billion and Internet services revenues totaled $4.8 billion.
IP Network and Interconnection. The Company is designing the Level 3
network to be optimized for IP-based communications, rather than circuit-switch
based communications such as that utilized by the PSTN. The network is being
designed with the goal of providing the Company with the ability to adapt its
facilities, hardware and software to future technology developments in
packet-switch based communications systems.
There are many IP networks currently in operation. While generally adequate
for data transmission needs, these networks usually are not configured to
provide the voice quality, real-time communications requirements of a
traditional telephone call. With current technology, this quality can only be
achieved by providing a substantial cushion of communications capacity. In
addition, existing voice-over IP services generally require either customized
end-user equipment or the dialing of "access codes" or the following of other
special procedures to initiate a call. There are also concerns about the
reliability and security of existing IP-voice networks.
The Company is developing its IP-voice services so that customers will not
be required to dial access codes or follow other special procedures to initiate
a call. The Company and other technology providers are developing soft-switch
technology to enable the transmission of traffic seamlessly between a
router-based IP network and the circuit-based PSTN. This technology is expected
to provide the Level 3 network with the same ubiquity of the PSTN. Specifically,
the Company's technology is expected to provide Level 3 with (1) the ability to
originate PSTN telephone traffic from an ILEC's switch (when the origination
point is not on the Level 3 network), (2) route the traffic over the Level 3
network and (3) deliver the traffic either (a) directly to its destination (if
the destination is on the Level 3 network) or (b) to an interconnection point
where the traffic is transferred back to the PSTN (the routing of traffic to
this interconnection point will be determined based on a least-cost routing
criteria). When this capability is fully developed, based in part on acquired
software, Level 3 expects to be able to obtain the benefits of packet-switch
based communications protocols on its network, while allowing its customers to
use their existing equipment, telephone numbers and dialing procedures, without
additional access codes, for routing the call to the Level 3 network. Level 3
believes that by building its own network with significant excess capacity,
expandability and the latest technological advances in network design and
equipment and having the ability to route calls over the PSTN in the event of
service disruptions, the other significant issues associated with IP-voice
transmission (quality, latency, reliability and security) should be
satisfactorily addressed. The Company plans to begin commercially testing its
IP-voice transmission services in selected markets in the second quarter of
1999.
On November 16, 1998, Level 3 and Bell Communications Research Inc.
announced the merger of their respective specifications for a new protocol
designed to bridge between the current circuit-based PSTN and emerging IP
technology based networks.
The merged specification, called the Media Gateway Control Protocol, or
MGCP, represents a combination of the Internet Protocol Device Control, or IPDC
specification developed by a consortium formed by Level 3 and made up of leading
communications hardware and software companies, and the Simple Gateway Control
protocol, developed by Bell Communications Research Inc. and Cisco Systems, Inc.
The MGCP specification is available without a fee to service providers and
hardware and software vendors interested in implementing it in their networks
and equipment.
The significance of MGCP is that when implemented it will provide customers
with a seamless interconnection between traditional PSTN and the newer IP
technology networks. Level 3 believes that this integration will enable
customers to benefit from the lower cost of IP network services, including voice
and fax, without modifying existing telephone and fax equipment or dialing
access codes. Level 3 plans to use MGCP in the development of its own network.
Business Plan
Since late 1997, the Company has substantially increased the emphasis it
places on and the resources devoted to its communications and information
services business. Since that time, the Company has become a facilities-based
provider (that is, a provider that owns or leases a substantial portion of the
plant, property and equipment necessary to provide its services) of a broad
range of integrated communications services. The Company has expanded
substantially the business of its subsidiary PKS Information Services, Inc.
("PKSIS") and is creating, 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 the Level 3
network based on IP technology in order to leverage the efficiencies of this
technology to provide lower cost communications services.
Market and Technology Opportunity. The Company believes that, as technology
advances, a comprehensive range of both consumer and business communications and
information services will be provided over networks utilizing IP technology.
These services will include traditional voice services and fax transmission, as
well as other data services such as Internet access and virtual private
networks. The Company believes this shift has begun, and over time should
accelerate, for the following reasons:
o Efficiency. As a packet-switched technology, IP technology generally uses
network capacity more efficiently than the traditional circuit-switched
PSTN. Therefore, certain services can be provided for lower cost over a
network using IP technology, particularly those services which are not
timing sensitive, such as e-mail and file transfer.
o Flexibility. IP technology is an open protocol (a non-proprietary,
published standard) which allows for market driven development of new uses
and applications for IP networks. In contrast, the PSTN is based on
proprietary protocols, which are governed and maintained by international
standards bodies that are generally controlled by government-affiliated
entities and slower to accept change.
o Improving Technologies. The Company believes that IP's market based
protocol will likely lead to technological advances that will address the
problems currently associated with IP-based applications, including the
difficulty achieving seamless interconnection with the PSTN, latency (delay
through the network which can negatively affect timing sensitive
communications such as voice and fax), quality and concerns about adequate
security and reliability.
o Standardized Interface. Web browsers were developed for the public Internet
and are usable with many IP networks. Web browsers can provide a
standardized interface to data and applications on an IP network.
Standardized interfaces make it easier for end users to access and use
these resources.
Level 3's Strategy. The Company is seeking to capitalize on the benefits of
IP technology by pursuing the Business Plan. Key elements of the Company's
strategy include:
o Become the Low Cost Provider of Communications Services. Level 3 is
designing its network to provide high quality communications services at a
lower cost and to incorporate more readily future technological
improvements relative to older, less adaptable networks. For example, the
Level 3 network is being constructed using multiple conduits to allow the
Company to cost-effectively deploy future generations of optical networking
components and thereby expand capacity and reduce unit costs. In addition,
the Company's strategy is to maximize the use of open, non-proprietary
interfaces in the design of its network software and hardware. This
approach is intended to provide Level 3 with the ability to purchase the
most cost-effective network equipment from multiple vendors.
o Offer a Comprehensive Range of Communications Services. As the Business
Plan is implemented, the Company intends to provide a comprehensive range
of communications services over the Level 3 network, including private
line, colocation, Internet access, managed modem and voice and fax
transmission service. The Company is currently offering all of these
services other than voice and fax transmission services.
o Provide Seamless Interconnection to the PSTN. The Company and other
technology providers are developing technology to allow seamless
interconnection of the Level 3 network with the PSTN. A seamless
interconnection will allow customers to use the Level 3 network, including
voice and fax, without modifying existing telephone and fax equipment or
existing dialing procedures (that is, without the need to dial access codes
or follow other similar special procedures).
o Accelerate Market Roll-out. To support the launch of its services and
develop a customer base in advance of completing the construction of its
network, Level 3 has begun offering services in 17 U.S. cities and in
London and Frankfurt over leased local and intercity facilities. Over time,
these leased networks will be displaced by networks that the Company is
constructing.
o Expand Target Market Opportunities. The Company has a direct sales force
that targets large businesses. In addition, the Company has developed
alternative distribution channels to gain access to a substantially larger
base of potential customers than the Company could otherwise initially
address through its direct sales force. Through the combination of a direct
sales force and alternative distribution channels, the Company believes
that it will be able to rapidly increase revenue-producing traffic on its
network.
o Develop Advanced Business Support Systems. The Company is developing a
substantial, scalable and web-enabled business support system
infrastructure specifically designed to enable the Company to offer
services efficiently to its targeted customers. The Company believes that
this system will reduce our operating costs, give our customers direct
control over some of the services they buy from us and allow us to grow
rapidly without redesigning the architecture of its business support
system.
o Leverage Existing Information Services Capabilities. The Company is
expanding its existing capabilities in computer network systems
integration, consulting, outsourcing and software reengineering, with
particular emphasis on the conversion of legacy software systems to systems
that are compatible with IP networks and web browser access.
o Attract and Motivate High Quality Employees. The Company has developed
programs designed to attract and retain employees with the technical skills
necessary to implement the Business Plan. The programs include the
Company's Shareworks stock purchase plan and its Outperform Stock Option
program.
Competitive Advantages. The Company believes that it has the following
competitive advantages that, together with its strategy, will assist it in
implementing the Business Plan:
o Experienced Management Team. Level 3 has assembled a management team that
it believes is well suited to implement the Business Plan. Most of Level
3's senior management was involved in leading the development and marketing
of telecommunication products and in designing, constructing and managing
intercity, metropolitan and international networks.
o Opportunity to Create a More Readily Upgradable Network Infrastructure.
Level 3's network design strategy seeks to take advantage of recent
innovations, incorporating many of the features that are not present in
older communication networks and provides Level 3 flexibility to take
advantage of future development and innovation.
o Integrated End-to-End Network Platform. Level 3's strategy is to deploy
network infrastructure in major metropolitan areas and to link these
networks with significant intercity networks in North America and Europe.
The Company believes that the integration of its local and intercity
networks will expand the scope and reach of its on-net customer coverage,
and facilitate the uniform deployment of technological innovations as the
Company manages its future upgrade paths.
o Systems Integration Capabilities. The Company believes that its ability to
offer computer outsourcing and systems integration services, particularly
services relating to allowing a customer's legacy systems to be accessed
with web browsers, will provide additional opportunities for selling the
Company's products and services.
The Level 3 Network
An important element of the Business Plan is the development of the Level 3
network, an international, end-to-end network optimized for IP technology.
Today, the Company is primarily offering its communications services using local
and intercity facilities that are leased from third parties. This enables the
Company to offer services during the construction of its own facilities. Over
time, the portion of the Company's network that is owned by the Company will
increase and the portion of the facilities leased will decrease. Over the next
three to five years, the Company's network is expected to encompass:
o an intercity network covering nearly 16,000 miles in North America;
o backbone facilities in 40 North American markets;
o leased backbone facilities in 10 additional North American markets;
o an intercity network covering approximately 3,500 miles across Europe;
o leased or owned backbone facilities in 13 European and 8 Pacific Rim
markets; and
o transoceanic capacity.
Intercity Networks. The Company's nearly 16,000 mile fiber optic intercity
network in North America will consist of the following:
o Rights-of-way ("ROW") from a number of third parties including railroads,
highway commissions and utilities. The Company is procuring these rights
from sources which maximize the security and quality of the Company's
installed network. As of February 2, 1999, the Company had use of
approximately 14,400 miles of ROW which will satisfy approximately 93% of
the ROW requirements for the North American intercity network. It has
obtained these rights pursuant to agreements with Union Pacific Railroad
Company, Burlington Northern & Santa Fe Railroad Company, Canadian Pacific
Railway Co., Norfolk Southern Corporation and others.
o Multiple conduits connecting local city networks in approximately 200 North
American cities, in 50 of which the Company expects to have city networks.
In general, Level 3 will install groups of 10 conduits in its intercity
network, but will install groups of up to 12 conduits in areas where it
expects network demand to be stronger. The Company believes that the
availability of spare conduit will allow it to deploy future technological
innovations in optical networking components as well as providing Level 3
with the flexibility to offer conduit to other entities.
o Initial installation of optical fiber strands designed to accommodate dense
wave division multiplexing transmission technology. This fiber allows
deployment of equipment which transmits signals on 32 or more individual
wavelengths of light per strand, thereby significantly increasing the
capacity of the Company's network relative to older networks which
generally use optical fiber strands that transmit fewer wavelengths of
light per strand. In addition, the Company believes that the installation
of newer optical fibers will allow a combination of greater wavelengths of
light per strand, higher digital transmission speeds and greater spacing of
network electronics. The Company also believes that each new generation of
optical fiber will allow increases in the performance of these aspects of
the fiber and will result in lower unit costs.
o High speed SONET transmission equipment employing self-healing protection
switching and designed for high quality and reliable transmission.
o A design that maximizes the use of open, non-proprietary hardware and
software interfaces to allow less costly upgrades as hardware and software
technology improves.
To support the launch of its services in the third quarter of 1998, the
Company has leased intercity capacity from two providers, connecting the first
15 Level 3 North American markets. This leased capacity will be displaced over
time by Level 3's North American intercity network.
On July 20, 1998, Level 3 entered into a network construction cost-sharing
agreement with INTERNEXT, LLC, a subsidiary of NEXTLINK Communications, Inc. The
agreement, which is valued at $700 million, calls for INTERNEXT to acquire the
right to use 24 fibers and certain associated facilities installed along the
entire route of Level 3's North American intercity network in the United States.
INTERNEXT will pay Level 3 as segments of the intercity network are completed
which will reduce the overall cost of the network to the Company. The network as
provided to INTERNEXT will not include the necessary electronics that allow the
fiber to carry communications transmissions. Also, under the terms of the
agreement, INTERNEXT has the right to an additional conduit for its exclusive
use and to share costs and capacity in certain future fiber cable installations
in Level 3 conduits.
The following diagram depicts the currently planned North American intercity
network when fully constructed:
[Map depicting the Company's U.S. intercity network at completion.]
The North American intercity network is expected to be completed during the
first quarter of 2001. Deployment of the North American intercity network will
be accomplished through simultaneous construction efforts in multiple locations,
with different portions being completed at different times. As of December 31,
1998, the Company has completed 410 route miles of the intercity network and has
an additional 850 route miles under construction.
In Europe, the Company is deploying an approximately 3,500 mile fiber optic
intercity network with characteristics similar to those of the North American
intercity network. As in North America, the Company will provide initial service
in Europe over a leased line and dark fiber network that will be displaced over
time by the intercity network owned by the Company. The Company has recently
begun development of the first approximately 1,750 mile portion of the European
intercity network, with completion expected by the end of the third quarter of
2000. In the Pacific Rim, the Company currently intends to provide service over
a leased line intercity network and long term leases of submarine cable
capacity.
In 1998, the Company entered into transoceanic capacity agreements for
three systems which will link Level 3's North American, European and Pacific Rim
intercity networks. One agreement provides for Level 3's participation in the
construction of an undersea cable system that will connect Japan and the United
States by mid-year 2000. The remaining two agreements were entered into by the
Company for trans-Atlantic capacity.
Local Market Infrastructure. The Company's local facilities include fiber
optic networks, in a SONET ring configuration, connecting Level 3's intercity
network gateway sites to ILEC and CLEC central offices, long distance carrier
POPs, buildings housing communication-intensive end users and Internet peering
and transit facilities.
The Company has secured approximately 1.25 million square feet of space for
its gateway facilities as of January 1999 and has completed the buildout of
approximately 825,000 square feet of this space. The Company's gateway
facilities are being designed to house local sales staff, operational staff, the
Company's transmission and IP routing/switching facilities and technical space
to accommodate colocation of equipment by high-volume Level 3 customers, such as
ISPs, in an environmentally controlled, secure site with direct access to the
Level 3 network through dual, fault tolerant connections. The Company has
gateway facilities, which vary in size, in New York City, Washington, D.C.,
Philadelphia, Atlanta, Boston, Dallas, Houston, Chicago, Detroit, Denver,
Seattle, San Francisco, San Jose, Los Angeles, San Diego, Manchester, New
Hampshire and Providence, Rhode Island. The Company is offering a limited set of
services (including private line, colocation services, Internet access and
managed modem) at its gateway sites in these cities. The availability of these
services varies by location.
Construction of initial local fiber loops in eight cities is expected to be
completed by the end of the second quarter of 1999.
As of February 1, 1999, the Company had 107 approved ILEC colocation
applications in 27 cities and completed construction in 38 of these central
offices. As of February 1, 1999, the Company had entered into interconnection
agreements with RBOCs covering 22 cities.
The Company has negotiated master leases with several CLECs and ILECs to
obtain leased capacity from those providers so that the Company can provide its
clients with local transmission capabilities before its own local networks are
complete and in locations not directly accessed by the Company's owned
facilities.
The launches of services in London and Frankfurt followed the Company's
acquisitions of BusinessNet Limited, a leading UK ISP, in January 1999 and
miknet Internet Based Services GmbH, a leading German ISP, in September 1998.
The Company launched its international gateway in London in January 1999. The
75,000 square foot office and operations facility will be the hub of European
operations and will house the operational center and network equipment, along
with additional space for expansion and colocation services. The Company plans
to offer services in and between Paris, Amsterdam and Frankfurt in 1999 and one
additional European city, also in 1999.
Communication and Information Services
In connection with the Business Plan, the Company is substantially
increasing the emphasis it places on and the resources devoted to its
communications and information services business. The Company intends to build
on the strengths of its information services business and the benefits of the
Level 3 network to offer a broad range of other services to business and other
end users.
Level 3 currently offers, through its subsidiary PKSIS, computer operations
outsourcing and systems integration services to customers located throughout the
United States as well as abroad. The Company's systems integration services help
customers define, develop and implement cost-effective information services. The
computer outsourcing services offered by the Company include networking and
computing services necessary for older mainframe-based systems and newer
client/server-based systems. The Company provides its outsourcing services to
clients that want to focus their resources on core businesses, rather than
expend capital and incur overhead costs to operate their own computing
environments. Level 3 believes that it is able to utilize its expertise and
experience, as well as operating efficiencies, to provide its outsourcing
customers with levels of service equal to or better than those achievable by the
customers themselves, while at the same time reducing the customers' cost for
such services. This service is particularly useful for those customers moving
from older computing platforms to more modern client/server networks.
The Company offers reengineering services that allow companies to convert
older legacy software systems to modern networked computing systems, with a
focus on reengineering software to enable older software application and data
repositories to be accessed by web browsers over the Internet or over private or
limited access IP networks. Through its Suite 2000SM line of services, the
Company provides customers with a multi-phased service for converting programs
and applications so that date-related information is accurately processed and
stored before and after the year 2000. The Company also provides customers with
a combination of workbench tools and methodologies that provide a complete
strategy for converting mainframe-based application systems to client/server
architecture, while at the same time ensuring Year 2000 compliance.
As the Business Plan is being implemented, the Company is beginning to
offer a comprehensive range of communications services, including the following:
o Private Line and Special Access. Private line and special access services
are established as a permanent physical connection between locations for
the exclusive use of the customer. The Company is offering the following
types of special access and private line services:
o Private Line. This type of link is a dedicated line connecting two end-user
locations for voice and data applications, including ISPs.
o Carrier-to-Carrier Special Access. This type of link connects carriers
(long distance providers, wireless providers, ILECs and CLECs) to other
carriers.
o End-user to Long Distance Provider Special Access. This type of link
connects an end-user, such as a large business, with the local POP of its
chosen long distance provider.
The Company is currently offering its local special access and private line
services with available transmission speeds from T1 to OC3 and OC48 and its long
distance services will be offered at speeds from T1 to OC3 and OC48. The Company
is initially marketing its special access and private line services to ISPs,
resellers and medium to large corporate customers.
o Colocation. The Company is offering its customers and other service
providers the ability to locate their communications and networking
equipment at Level 3's gateway sites in a safe and secure technical
operating environment. The demand for these colocation services has
increased as companies expand into geographic areas in which they do not
have appropriate space or technical personnel to support their equipment
and operations. At its operational colocation sites, the Company is
offering customers AC/DC power, optional UPS power, emergency back-up
generator power, HVAC, fire protection and security. Level 3 is also
offering high-speed, reliable connectivity to the Level 3 leased network
and other networks, including both local and wide area networks, the PSTN
and Internet. These sites are being monitored and maintained 24 hours a
day, seven days a week.
Level 3 is offering customers, including ISPs, the opportunity to colocate
their web-server computers at the Company's larger gateway sites, enabling
them to take advantage of the marketing, customer service, internal company
information ("intranets") and other benefits offered by such web presence.
By colocating its web-server in a Level 3 facility, a customer has the
ability to deploy a high-quality, high-reliability Internet presence
without investing capital in data center space, multiple high-speed
connections or other capital intensive infrastructure. Although the
customer is responsible for maintaining the content and performance of its
server, the Company's technicians will be available to monitor basic server
operation. The Company will also offer redundant infrastructure consisting
of multiple routers and connections to Internet backbones and is also
offering IP services such as e-mail, news feeds and Domain Name Services.
o Internet Access. The Company is beginning to offer Internet access to
business customers, other carriers and ISPs. These services include
high-capacity Internet connections ranging from T1 to OC3 transmission
speeds. The Company has peering arrangements with approximately 60 ISPs and
is currently purchasing transit from two major ISPs.
o Managed Modem. The Company is offering to its customers an outsourced,
turn-key infrastructure solution for the management of dial up access to
either the public Internet or a corporate data network that may include
access to the public Internet ("Managed Modem"). While ISPs are provided a
fully managed dial-up network infrastructure for access to the public
Internet, corporate customers that purchase Managed Modem services receive
connectivity for remote users to support data applications such as
telecommuting, e-mail retrieval, and client/server applications. For
Managed Modem customers, Level 3 arranges for the provision of local
network coverage, dedicated local telephone numbers (which the Managed
Modem customer distributes to its customers in the case of an ISP or to its
employees in the case of a corporate customer), racks and modems as well as
dedicated connectivity from the customers location to the Level 3 gateway
facility. Level 3 also provides monitoring of this infrastructure 24 hours
a day, seven days a week. By providing a turn-key infrastructure modem
solution, Level 3 believes that this product allows its customers to save
both capital and operating costs.
o Voice and Fax. The Company seeks to offer voice and fax services, including
both real-time voice and fax transmission services, which are accessed
using existing telephone and fax equipment and existing dialing procedures.
The Company expects that these services will be offered at a quality level
equal to that of the PSTN.
o Special Services. The Company is offering dark fiber and conduit along its
local and intercity networks on a long term lease basis. Dark fiber is the
term that is used to describe fiber optic strands that are not connected to
transmission equipment. A customer can obtain dark fiber and/or conduit in
any combination of three ways: (1) segment by segment, (2) full ring or (3)
the entire Level 3 network. Level 3 offers colocation space in its gateway
and intercity retransmission facilities to these customers for the
placement of their transmission electronics. Although Level 3 will not be
responsible for the management of the customer's transmission electronics,
Level 3 is contemplating providing installation and maintenance services
for this equipment on a fee for service basis.
Distribution Strategy
The Company's distribution strategy is to utilize a direct sales force as
well as alternative distribution channels. Through the combination of a direct
sales force and alternative distribution channels, the Company believes that it
will be able to more rapidly access markets and increase revenue-producing
traffic on its network. To implement its distribution strategy, the Company is
developing an in-house direct sales force and several alternative distribution
channels.
The Company uses its direct sales force to market its available products
and services directly to large communications-intensive businesses. In addition,
the direct sales force targets national and international accounts. These
communications-intensive customers would typically be connected directly to the
Level 3 leased network using unswitched, dedicated facilities.
As part of its distribution strategy, the Company is developing several
alternative distribution channels. These include agents, resellers and
wholesalers.
o Agents are independent organizations that sell Level 3's products and
services under the Level 3 brand name to end-users in exchange for revenue
based commissions. The Company's agents generally focus on specific market
segments (such as small and medium sized businesses) and have existing
customer bases. Sales through this alternative distribution channel require
Level 3 to provide the same type of services that would be provided in the
case of sales through its own direct sales force such as order fulfillment,
billing and collections, customer care and direct sales management.
o Resellers are independent companies that purchase Level 3's products and
services and then "repackage" these services for sale to their customers
under their own brand name. Resellers generally require access to certain
of the Company's business operating systems in connection with the sale of
the Company's services to the resellers' customers. Sales through this
distribution channel generally do not require Level 3 to provide order
fulfillment, billing and collection and customer care.
o Wholesalers are independent companies that purchase from the Company
unbundled network and service capabilities in large quantities in order to
market their own products and services under a brand name other than Level
3. Wholesalers have minimal dependence on the Company's business support
systems in connection with the sale of services to their customers.
The Company anticipates that participants in its alternative distribution
channels will sell services directly to medium and small businesses and
consumers. The Company expects these medium and small businesses and consumers
to access the Level 3 network by using local switched services that are provided
by CLECs or ILECs or by utilizing newly emerging alternatives including various
DSL modem technologies, cable modems and wireless access technologies.
Business Support System
In order to pursue its direct sales and alternative distribution
strategies, the Company is developing a set of integrated software applications
designed to automate the Company's operational processes. Through the
development of a robust, scalable business support system, the Company believes
that it has the opportunity to develop a competitive advantage relative to
traditional telecommunications companies. Whereas traditional telecommunications
companies operate extensive legacy business support systems with
compartmentalized architectures that limit their ability to scale rapidly and
introduce enhanced services and features, the Company has developed a business
support system architecture intended to maximize both reliability and
scalability.
Key design aspects of the business support system development program are:
o integrated modular applications to allow the Company to upgrade specific
applications as new products are available;
o a scalable architecture that allows certain functions that would otherwise
have to be performed by Level 3 employees to be performed by the Company's
alternative distribution channel participants;
o phased completion of software releases designed to allow the Company to
test functionality on an incremental basis;
o "web-enabled" applications so that on-line access to all order entry,
network operations, billing, and customer care functions is available to
all authorized users, including Level 3's customers and resellers;
o use of a three-tiered, client/server architecture that is designed to
separate data and applications, and is expected to enable continued
improvement of software functionality at minimum cost; and
o maximum use of pre-developed or "shrink wrapped" applications, which will
interface to Level 3's enterprise resource planning suites.
The first three releases of the business support system have been delivered
and contain functionality necessary to support the set of services presently
offered. See "--Communication and Information Services."
Interconnection and Peering
As a result of the Telecom Act, properly certificated companies may, as a
matter of law, interconnect with ILECs on terms designed to help ensure
economic, technical and administrative equality between the interconnected
parties. The Telecom Act provides, among other things, that ILECs must offer
competitors the services and facilities necessary to offer local switched
services. See "--Regulation."
As of February 1, 1999, the Company had entered into interconnection
agreements covering 22 cities. The Company may be required to negotiate new or
renegotiate existing interconnection agreements as Level 3 expands its
operations in current and additional markets in the future.
Peering agreements between the Company and ISPs are necessary in order for
the Company to exchange traffic with those ISPs without having to pay transit
costs. The Company has peering arrangements with approximately 60 ISPs and is
currently purchasing transit from two major ISPs. The basis on which the large
national ISPs make peering available or impose settlement charges is evolving as
the provision of Internet access and related services has expanded. Recently,
companies that have previously offered peering have cut back or eliminated
peering relationships and are establishing new, more restrictive criteria for
peering. In order to maintain certain of its peering relationships, Level 3 will
have to meet these more restrictive criteria.
Employee Recruiting and Retention
As of December 31, 1998, Level 3 had 1,225 employees in the communications
portion of its business and PKSIS had approximately 959 employees, for a total
of 2,184 employees. The Company believes that its ability to implement the
Business Plan will depend in large part on its ability to attract and retain
substantial numbers of additional qualified employees. In order to attract and
retain highly qualified employees, the Company believes that it is important to
provide (i) a work environment that encourages each individual to perform to his
or her potential, (ii) a work environment that facilitates cooperation towards
shared goals and (iii) a compensation program designed to attract the kinds of
individuals the Company seeks and to align employees' interests with the
Company's. The Company believes the Business Plan and its announced relocation
to new facilities, currently being constructed in the Denver metropolitan area,
help provide such a work environment. With respect to compensation programs,
while the Company believes financial rewards alone are not sufficient to attract
and retain qualified employees, the Company believes a properly designed
compensation program is a necessary component of employee recruitment and
retention. In this regard the Company's philosophy is to pay annual cash
compensation which, if the Company's annual goals are met, is moderately greater
than the cash compensation paid by competitors. The Company's non-cash benefit
programs (including medical and health insurance, life insurance, disability
insurance, etc.) are designed to be comparable to those offered by its
competitors.
The Company believes that the qualified candidates it seeks place
particular emphasis on equity-based long term incentive ("LTI") programs. The
Company currently has two complementary programs: (i) the equity-based
"Shareworks" program, which helps ensure that all employees have an ownership
interest in the Company and are encouraged to invest risk capital in the
Company's stock; and (ii) an innovative Outperform Stock Option ("OSO") program.
The Shareworks program currently enables employees to contribute up to 7% of
their compensation toward the purchase of restricted common stock. If an
employee remains employed by the Company for three years from the date of
purchase, the shares will vest and be matched by the Company with a grant of an
equal number of shares of its common stock. The Shareworks program also provides
that, subject to satisfactory Company performance, the Company's employees will
be eligible annually for grants by the Company of its restricted common stock of
up to 3% of the employees' compensation, which shares will vest three years from
the grant date.
The Company has adopted the OSO program, which differs from LTI programs
generally adopted by the Company's competitors that make employees eligible for
conventional non-qualified stock options ("NQSOs"). While widely adopted, the
Company believes such NQSO programs reward eligible employees when company stock
price performance is inferior to investments of similar risks, dilute public
stockholders in a manner not directly proportional to performance and fail to
provide a preferred return on stockholders' invested capital over the return to
option holders. The Company believes that the OSO program is superior to an
NQSO-based program with respect to these issues while, at the same time,
providing eligible employees a success-based reward balancing the associated
risk.
The OSO program was designed by the Company so that its stockholders
receive a market related 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
S&P 500 Index. The value received for awards under the OSO plan is based on a
formula involving a multiplier related to how much our common stock outperforms
the S&P 500 Index. Participants in the OSO program do not realize any value from
OSOs unless our common stock price outperforms the S&P 500 Index. To the extent
that our common stock outperforms the S&P 500, the value of OSOs to an option
holder may exceed the value of NQSOs.
The Company adopted the recognition provisions of SFAS No. 123 in 1998.
Under SFAS No. 123, the fair value of an OSO (as computed in accordance with
accepted option valuation models) on the date of grant is amortized over the
vesting period of the OSO. The recognition provisions of SFAS No. 123 are
applied prospectively upon adoption. As a result, they 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. While the Company has not yet determined
the total effect of adopting the recognition provisions of SFAS No. 123, the
adoption resulted in non-cash charges to operations in 1998 of approximately $39
million and will result in OSO program non-cash charges to operations for future
periods that the Company believes will also be material. The amount of the
non-cash charge will be dependent upon a number of factors, including the number
of awards granted and the fair value estimated at the time of grant.
Competition
The communications and information services industry is highly competitive.
Many of the Company's existing and potential competitors in the communications
and information services industry have financial, personnel, marketing and other
resources significantly greater than those of the Company, as well as other
competitive advantages including existing customer bases. Increased
consolidation and strategic alliances in the industry resulting from the Telecom
Act, the opening of the U.S. market to foreign carriers, technological advances
and further deregulation could give rise to significant new competitors to the
Company.
In the special access and private line services market, the Company's
primary competitors will be IXCs, ILECs and CLECs. In the market for the
colocation of CLECs, the Company will compete with ILECs and CLECs. Most of
these competitors have a significant base of customers for whom they are
currently providing colocation services. Due to the high costs to CLECs of
switching colocation sites, the Company may have a competitive disadvantage
relative to these competitors. The market for the colocation of web-servers is
extremely competitive. In this market, the Company competes with ISPs and many
others, including IXCs, companies that provide only web hosting/IP colocation
services and a number of companies in the computer industry.
For voice and fax services, the Company will compete primarily with
national and regional network providers. There are currently three principal
facilities- based long distance fiber optic networks (AT&T, Sprint and MCI
WorldCom, Inc. ("MCI WorldCom")), as well as numerous ILEC and CLEC networks.
Others, including Qwest, IXC and Williams, are building additional networks that
employ advanced technology similar to that of the Level 3 Network and offer
significantly more capacity to the marketplace. The additional capacity that is
expected to become available in the next several years may cause significant
decreases in the prices for services. The ability of the Company to compete
effectively in this market will depend upon its ability to maintain high quality
services at prices equal to or below those charged by its competitors. IXCs and
certain CLECs with excess fiber optic strands may be competitors in the dark
fiber business. In the long distance market, the Company's primary competitors
will include AT&T, MCI WorldCom and Sprint, all of whom have extensive
experience in the long distance market. In addition, the Telecom Act will allow
the RBOCs and others to enter the long distance market. These providers are also
competitors in the provision of internet access. In local markets the Company
will compete with ILECs and CLECs, many of whom have extensive experience in the
local market. While the Company believes that IP technology will prove to be a
viable technology for the transmission of voice and fax services, technology is
not yet in place that will enable the Company to provide voice and fax services
at an acceptable level of quality. There can be no assurance that the Company
can develop or acquire such technology.
The communications and information services industry is subject to rapid
and significant changes in technology. For instance, recent technological
advances permit substantial increases in transmission capacity of both new and
existing fiber, and the introduction of new products or emergence of new
technologies may reduce the cost or increase the supply of certain services
similar to those which the Company plans on providing. Accordingly, in the
future the Company's most significant competitors may be new entrants to the
communications and information services industry, which are not burdened by an
installed base of outmoded equipment.
Regulation
The Company's communications services business will be subject to varying
degrees of federal, state, local and international regulation.
Federal Regulation
The FCC regulates interstate and international telecommunications services.
The FCC imposes extensive regulations on common carriers such as ILECs that have
some degree of market power. The FCC imposes less regulation on common carriers
without market power, such as the Company. The FCC permits these nondominant
carriers to provide domestic interstate services (including long distance and
access services) without prior authorization; but it requires carriers to
receive an authorization to construct and operate telecommunications facilities,
and to provide or resell telecommunications services, between the United States
and international points. The Company has obtained FCC authorization to provide
international services on a facilities and resale basis. The Company will be
required to file tariffs for its interstate and international long distance
services with the FCC before commencing operations.
Under the Telecom Act, any entity, including cable television companies,
and electric and gas utilities, may enter any telecommunications market, subject
to reasonable state regulation of safety, quality and consumer protection.
Because implementation of the Telecom Act is subject to numerous federal and
state policy rulemaking proceedings and judicial review, there is still
uncertainty as to what impact it will have on the Company. The Telecom Act is
intended to increase competition. The Telecom Act opens the local services
market by requiring ILECs to permit interconnection to their networks and
establishing ILEC obligations with respect to:
o Reciprocal Compensation. Requires all ILECs and CLECs to complete calls
originated by competing carriers under reciprocal arrangements at prices
based on a reasonable approximation of incremental cost or through mutual
exchange of traffic without explicit payment.
o Resale. Requires all ILECs and CLECs to permit resale of their
telecommunications services without unreasonable restrictions or
conditions. In addition, ILECs are required to offer wholesale versions of
all retail services to other telecommunications carriers for resale at
discounted rates, based on the costs avoided by the ILEC in the wholesale
offering.
o Interconnection. Requires all ILECs and CLECs to permit their competitors
to interconnect with their facilities. Requires all ILECs to permit
interconnection at any technically feasible point within their networks, on
nondiscriminatory terms, at prices based on cost (which may include a
reasonable profit). At the option of the carrier seeking interconnection,
colocation of the requesting carrier's equipment in an ILEC's premises must
be offered, except where the ILEC can demonstrate space limitations or
other technical impediments to colocation.
o Unbundled Access. Requires all ILECs to provide nondiscriminatory access to
unbundled network elements (including network facilities, equipment,
features, functions, and capabilities) at any technically feasible point
within their networks, on nondiscriminatory terms, at prices based on cost
(which may include a reasonable profit).
o Number Portability. Requires all ILECs and CLECs to permit users of
telecommunications services to retain existing telephone numbers without
impairment of quality, reliability or convenience when switching from one
telecommunications carrier to another.
o Dialing Parity. Requires all ILECs and CLECs to provide "1+" equal access
to competing providers of telephone exchange service and toll service, and
to provide nondiscriminatory access to telephone numbers, operator
services, directory assistance, and directory listing, with no unreasonable
dialing delays.
o Access to Rights-of-Way. Requires all ILECs and CLECs to permit competing
carriers access to poles, ducts, conduits and rights-of-way at regulated
prices.
ILECs are required to negotiate in good faith with carriers requesting any
or all of the above arrangements. If the negotiating carriers cannot reach
agreement within a prescribed time, either carrier may request binding
arbitration of the disputed issues by the state regulatory commission. Where an
agreement has not been reached, ILECs remain subject to interconnection
obligations established by the FCC and state telecommunication regulatory
commissions.
In August 1996, the FCC released a decision (the "Interconnection
Decision") establishing rules implementing the above-listed requirements and
providing guidelines for review of interconnection agreements by state public
utility commissions. The United States Court of Appeals for the Eighth Circuit
(the "Eighth Circuit") vacated certain portions of the Interconnection Decision.
On January 25, 1999, the Supreme Court reversed the Eighth Circuit with respect
to the FCC's jurisdiction to issue regulations governing local interconnection
pricing (including regulations governing reciprocal compensation). The Supreme
Court also found that the FCC had authority to promulgate a "pick and choose"
rule and upheld most of the FCC's rules governing access to unbundled network
elements. The Supreme Court, however, remanded to the FCC the standard by which
the FCC identified the network elements that must be made available on an
unbundled basis.
The Eighth Circuit decisions and their recent reversal by the Supreme Court
continue to cause uncertainty about the rules governing the pricing, terms and
conditions of interconnection agreements. The Supreme Court's action in
particular may require or trigger the renegotiation of existing agreements.
Although state public utilities commissions have continued to conduct
arbitrations, and to implement and enforce interconnection agreements during the
pendency of the Eighth Circuit proceedings, the Supreme Court's recent ruling
and further proceedings on remand (either at the Eighth Circuit or the FCC) may
affect the scope of state commissions' authority to conduct such proceedings or
to implement or enforce interconnection agreements. They could also result in
new or additional rules being promulgated by the FCC. Given the general
uncertainty surrounding the effect of the Eighth Circuit decisions and the
recent decision of the Supreme Court reversing them, there can be no assurance
that the Company will be able to continue to obtain or enforce interconnection
terms that are acceptable to it or that are consistent with its business plans.
The Telecom Act also codifies the ILECs' equal access and nondiscrimination
obligations and preempts inconsistent state regulation. The Telecom Act contains
special provisions that modify previous court decrees that prevented RBOCs from
providing long distance services and engaging in telecommunications equipment
manufacturing. These provisions permit a RBOC to enter the long distance market
in its traditional service area if it satisfies several procedural and
substantive requirements, including obtaining FCC approval upon a showing that
the RBOC has entered into interconnection agreements (or, under some
circumstances, has offered to enter into such agreements) in those states in
which it seeks long distance relief, the interconnection agreements satisfy a
14-point "checklist" of competitive requirements, and the FCC is satisfied that
the RBOC's entry into long distance markets is in the public interest. To date,
several petitions by RBOCs for such entry have been denied by the FCC, and none
have been granted. The Telecom Act permitted the RBOCs to enter the
out-of-region long distance market immediately upon its enactment.
In October 1996, the FCC adopted an order in which it eliminated the
requirement that non-dominant carriers such as the Company maintain tariffs on
file with the FCC for domestic interstate services. This order applies to all
non-dominant interstate carriers, including AT&T. The order does not apply to
the RBOCs or other local exchange providers. The FCC order was issued pursuant
to authority granted to the FCC in the Telecom Act to "forbear" from regulating
any telecommunications services provider if the FCC determines that the public
interest will be served. On February 13, 1997, the United States Court of
Appeals for the District of Columbia Circuit stayed the implementation of the
FCC order pending its review of the order on the merits. Currently, that
temporary stay remains in effect.
If the stay is lifted and the FCC order becomes effective,
telecommunications carriers such as the Company will no longer be able to rely
on the filing of tariffs with the FCC as a means of providing notice to
customers of prices, terms and conditions on which they offer their interstate
services. The obligation to provide non-discriminatory, just and reasonable
prices remains unchanged under the Communications Act of 1934. While tariffs
provided a means of providing notice of prices, terms and conditions, the
Company intends to rely primarily on its sales force and direct marketing to
provide such information to its customers.
The Company's costs of providing long distance services, as well as its
revenues from providing local services, will both be affected by changes in the
"access charge" rates imposed by ILECs on long distance carriers for origination
and termination of calls over local facilities. In two orders released on
December 24, 1996, and May 16, 1997, the FCC made major changes in the
interstate access charge structure. In the December 24th order, the FCC removed
restrictions on ILECs' ability to lower access prices and relaxed the regulation
of new switched access services in those markets where there are other providers
of access services. If this increased pricing flexibility is not effectively
monitored by federal regulators, it could have a material adverse effect on the
Company's ability to price its interstate access services competitively. The May
16th order substantially increased the amounts that ILECs subject to the FCC's
price cap rules ("price cap LECs") recover through monthly flat-rate charges and
substantially decreased the amounts that these LECs recover through traffic
sensitive (per-minute) access charges. In the May 16th order, the FCC also
announced its plan to bring interstate access rate levels more in line with
cost. The plan will include rules that are expected to be established sometime
in 1999 that may grant price cap LECs increased pricing flexibility upon
demonstrations of increased competition (or potential competition) in relevant
markets. The manner in which the FCC implements this approach to lowering access
charge levels could have a material effect on the Company's revenues and costs.
Several parties have appealed the May 16th order. Those appeals were
consolidated and transferred to the Eighth Circuit. On August 19, 1998, the
Eighth Circuit upheld the FCC's access charge reform rules.
Beginning in June 1997, every RBOC advised CLECs that they did not consider
calls in the same local calling area from their customers to CLEC customers, who
are ISPs, to be local calls under the interconnection agreements between the
RBOCs and the CLECs. The RBOCs claim that these calls are exchange access calls
for which exchange access charges would be owed. The RBOCs claimed, however,
that the FCC exempted these calls from access charges so that no compensation is
owed to the CLECs for transporting and terminating such calls. As a result, the
RBOCs threatened to withhold, and in many cases did withhold, reciprocal
compensation for the transport and termination of such calls. To date,
twenty-nine state commissions have ruled on this issue in the context of state
commission arbitration proceedings or enforcement proceedings. In every state,
to date, the state commission has determined that reciprocal compensation is
owed for such calls. Several of these cases are presently on appeal. Reviewing
courts have upheld the state commissions in the four decisions rendered to date
on appeal. Appeals from these decisions are pending in the Fifth, Seventh and
Ninth U.S. Circuit Courts of Appeal. On February 25, 1999, the FCC issued a
Declaratory Ruling on the issue of inter-carrier compensation for calls bound to
ISPs. The FCC ruled that the calls are jurisdictionally interstate calls, not
local calls. The FCC, however, determined that this issue was not dispositive of
whether inter-carrier compensation is owed. The FCC noted a number of factors
which would allow the state commissions to leave their decisions requiring the
payment of compensation undisturbed. The Company cannot predict the effect of
the FCC's ruling on existing state decisions, or the outcome of pending appeals
or of additional pending cases. The FCC also issued proposed rules to address
inter- carrier compensation in the future. If no compensation is provided for
these calls, it could have an adverse effect on the Company.
Since the FCC issued its order, each RBOC, including BellAtlantic from
which the Company has been receiving reciprocal compensation, has filed
petitions in selected states seeking relief from its obligations to pay
reciprocal compensation for ISP traffic. Where appropriate, the Company has
taken an active role in opposing these petitions.
The FCC has to date treated ISPs as "enhanced service providers," exempt
from federal and state regulations governing common carriers, including the
obligation to pay access charges and contribute to the universal service fund.
Nevertheless, regulations governing disclosure of confidential communications,
copyright, excise tax, and other requirements may apply to the Company's
provision of Internet access services. The Company cannot predict the likelihood
that state, federal or foreign governments will impose additional regulation on
the Company's Internet business, nor can it predict the impact that future
regulation will have on the Company's operations.
In December 1996, the FCC initiated a Notice of Inquiry regarding whether
to impose regulations or surcharges upon providers of Internet access and
information services (the "Internet NOI"). The Internet NOI sought public
comment upon whether to impose or continue to forebear from regulation of
Internet and other packet-switched network service providers. The Internet NOI
specifically identifies Internet telephony as a subject for FCC consideration.
On April 10, 1998, the FCC issued a Report to Congress on its implementation of
the universal service provisions of the Telecom Act. In that Report, the FCC
stated, among other things, that the provision of transmission capacity to ISPs
constitutes the provision of telecommunications and is, therefore, subject to
common carrier regulations. The FCC indicated that it would reexamine its policy
of not requiring an ISP to contribute to the universal service mechanisms when
the ISP provides its own transmission facilities and engages in data transport
over those facilities in order to provide an information service. Any such
contribution by a facilities-based ISP would be related to the ISP's provision
of the underlying telecommunications services. In the Report, the FCC also
indicated that it would examine the question of whether certain forms of
"phone-to-phone IP telephony" are information services or telecommunications
services. It noted that the FCC did not have an adequate record on which to make
any definitive pronouncements on that issue at this time, but that the record
the FCC had reviewed suggests that certain forms of phone-to-phone IP telephony
appear to have similar functionality to non-IP telecommunications services and
lack the characteristics that would render them information services. If the FCC
were to determine that certain IP telephony services are subject to FCC
regulations as telecommunications services, the FCC noted it may find it
reasonable that the ISPs pay access charges and make universal service
contributions similar to non-IP-based telecommunications service providers. The
FCC also noted that other forms of IP telephony appear to be information
services. The Company cannot predict the outcome of these proceedings or other
FCC proceedings that may effect the Company's operations or impose additional
requirements, or regulations or charges upon the Company's provision of Internet
access services.
On May 8, 1997, the FCC issued an order establishing a significantly
expanded federal universal service subsidy regime. For example, the FCC
established new universal service funds to support telecommunications and
information services provided to qualifying schools and libraries (with an
annual cap of $2.25 billion) and to rural health care providers (with an annual
cap of $400 million). The FCC also expanded the federal subsidies for local
exchange telephone services provided to low-income consumers. Providers of
interstate telecommunications service, such as the Company, as well as certain
other entities, must pay for these programs. The Company's contribution to these
universal service funds will be based on its telecommunications service end-user
revenues. The extent to which the Company's services are viewed as
telecommunications services or as information services will impact the amount of
the Company's contributions, if any. As indicated in the preceding paragraph,
that issue has not been resolved. Currently, the FCC assesses such payments on
the basis of a provider's revenue for the previous year. Since the Company had
no significant telecommunications service revenues in 1997, it was not liable
for subsidy payments in any material amount during 1998. With respect to
subsequent years, however, the Company is currently unable to quantify the
amount of subsidy payments that it will be required to make and the effect that
these required payments will have on its financial condition because of
uncertainties concerning the size of the universal fund and uncertainties
concerning the classification of its services. In the May 8th order, the FCC
also announced that it will soon revise its rules for subsidizing service
provided to consumers in high cost areas, which may result in further
substantial increases in the overall cost of the subsidy program. Several
parties have appealed the May 8th order. Such appeals have been consolidated and
transferred to the Fifth Circuit Court of Appeals where they are currently
pending. The FCC's universal service program may also be altered as a result of
the agency's reconsideration of its policies, or by future Congressional action.
State Regulation
The Telecom Act is intended to increase competition in the
telecommunications industry, especially in the local exchange market. With
respect to local services, ILECs are required to allow interconnection to their
networks and to provide unbundled access to network facilities, as well as a
number of other procompetitive measures. Because the implementation of the
Telecom Act is subject to numerous state rulemaking proceedings on these issues,
it is currently difficult to predict how quickly full competition for local
services, including local dial tone, will be introduced.
State regulatory agencies have jurisdiction when Company facilities and
services are used to provide intrastate services. A portion of the Company's
traffic may be classified as intrastate and therefore subject to state
regulation. The Company expects that it will offer more intrastate services
(including intrastate switched services) as its business and product lines
expand and state regulations are modified to allow increased local services
competition. To provide intrastate services, the Company generally must obtain a
certificate of public convenience and necessity from the state regulatory agency
and comply with state requirements for telecommunications utilities, including
state tariffing requirements. The Company currently is authorized to provide
telecommunications services in Arkansas (facilities-based IXC), California,
Colorado, Connecticut, Delaware, the District of Columbia, Florida, Georgia,
Idaho, Illinois, Indiana, Kentucky, Maryland, Massachusetts, Michigan, Missouri,
Montana, Nebraska, Nevada, New Hampshire, New Jersey, New York, Ohio, Oregon,
Pennsylvania, Rhode Island, South Carolina, Tennessee, Texas, Virginia,
Washington, and Wyoming.
The Company has pending applications for authority to provide
telecommunications service in Alabama, Arizona, Iowa, Kansas, Louisiana, Maine,
Minnesota, Mississippi, New Mexico, North Carolina, North Dakota, Oklahoma,
South Dakota, Vermont, West Virginia, Wisconsin, and Utah.
Local Regulation
The Company's networks will be subject to numerous local regulations such
as building codes and licensing. Such regulations vary on a city-by-city,
county- by-county and state-by-state basis. To install its own fiber optic
transmission facilities, the Company will need to obtain rights-of-way over
private and publicly owned land. There can be no assurance that rights-of-way
that are not already secured will be available to the Company on economically
reasonable or advantageous terms.
Canadian Regulation
The Canadian Radio-Television and Telecommunications Commission (the
"CRTC") generally regulates long distance telecommunications services in Canada.
Regulatory developments over the past several years have terminated the historic
monopolies of the regional telephone companies, bringing significant competition
to this industry for both domestic and international long distance services, but
also lessening regulation of domestic long distance companies. Resellers, which,
as well as facilities-based carriers, now have interconnection rights, but which
are not obligated to file tariffs, may not only provide transborder services to
the U.S. by reselling the services provided by the regional companies and other
entities but also may resell the services of the monopoly international carrier,
Teleglobe Canada ("Teleglobe"), including offering international switched
services provisioned over leased lines. Although the CRTC formerly restricted
the practice of "switched hubbing" over leased lines through intermediate
countries to a third country, the CRTC recently lifted this restriction. The
Teleglobe monopoly on international services and submarine cable landing rights
terminated as of October 1, 1998, although the provision of Canadian
international facilities-based services remains restricted to "Canadian
carriers" with majority ownership by Canadians. Ownership of non-international
facilities are limited to Canadian carriers but the Company can own
international submarine cables landing in Canada. The Company cannot, under
current or foreseen law, enter the Canadian market as a provider of
facilities-based domestic services. Pending proceedings address issues such as
the scope of contribution charges payable to the telephone companies to offset
some of the capital and operating costs of interconnection as well as
deregulation of the long distance services of the incumbent regional telephone
companies.
While competition is now emerging in other Canadian telecommunications
market segments, the Company believes that the regional companies continue to
retain a substantial majority of the local and calling card markets. Beginning
in May 1997, the CRTC released a number of decisions opening to competition the
Canadian local telecommunications services market, which decisions were made
applicable in the territories of all Stentor member companies except SaskTel
(although Saskatchewan has subsequently allowed local service competition in
that province). As a result, networks operated by CLECs may now be
interconnected with the networks of the ILECs. Facilities-based ILECs are
subject to the same majority Canadian ownership "Canadian carrier" requirements
as facilities-based long distance carriers. CLECs have the same status as ILECs,
but they do not have universal service or customer tariff-filing obligations.
CLECs are subject to certain consumer protection safeguards and other CRTC
regulatory oversight requirements. CLECs must file interconnection tariffs for
services to interexchange service providers and wireless service providers.
Certain ILEC services must be provided to CLECs on an unbundled basis and
subject to mandatory pricing, including central office codes, subscriber
listings, and local loops in small urban and rural areas. For a five-year
period, certain other important CLEC services must be provided on an unbundled
basis at mandated prices. ILECs, which, unlike CLECs, remained fully regulated,
will not be subject to rate of return regulation for an initial four-year period
beginning May 1, 1997, but their services must not be priced below cost.
Interexchange contribution payments are now pooled and distributed among ILECs
and CLECs according to a formula based on their respective proportions of
residential lines, with no explicit contribution payable from local business
exchange or directory revenues. CLECs must pay an annual telecommunications fee
based on their proportion of total CLEC operating revenues. All bundled and
unbundled local services (including residential lines and other bulk services)
may now be resold, but ILECs need not provide these services to resellers at
wholesale prices. Transmission facilities-based local and long distance carriers
(but not resellers) are entitled to colocate equipment in ILEC central offices
pursuant to terms and conditions of tariffs and intercarrier agreements. Certain
local competition issues are still to be resolved. The CRTC has ruled that
resellers cannot be classified as CLECs, and thus are not entitled to CLEC
interconnection terms and conditions.
The Company's Other Businesses.
The Company's other businesses include its investment in the C-TEC
Companies (as defined), coal mining, the SR91 Tollroad (as defined) and certain
other assets. The Company recently completed the sale of its interests in United
Infrastructure Company, MidAmerican and Kiewit Investment Management Corp.
C-TEC Companies
On September 30, 1997, C-TEC completed a tax-free restructuring, which
divided C-TEC into three public companies (the "C-TEC Companies"): C-TEC, which
changed its name to Commonwealth Telephone, RCN and Cable Michigan. The
Company's interests in the C-TEC Companies are held through a holding company
(the "C-TEC Holding Company"). The Company owns 90% of the common stock of the
C-TEC Holding Company, and preferred stock of the C-TEC Holding Company with a
liquidation value of approximately $467 million as of December 31, 1998. The
remaining 10% of the common stock of the C-TEC Holding Company is held by David
C. McCourt, a director of the Company who was formerly the Chairman of C-TEC. In
the event of a liquidation of the C-TEC Holding Company, the Company would first
receive the liquidation value of the preferred stock. Any excess of the value of
the C-TEC Holding Company above the liquidation value of the preferred stock
would be split according to the ownership of the common stock.
Commonwealth Telephone. Commonwealth Telephone is a Pennsylvania public
utility providing local telephone service to a 19-county, 5,191 square mile
service territory in Pennsylvania. Commonwealth Telephone services approximately
259,000 main access lines. Commonwealth Telephone also provides network access
and long distance services to IXCs. Commonwealth Telephone's business customer
base is diverse in size as well as industry, with very little concentration. A
subsidiary, Commonwealth Communications Inc. provides telecommunications
engineering and technical services to large corporate clients, hospitals and
universities in the northeastern United States. Another subsidiary, Commonwealth
Long Distance operates principally in Pennsylvania, providing switched services
and resale of several types of services, using the networks of several long
distance providers on a wholesale basis. As of December 31, 1998, the C-TEC
Holding Company owned approximately 48% of the outstanding common stock of
Commonwealth Telephone.
On October 23, 1998, Commonwealth Telephone completed a rights offering of
3.7 million shares of its common stock. In the offering, Level 3 exercised all
rights it received and purchased approximately 1.8 million additional shares of
Commonwealth Telephone common stock for an aggregate subscription price of $38
million.
RCN. RCN is a full service provider of local, long distance, Internet and
cable television services primarily to residential users in densely populated
areas in the Northeast. RCN operates as a competitive telecommunications service
provider in New York City and Boston. RCN also owns cable television operations
in New York, New Jersey and Pennsylvania; a 40% interest in Megacable, S.A. de
C.V., Mexico's second largest cable television operator; and has long distance
operations (other than the operations in certain areas of Pennsylvania). RCN is
developing advanced fiber optic networks to provide a wide range of
telecommunications services, including local and long distance telephone, video
programming and data services (including high speed Internet access), primarily
to residential customers in selected markets in the Boston to Washington, D.C.
corridor. During the first quarter of 1998, RCN acquired Ultranet
Communications, Inc. and Erols Internet, Inc., two ISPs with operations in the
Boston to Washington, D.C. corridor. As of December 31, 1998, the C-TEC Holding
Company owned approximately 41% of the outstanding common stock of RCN.
Cable Michigan. Cable Michigan is a cable television operator in the State
of Michigan which, as of December 31, 1997, served approximately 204,000
subscribers including approximately 39,400 subscribers served by Mercom.
Clustered primarily around the Michigan communities of Grand Rapids, Traverse
City, Lapeer and Monroe (Mercom), Cable Michigan's systems serve a total of
approximately 400 municipalities in suburban markets and small towns. On June 4,
1998, Cable Michigan announced that it had agreed to be acquired by Avalon
Cable. Level 3 received approximately $129 million in cash when the transaction
closed on November 6, 1998.
Coal Mining
The Company is engaged in coal mining through its subsidiary, KCP Inc.
("KCP"). KCP has a 50% interest in three mines, which are operated by a
subsidiary of Peter Kiewit Sons', Inc. ("New PKS"). Decker Coal Company
("Decker") is a joint venture with Western Minerals, Inc., a subsidiary of The
RTZ Corporation PLC. Black Butte Coal Company ("Black Butte") is a joint venture
with Bitter Creek Coal Company, a subsidiary of Union Pacific Resources Group
Inc. Walnut Creek Mining Company ("Walnut Creek") is a general partnership with
Phillips Coal Company, a subsidiary of Phillips Petroleum Company. The Decker
mine is located in southeastern Montana, the Black Butte mine is in southwestern
Wyoming, and the Walnut Creek mine is in east-central Texas. The coal mines use
the surface mining method.
The coal produced from the KCP mines is sold primarily to electric
utilities, which burn coal in order to produce steam to generate electricity.
Approximately 89% of sales are made under long-term contracts, and the remainder
are made on the spot market. Approximately 77%, 79% and 80% of KCP's revenues in
1998, 1997 and 1996, respectively, were derived from long-term contracts with
Commonwealth Edison Company (with Decker and Black Butte) and The Detroit Edison
Company (with Decker). The primary customer of Walnut Creek is the Texas-New
Mexico Power Company ("TNP"). KCP also has other sales commitments, including
those with Sierra Pacific, Idaho Power, Solvay Minerals, Pacific Power & Light,
Minnesota Power, and Mississippi Power, that provide for the delivery of
approximately 13 million tons through 2005. The level of cash flows generated in
recent periods by the Company's coal operations will not continue after the year
2000 because the delivery requirements under the Company's current long-term
contracts decline significantly.
Under a mine management agreement, KCP pays a subsidiary of New PKS an
annual fee equal to 30% of KCP's adjusted operating income. The fee in 1998 was
$34 million.
The coal industry is highly competitive. KCP competes not only with other
domestic and foreign coal suppliers, some of whom are larger and have greater
capital resources than KCP, but also with alternative methods of generating
electricity and alternative energy sources. In 1997, KCP's production
represented 1.4% of total U.S. coal production. Demand for KCP's coal is
affected by economic, political and regulatory factors. For example, recent
"clean air" laws may stimulate demand for low sulfur coal. KCP's western coal
reserves generally have a low sulfur content (less than one percent) and are
currently useful principally as fuel for coal-fired, steam-electric generating
units.
KCP's sales of its western coal, like sales by other western coal
producers, typically provide for delivery to customers at the mine. A
significant portion of the customer's delivered cost of coal is attributable to
transportation costs. Most of the coal sold from KCP's western mines is
currently shipped by rail to utilities outside Montana and Wyoming. The Decker
and Black Butte mines are each served by a single railroad. Many of their
western coal competitors are served by two railroads and such competitors'
customers often benefit from lower transportation costs because of competition
between railroads for coal hauling business. Other western coal producers,
particularly those in the Powder River Basin of Wyoming, have lower stripping
ratios (that is, the amount of overburden that must be removed in proportion to
the amount of minable coal) than the Black Butte and Decker mines, often
resulting in lower comparative costs of production. As a result, KCP's
production costs per ton of coal at the Black Butte and Decker mines can be as
much as four and five times greater than production costs of certain
competitors. KCP's production cost disadvantage has contributed to its agreement
to amend its long-term contract with Commonwealth Edison Company to provide for
delivery of coal from alternate source mines rather than from Black Butte.
Because of these cost disadvantages, KCP does not expect that it will be able to
enter into long-term coal purchase contracts for Black Butte and Decker
production as the current long-term contracts expire. In addition, these cost
disadvantages may adversely affect KCP's ability to compete for spot sales in
the future.
The Company is required to comply with various federal, state and local
laws and regulations concerning protection of the environment. KCP's share of
land reclamation expenses in 1998 was approximately $4 million. KCP's share of
accrued estimated reclamation costs was $96 million at the end of 1998. The
Company did not make significant capital expenditures for environmental
compliance with respect to the coal business in 1998. The Company believes its
compliance with environmental protection and land restoration laws will not
affect its competitive position since its competitors in the mining industry are
similarly affected by such laws. However, failure to comply with environmental
protection and land restoration laws, or actual reclamation costs in excess of
the Company's accruals, could have an adverse effect on the Company's business,
results of operations, or financial condition.
SR91 Tollroad
The Company has invested $12 million for a 65% equity interest and lent
$5.1 million to California Private Transportation Company L.P. ("CPTC"), which
developed, financed, and currently operates the 91 Express Lanes, a ten mile,
four-lane tollroad in Orange County, California (the "SR91 Tollroad"). The fully
automated highway uses an electronic toll collection system and variable pricing
to adjust tolls to demand. Capital costs at completion were $130 million, $110
million of which was funded with debt that was not guaranteed by Level 3.
However, certain defaults by Level 3 on its outstanding debt and certain
judgments against Level 3 can result in default under this debt of CPTC. Revenue
collected over the 35-year franchise period is used for operating expenses, debt
repayment, and profit distributions. The SR91 Tollroad opened in December 1995
and achieved operating break-even in 1996. Approximately 91,500 customers have
registered to use the tollroad as of December 1998, and weekday volumes
typically exceed 27,000 vehicles per day during December 1998.
Glossary
access Telecommunications services that permit long distance
carriers to use local exchange facilities to
originate and/or terminate long distance service.
access charges The fees paid by long distance carriers to LECs for
originating and terminating long distance calls on
the LECs' local networks.
backbone A centralized high-speed network that interconnects
smaller, independent networks. It is the
through-portion of a transmission network, as opposed
to spurs which branch off the through-portions.
CAP Competitive Access Provider. A company that provides
its customers with an alternative to the local
exchange for local transport of private line and
special access telecommunications services.
capacity The information carrying ability of a
telecommunications facility.
carrier A provider of communications transmission services by
fiber, wire or radio.
Central Office Telephone company facility where subscribers'
lines are joined to switching equipment for
connecting other subscribers to each other, locally
and long distance.
CLEC Competitive Local Exchange Carrier. A company that
competes with LECs in the local services market.
colocation Colocation refers to the physical location of a
telecommunication carrier's equipment in ILEC or CLEC
premises to facilitate the interconnection of their
respective switching/routing equipment.
common carrier A government-defined group of private
companies offering telecommunications services or
facilities to the general public on a
non-discriminatory basis.
conduit A pipe, usually made of metal, ceramic or plastic,
that protects buried cables.
dedicated lines Telecommunications lines reserved for use by
particular customers.
dialing parity The ability of a competing local or toll
service provider to provide telecommunications
services in such a manner that customers have the
ability to route automatically, without the use of
any access code, their telecommunications to the
service provider of the customers' designation.
equal access The basis upon which customers of
interexchange carriers are able to obtain access to
their Primary Interexchange Carriers' (PIC) long
distance telephone network by dialing "1", thus
eliminating the need to dial additional digits and an
authorization code to obtain such access.
facilities-based carriers Carriers that own and operate their own network and
equipment.
fiber optics A technology in which light is used to transport
information from one point to another. Fiber optic
cables are thin filaments of glass through which
light beams are transmitted over long distances
carrying enormous amounts of data. Modulating
light on thin strands of glass produces major
benefits including high bandwidth, relatively low
cost, low power consumption, small space needs and
total insensitivity to electromagnetic interference.
Gbps 1000 Mbps.
ILEC Incumbent Local Exchange Carrier. A company
historically providing local telephone service.
Often refers to one of the Regional Bell Operating
Companies (RBOCs). Often referred to as "LEC"
(Local Exchange Carrier).
interconnection Interconnection of facilities between or among local
exchange carriers, including potential physical
colocation of one carrier's equipment in the other
carrier's premises to facilitate such
interconnection.
interLATA Telecommunications services originating in a LATA and
terminating outside of that LATA.
Internet A global collection of interconnected computer
networks which use a specific communications
protocol.
intraLATA Telecommunications services originating and
terminating in the same LATA.
IP Internet Protocol. Network protocols that allow
computers with different architectures and operating
system software to communicate with other computers
on the Internet.
ISDN Integrated Services Digital Network. An information
transfer standard for transmitting digital voice and
data over telephone lines at speeds up to 128 Kbps.
ISPs Internet Service Providers. Companies formed to
provide access to the Internet to consumers and
business customers via local networks.
IXC Interexchange Carrier. A telecommunications company
that provides telecommunications services between
local exchanges on an interstate or intrastate basis.
A transmission rate. One kilobit equals 1,024 bits of
information.
Kbps Kilobits per second. A transmission rate. One kilobit
equals 1,024 bits of information.
LATA Local Access and Transport Area. A geographic area
composed of contiguous local exchanges, usually but
not always within a single state. There are
approximately 200 LATAs in the United States.
leased line Telecommunications line dedicated to a particular
customer along predetermined routes.
LEC Local Exchange Carrier. A telecommunications company
that provides telecommunications services in a
geographic area in which calls generally are
transmitted without toll charges. LECs include both
ILECs and CLECs.
local exchange A geographic area determined by the
appropriate state regulatory authority in which calls
generally are transmitted without toll charges to the
calling or called party.
local loop A circuit that connects an end user to the LEC
central office within a LATA.
long distance carriers (interexchange carriers) Long distance carriers
provide services between local exchanges on an
interstate or intrastate basis. A long distance
carrier may offer services over its own or another
carrier's facilities.
Mbps Megabits per second. A transmission rate. One megabit
equals 1,024 kilobits.
multiplexing An electronic or optical process that combines a
large number of lower speed transmission lines into
one high speed line by splitting the total available
bandwidth into narrower bands (frequency division),
or by allotting a common channel to several different
transmitting devices, one at a time in sequence (time
division).
NAP Network Access Point. A location at which ISPs
exchange each other's traffic.
OC3 A data communications circuit consisting of three
DS3s capable of transmitting data at 155 Mbps.
OC48 A data communications circuit consisting of
forty-eight DS3s capable of transmitting data at
approximately 2.45 Gbps.
peering The commercial practice under which ISPs exchange
each other's traffic without the payment of
settlement charges. Peering occurs at both public and
private exchange points.
POP Point of Presence. Telecommunications facility where
a communications provider locates network equipment
used to connect customers to its network backbone.
private line A dedicated telecommunications connection between end
user locations.
PSTN Public Switched Telephone Network. That portion of a
local exchange company's network available to all
users generally on a shared basis (i.e., not
dedicated to a particular user). Traffic along the
public switched network is generally switched at the
local exchange company's central offices.
RBOCs Regional Bell Operating Companies. Originally, the
seven local telephone companies (formerly part of
AT&T)established as a result of the AT&T Divestiture.
Currently consists of five local telephone companies
as a result of the mergers of Bell Atlantic with
NYNEX and SBC with Pacific Telesis.
reciprocal compensation The compensation of a new competitive local exchange
carrier for termination of a local call by the
local exchange carrier on the new carrier's
network, which is the same as the compensation
that the new carrier pays the local exchange
carrier for termination of local calls on the local
exchange carrier network.
resale Resale by a provider of telecommunications services
(such as a LEC) of such services to other providers
or carriers on a wholesale or a retail basis.
router Equipment placed between networks that relays data to
those networks based upon a destination address
contained in the data packets being routed.
SONET Synchronous Optical Network. An electronics and
network architecture for variable bandwidth products
which enables transmission of voice, data and video
(multimedia) at very high speeds. SONET ring
architecture provides for virtually instantaneous
restoration of service in the event of a fiber cut by
automatically rerouting traffic in the opposite
direction around the ring.
special access services The lease of private, dedicated telecommunications
lines or "circuits" along the network of a local
exchange company or a CAP, which lines or circuits
run to or from the long distance carrier POPs.
Examples of special access services are
telecommunications lines running between POPs of a
single long distance carrier, from one long distance
carrier POP to the POP of another long distance
carrier or from an end user to a long distance
carrier POP.
switch A device that selects the paths or circuits to be
used for transmission of information and establishes
a connection. Switching is the process of
interconnecting circuits to form a transmission path
between users and it also captures information for
billing purposes.
TI A data communications circuit capable of transmitting
data at 1.544 Mbps.
unbundled Services, programs, software and training sold
separately from the hardware.
unbundled access Access to unbundled elements of a telecommunications
services provider's network including network
facilities, equipment, features, functions and
capabilities, at any technically feasible point
within such network.
web site A server connected to the Internet from which
Internet users can obtain information.
wireless A communications system that operates without wires.
Cellular service is an example.
world wide web or web A collection of computer systems supporting a
communications protocol that permits multimedia
presentation of information over the Internet.
xDSL A term referring to a variety of new Digital
Subscriber Line technologies. Some of these new
varieties area symmetric with different data rates in
the downstream and upstream directions. Others are
symmetric. Downstream speeds range from 384 Kbps (or
"SDSL") to 1.5 to 8 Mbps ("ADSL").
Directors and Executive Officers
Set forth below is information as of March 23, 1999 about each director and
each executive officer of the Company. The executive officers of the Company
have been determined in accordance with the rules of the SEC.
Name Age Position
Walter Scott, Jr. 67 Chairman of the Board
James Q. Crowe 49 President, Chief Executive Officer and Director
R. Douglas Bradbury 48 Executive Vice President, Chief Financial Officer
and Director
Kevin J. O'Hara 38 Executive Vice President and Chief Operating
Officer
Colin V.K. Williams 59 Executive Vice President
Mark L. Gershien 48 Senior Vice President
Michael D. Jones 41 Senior Vice President
Thomas C. Stortz 47 Senior Vice President, General Counsel and
Secretary
Philip B. Fletcher 66 Director
William L. Grewcock 73 Director
Richard R. Jaros 47 Director
Robert E. Julian 59 Director
David C. McCourt 42 Director
Kenneth E. Stinson 56 Director
Michael B. Yanney 65 Director
Other Management
Set forth below is information as of March 23, 1999 about the following
members of senior management of the Company.
Name Age Position
Daniel P. Caruso 35 Senior Vice President
Donald H. Gips 39 Senior Vice President
Joseph M. Howell, III 52 Senior Vice President
Gail P. Smith 39 Senior Vice President
Thomas Sweeney 38 Senior Vice President
Ronald J. Vidal 38 Senior Vice President
Sureel A. Choksi 26 Vice President and Treasurer
Walter Scott, Jr. has been the Chairman of the Board of the Company since
September 1979, and a director of the Company since April 1964. Mr. Scott has
been Chairman Emeritus of New PKS since the Split-off. Mr. Scott is also a
director of New PKS, Berkshire Hathaway Inc., Burlington Resources Inc.,
MidAmerican, ConAgra, Inc., Commonwealth Telephone, RCN, U.S. Bancorp and
Valmont Industries, Inc.
James Q. Crowe has been the President and Chief Executive Officer of the
Company since August 1997, and a director of the Company since June 1993. Mr.
Crowe was President and Chief Executive Officer of MFS from June 1993 to June
1997. Mr. Crowe also served as Chairman of the Board of MFS/WorldCom from
January 1997 until July 1997, and as Chairman of the Board of MFS from 1992
through 1996. Mr. Crowe is presently a director of New PKS, Commonwealth
Telephone, RCN and InaCom Communications, Inc.
R. Douglas Bradbury has been Executive Vice President and Chief Financial
Officer of the Company since August 1997, and a director of the Company since
March 1998. Mr. Bradbury served as Chief Financial Officer of MFS from 1992 to
1996, Senior Vice President of MFS from 1992 to 1995, and Executive Vice
President of MFS from 1995 to 1996.
Kevin J. O'Hara has been Executive Vice President of the Company since
August 1997, and Chief Operating Officer of the Company since March 1998. Prior
to that, Mr. O'Hara served as President and Chief Executive Officer of MFS
Global Network Services, Inc. from 1995 to 1997, and as Senior Vice President of
MFS and President of MFS Development, Inc. from October 1992 to August 1995.
From 1990 to 1992, he was a Vice President of MFS Telecom, Inc. ("MFS Telecom").
Colin V.K. Williams has been Executive Vice President of the Company since
July 1998 and President of Level 3 International, Inc. since July 1998. Prior to
joining the company, Mr. Williams was Chairman of WorldCom International, Inc.,
where he was responsible for the international communications business and the
development and operation of WorldCom's fiber networks overseas. In 1993 Mr.
Williams initiated and built the international operations of MFS. Prior to
joining MFS, Mr. Williams was Corporate Director, Business Development at
British Telecom from 1988 until 1992.
Mark L. Gershien has been Senior Vice President, Sales of the Company since
January 1998. Prior to that, Mr. Gershien was Vice President/General Manager of
MFS during 1993, Division President of MFS from 1993 to 1995, Chief Operating
Officer of MFS Telecom from May 1995 to July 1996, President of MFS Telecom from
1996 to 1997, and Senior Vice President, National Accounts of MFS/WorldCom from
1997 to 1998.
Michael D. Jones has been the Acting Chief Executive Officer of PKSIS since
December 1998. Mr. Jones also has served as Senior Vice President and Chief
Information Officer of the Company since December 1998. Prior to that, Mr. Jones
was Vice President and Chief Information Officer of Corporate Express, Inc. from
May 1994 to May 1998.
Thomas C. Stortz has been Senior Vice President, General Counsel and
Secretary of the Company since September 1998. Prior to that, he served as Vice
President and General Counsel of Peter Kiewit Sons', Inc. and Kiewit
Construction Group, Inc. from April 1991 to September 1998. He has served as a
director of Peter Kiewit Sons', Inc., RCN, C-TEC, Kiewit Diversified Group Inc.
and CCL Industries, Inc.
Philip B. Fletcher has been a director of the Company since February 1999.
Mr. Fletcher was Chairman of the Board of ConAgra, Inc. from May 1993 until
September 1998. Mr. Fletcher was Chief Executive Officer of ConAgra, Inc. from
September 1992 to September 1997. Mr. Fletcher is a director of ConAgra, Inc.
and chairman of its executive committee.
William L. Grewcock has been a director of the Company since January 1968.
Prior to the Split-off, Mr. Grewcock was Vice Chairman of the Company for more
than five years. He is presently a director of New PKS.
Richard R. Jaros has been a director of the Company since June 1993 and
served as President of the Company from 1996 to 1997. Mr. Jaros served as
Executive Vice President of the Company from 1993 to 1996 and Chief Financial
Officer of the Company from 1995 to 1996. He also served as President and Chief
Operating Officer of MidAmerican from 1992 to 1993, and is presently a director
of MidAmerican, Commonwealth Telephone and RCN.
Robert E. Julian has been a director of the Company since March 31, 1998.
Mr. Julian has also been Chairman of the Board of PKSIS since 1995. From 1992 to
1995 Mr. Julian served as Executive Vice President and Chief Financial Officer
of the Company.
David C. McCourt has been a director of the Company since March 31, 1998.
Mr. McCourt has also served as Chairman and Chief Executive Officer of
Commonwealth Telephone and RCN since October 1997. From 1993 to 1997 Mr. McCourt
served as Chairman of the Board and Chief Executive Officer of C-TEC.
Kenneth E. Stinson has been a director of the Company since January 1987.
Mr. Stinson has been Chairman of the Board and Chief Executive Officer of New
PKS since the Split-Off. Prior to the Split-Off, Mr. Stinson was Executive Vice
President of the Company for more than the last five years. Mr. Stinson is also
a director of ConAgra, Inc. and Valmont Industries, Inc.
Michael B. Yanney has been a director of the Company since March 31, 1998.
He has served as Chairman of the Board, President and Chief Executive Officer of
America First Companies L.L.C. for more than the last five years. Mr. Yanney is
also a director of Burlington Northern Santa Fe Corporation, RCN, Forest Oil
Corporation and Mid-America Apartment Communities, Inc.
Daniel P. Caruso has been Senior Vice President, Network Services of the
Company since October 1997. Prior to that, Mr. Caruso was Senior Vice President,
Local Service Delivery of WorldCom from December 1992 to September 1997 and was
a member of the senior management of Ameritech from June 1986 to November 1992.
Donald H. Gips has been Senior Vice President, Corporate Development of the
Company since November 1998. Prior to that, Mr. Gips served in the White House
as Chief Domestic Policy Advisor to Vice President Gore from April 1997 to April
1998. Before working at the White House, Mr. Gips was at the Federal
Communications Commission as the International Bureau Chief and Director of
Strategic Policy from January 1994 to April 1997. Prior to his government
service, Mr. Gips was a management consultant at McKinsey and Company.
Joseph M. Howell, III has been Senior Vice President, Corporate Marketing
of the Company since October 1997. Prior to that, Mr. Howell was Senior Vice
President of MFS/WorldCom from 1993 to 1997. Prior to joining MFS, Mr. Howell
was President and CEO of Carl Byoir & Associates, Inc., an international
marketing company, from 1991 to 1993.
Gail P. Smith has been Senior Vice President, International Sales and
Marketing of the Company since December 1998. Prior to that, Ms. Smith was Vice
President and General Manager of WorldCom International Networks from November
1994 to July 1997 and European Marketing Director during the start-up phase of
MFS International.
Thomas P. Sweeney has been Senior Vice President, Marketing of the Company
since December 1997. Prior to that, Mr. Sweeney was Vice President, Sales
Operations of MFS Intelenet, Inc. ("MFS Intelenet") from 1995 to 1996, Senior
Vice President, Marketing of MFS Intelenet from 1996 to 1997 and Senior Vice
President, Business Development of MFS/WorldCom during 1997.
Ronald J. Vidal has been Senior Vice President, New Ventures of the Company
since October 1997. Prior to that, Mr. Vidal was a Vice President of
MFS/WorldCom from September 1992 to October 1997. Mr. Vidal joined the Company
in construction project management in July 1983.
Sureel A. Choksi has been Vice President and Treasurer of the Company since
January 1999. Prior to that, Mr. Choksi was a Director of Finance at the Company
from 1997 to 1998, an Associate at TeleSoft Management, LLC in 1997 and an
Analyst at Gleacher Natwest from 1995 to 1997.
The Board is divided into three classes, designated Class I, Class II and
Class III, each class consisting, as nearly as may be possible, of one-third of
the total number of directors constituting the Board. The Class I Directors
currently consist of Walter Scott, Jr., James Q. Crowe and Philip B. Fletcher,
with one vacancy; the Class II Directors consist of William L. Grewcock, Richard
R. Jaros, Robert E. Julian and David C. McCourt; and the Class III Directors
consist of R. Douglas Bradbury, Kenneth E. Stinson and Michael B. Yanney. The
term of the initial Class I Directors will terminate on the date of the 2001
annual meeting of stockholders; the term of the initial Class II Directors will
terminate on the date of the 1999 annual meeting of stockholders; and the term
of the initial Class III Directors will terminate on the date of the 2000 annual
meeting of stockholders. At each annual meeting of stockholders, successors to
the class of directors whose term expires at that annual meeting will be elected
for three-year terms. The Company's officers are elected annually to serve until
each successor is elected and qualified or until his death, resignation or
removal.
Employees
As of December 31, 1998, Level 3 had 1,225 employees in the communications
portion of its business and PKSIS had approximately 959 employees, for a total
of 2,184 employees.
ITEM 2. PROPERTIES
The Company has announced that it has acquired 46 acres in the Northwest
corner of the Interlocken office park within the City of Broomfield, Colorado,
and within Boulder County, Colorado limits and will build a campus facility that
is expected to encompass eventually over 500,000 square feet of office space.
Construction has begun on this facility, and it is anticipated that the first
phase of this facility will be completed by the summer of 1999. In addition, the
Company has leased approximately 250,000 square feet of temporary office space
in Louisville, Colorado to allow for the relocation of the majority of its
employees (other than those of PKSIS) while its permanent facilities are under
construction. Properties relating to the Company's coal mining segment are
described under "--The Company's Other Businesses" above. In connection with
certain existing and historical operations, the Company is subject to
environmental risks.
The Company has approximately 1.25 million square feet of space for its
gateway facilities. The Company's gateway facilities are being designed to house
local sales staff, operational staff, the Company's transmission and IP
routing/switching facilities and technical space to accommodate colocation of
equipment by high-volume Level 3 customers.
PKSIS maintains its corporate headquarters in Omaha, Nebraska and leases
approximately 35,000 square feet of office space in Omaha. The computer
outsourcing business of PKSIS is located at an 89,000 square foot office space
in Omaha and at a 60,000 square foot computer center in Tempe, Arizona. PKSIS
maintains additional office space in Phoenix, Atlanta, Omaha and Parsippany for
its systems integration business.
ITEM 3. LEGAL PROCEEDINGS
The Company and its subsidiaries are parties to many pending legal
proceedings. Management believes that any resulting liabilities for legal
proceedings, beyond amounts reserved, will not materially affect the Company's
financial condition, results of operations or future cash flows.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted during the fourth quarter of the fiscal year
covered by this report to a vote of security holders, through the solicitation
of proxies or otherwise.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Market Information. The Company's common stock is traded on the Nasdaq
National Market under the symbol "LVLT." As of March 23, 1999, there were
approximately 3,000 holders of record of the Company's common stock, par value
$.01 per share. The Common Stock began trading on the Nasdaq National Market on
April 1, 1998, the day following the Split-off. The table below sets forth, for
the calendar quarters indicated, the high and low per share closing sale prices
of our common stock as reported by the Nasdaq National Market. The prices set
forth in the table have been adjusted to reflect the two-for-one split of our
common stock effected as a stock dividend in August 1998.
Year Ended December 31, 1998 High Low
Second Quarter (from April 1, 1998).........$37.1300 $24.0000
Third Quarter................................42.1300 29.7800
Fourth Quarter...............................43.1300 24.0000
Dividend Policy. The Company's current dividend policy, in effect since
April 1, 1998, is to retain future earnings for use in the Company's business.
As a result, management does not anticipate paying any cash dividends on shares
of Common Stock in the foreseeable future. In addition, the Company is
effectively restricted under certain debt covenants from paying cash dividends
on shares of its Common Stock.
Information For Periods Prior to April 1, 1998.
The following information relates to the equity securities of the Company
for periods prior to April 1, 1998. As part of the Split-off, an amended and
restated certificate of incorporation for the Company was filed in the State of
Delaware to provide for only one class of common stock, par value $.01 per
share. The information that follows is for historical purposes only and is
required to be presented by the rules of the Securities and Exchange Commission.
Company Repurchase Duty. Pursuant to the terms of the Company's Certificate
of Incorporation prior to April 1, 1998 (the "Pre-April 1998 Certificate"), the
Company was generally required to repurchase shares at a formula price upon
demand. Under the Pre-April 1998 Certificate effective January 1992, the Company
had three classes of common stock: Class B Construction & Mining Group Nonvoting
Restricted Redeemable Convertible Exchangeable Common Stock ("Class B"), Class C
Construction & Mining Group Restricted Redeemable Convertible Exchangeable
Common Stock, par value $.0625 per share (the "Class C Stock"), and Class D
Diversified Group Convertible Exchangeable Common Stock, par value $.0625 per
share (the "Class D Stock"). Prior to April 1, 1998, Class C Stock was issued
only to Company employees and could only be resold to the Company at a formula
price based on the year-end book value of the Construction Group. The Company
was generally required to repurchase Class C Stock for cash upon a stockholder's
demand. Class D Stock had a formula price based on the year-end book value of
the Diversified Group. The Company was generally required to repurchase Class D
Stock for cash upon a stockholder's demand at the formula price, unless the
Class D Stock become publicly traded.
Formula values. The formula price of the Class D Stock was based on the
book value of the Diversified Group and its subsidiaries, plus one-half of the
book value, on a stand-alone basis, of the parent company. The formula price of
the Class C Stock was based on the book value of the Construction Group and its
subsidiaries, plus one-half of the book value of the unconsolidated parent
company. A significant element of the Class C formula price was the subtraction
of the book value of property, plant, and equipment used in construction
activities.
Conversion. Under the Pre-April 1998 Certificate, Class C Stock was
convertible into Class D Stock at the end of each year. Between October 15 and
December 15 of each year a Class C Stockholder was able to elect to convert some
or all of his or her shares. Conversion occurred on the following January 1. The
conversion ratio was the relative formula prices of Class C and Class D Stock
determined as of the last Saturday in December. Class D Stock was convertible
into Class C Stock only as part of an annual offering of Class C Stock to
employees. Instead of purchasing the offered shares for cash, an employee owning
Class D Stock was able to convert such shares into Class C Stock at the
applicable conversion ratio.
Restrictions. Ownership of Class C Stock was generally restricted to active
Company employees. Upon retirement, termination of employment, or death, Class C
Stock was required to be resold to the Company at the applicable formula price,
but may be converted into Class D Stock if the terminating event occurs during
the annual conversion period. Class D Stock was not subject to ownership or
transfer restrictions.
Dividends and Prices. During 1997 the Company declared or paid the
following dividends on shares of Class C Stock and Class D Stock. The table also
shows the stock price after each dividend payment or other valuation event.
Date Date Paid Amount Class Date Price Adjusted Price
Oct. 25, 1996 Jan. 4, 1997 0.70 C Dec. 28, 1996 40.700
Apr. 23, 1997 May 1, 1997 0.70 C May 1, 1997 40.000
Oct. 22, 1997 Jan. 5, 1998 0.80 C Dec. 27, 1997 51.200
Oct. 27, 1995 Jan. 5, 1996 0.05 D Dec. 30, 1995 4.950*
Oct. 25, 1996 Jan. 4, 1997 0.05 D Dec. 28, 1996 5.425*
D Dec. 27, 1997 5.825*
* All stock prices and dividends for the Class D Stock reflect a dividend of
four shares of Class D Stock for each outstanding share of Class D Stock
that was effective December 1997 and a dividend of one share of Common Stock
(formerly Class D Stock) for each outstanding share of Common Stock
effective August 1998.
ITEM 6. SELECTED FINANCIAL DATA.
The Selected Financial Data of Level 3 Communications, Inc. and Subsidiaries
appears below.
Fiscal Year Ended (1)
(dollars in millions, -----------------------------------------------------------------
except per share amounts) 1998 1997 1996 1995 1994
- - ------------------------------------------------------------------------------------------------------------------
Results of Operations:
Revenue $ 392 $ 332 $ 652 $ 580 $ 537
Income (loss) from continuing
operations (2) (128) 83 104 126 28
Net earnings (3) 804 248 221 244 110
Per Common Share:
Earnings (loss)from continuing operations (0.43) 0.33 0.45 0.58 0.23
Dividends (4) - - 0.05 0.05 -
Financial Position:
Total assets 5,525 2,779 3,066 2,945 4,048
Current portion of
long-term debt 5 3 57 40 30
Long-term debt, less
current portion (5) 2,641 137 320 361 899
Stockholders' equity 2,165 2,230 1,819 1,607 1,736
<FN>
(1) In October 1993, Level 3 acquired 35% of the outstanding shares of C-TEC
Corporation ("C-TEC"), which shares entitled Level 3 to 57% of the
available voting rights of C-TEC. At December 28, 1996, Level 3 owned 48%
of the outstanding shares and 62% of the voting rights of C-TEC.
As a result of the restructuring of C-TEC in 1997, Level 3 owns less than
50% of the outstanding shares and voting rights of each of the three
entities into which C-TEC was divided, and therefore accounted for each
entity using the equity method in 1997 and 1998. Level 3 consolidated C-TEC
in its financial statements from 1994 to 1996.
The financial position and results of operations of the construction and
mining management businesses ("Construction Group") of Level 3 have been
classified as discontinued operations due to the March 31, 1998 split-off
of Level 3's Construction Group from its other businesses.
In 1995, Level 3 dividended its investment in its former subsidiary, MFS
Communications Company, Inc. ("MFS") to the holders of the Class D Stock.
MFS' results of operations have been classified as a single line item on
the statements of earnings for 1994 and 1995. MFS was consolidated in the
1994 balance sheet of Level 3. In 1994, MFS received net proceeds of
approximately $500 million from the sale of 9.375% Senior Discount Notes.
Level 3 sold its energy segment to MidAmerican Energy Holdings Company
(f/k/a CalEnergy Company, Inc.) ("MidAmerican") in 1998 and classified it
as discontinued operations within the financial statements.
</FN>
<FN>
(2) Level 3 incurred significant expenses in conjunction with the expansion of
its communications and information services businesses in 1998.
In 1998, Level 3 acquired XCOM Technologies, Inc. ("XCOM") and its
developing telephone-to-IP network bridge technology. Level 3 originally
recorded a $115 million nondeductible charge against earnings for the
write-off of in-process research and development acquired in the
transaction.
In October 1998, the Securities and Exchange Commission ("SEC") issued new
guidelines for valuing acquired research and development which are applied
retroactively. Consequently, the Company has reduced the charge by $85
million, which also increases goodwill by the corresponding amount. The
goodwill associated with the XCOM transaction is being amortized over a
five year period.
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.
</FN>
<FN>
(3) In 1998, Level 3 recognized a gain of $608 million equal to the difference
between the carrying value of the Construction Group and its fair value. No
taxes were provided on this gain due to the tax-free nature of the
split-off.
In 1998, Cable Michigan, Inc. was acquired by Avalon Cable of Michigan,
Inc. Level 3 received approximately $129 million for its shares of Cable
Michigan, Inc. in the acquisition and recognized a pre-tax gain of
approximately $90 million in the fourth quarter of 1998.
Level 3 also recognized in 1998 an after-tax gain of $324 million on the
sale of its energy segment to MidAmerican.
</FN>
<FN>
(4) The 1996 and 1995 dividends include $.05 for dividends declared in 1996
and 1995 but paid in January of the subsequent year.
The Company's current dividend policy, in effect since April 1, 1998, is to
retain future earnings for use in the Company's business. As a result,
management does not anticipate paying any cash dividends on shares of
Common Stock in the foreseeable future. In addition, the Company is
effectively restricted under certain covenants from paying cash dividends
on shares of its Common Stock.
</FN>
<FN>
(5) In 1998, Level 3 issued $2 billion of 9.125% Senior Notes due 2008 and $834
million principal amount at maturity of 10.5% Senior Discount Notes due
2008.
</FN>
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATION
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 Level 3 Communications, Inc. and its
subsidiaries ("Level 3" or 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.
Recent Developments
Split-off
In October 1996, the Board of Directors of the Company (the "Board")
directed management of the Company to pursue a listing of the Company's Class D
Diversified Group Convertible Exchangeable Common Stock, par value $.0625 per
share (the "Class D Stock"), as a way to address certain issues created by the
Company's then two-class capital stock structure and the need to attract and
retain the best management for the Company's businesses. During the course of
its examination of the consequences of a listing of the Class D Stock,
management concluded that a listing of the Class D Stock would not adequately
address these issues, and instead began to study a separation of the
construction operations ("Construction Group") from the other businesses of the
Company (the "Diversified Group"), thereby forming two independent companies. At
the time, the performance of the Diversified Group was reflected by the Class D
Stock. The performance of the Construction Group was reflected by the Company's
Class C Construction & Mining Group Restricted Redeemable Convertible
Exchangeable Common Stock, par value $.0625 per share (the "Class C Stock"). At
the regular meeting of the Board on July 23, 1997, management submitted to the
Board for consideration a proposal for the separation of the Construction Group
and the Diversified Group through a split-off of the Construction Group (the
"Split-off"). At a special meeting on August 14, 1997, the Board approved the
Split-off.
The separation of the Construction Group and the Diversified Group was
contingent upon a number of conditions, including the favorable ratification by
a majority of the holders of both the Company's Class C Stock and the Class D
Stock, and the receipt by the Company of an Internal Revenue Service ruling or
other assurance acceptable to the Board that the separation would be tax-free to
U.S. stockholders. On December 8, 1997, the holders of Class C Stock and Class D
Stock approved the Split-off and on March 5, 1998, the Company received a
favorable private letter ruling from the Internal Revenue Service. The Split-off
was effected on March 31, 1998. In connection with the Split-off, (i) the
Company exchanged each outstanding share of Class C Stock for one share of
Common Stock of PKS Holdings, Inc. ("New PKS"), the Company formed to hold the
Construction Group, to which eight-tenths of a share of the Company's Class R
Convertible Common Stock, par value $.01 per share (the "Class R Stock"), was
attached to replace certain conversion features in the Class C Stock which would
terminate upon the Split-off (ii) New PKS was renamed "Peter Kiewit Sons', Inc."
(iii) the Company was renamed "Level 3 Communications, Inc.", and (iv) the Class
D Stock was designated as common stock, par value $.01 per share (the "Common
Stock"). As a result of the Split-off, the Company no longer owns any interest
in New PKS or 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 financial position of the Construction Group as of December 27, 1997, and
the results of operations for the two years ended December 27, 1997.
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.
Conversion of Class R Stock
On May 1, 1998, the Board of the Company determined to force conversion of
all shares of the Company's Class R Stock into shares of Common Stock, effective
May 15, 1998. The Class R Stock was converted into the Company's Common Stock in
accordance with the formula set forth in the Company's Certificate of
Incorporation. The formula provided for a conversion ratio equal to $25, divided
by the average of the midpoints between the high and low sales prices for the
Company's Common Stock on each of the fifteen trading days during the period
beginning April 9, 1998 and ending April 30, 1998. The average for that period
was $32.14, adjusted for the stock dividend issued August 10, 1998. Accordingly,
each holder of Class R Stock received .7778 of a share of Common Stock for each
share of Class R Stock held. In total, the 6.5 million shares of Class R Stock
were converted into 5.1 million shares of Common Stock on May 15, 1998. As a
result of the forced conversion, certain adjustments were made to the cost
sharing and risk allocation provisions of the Separation Agreement and Tax
Sharing Agreement between the Company and Peter Kiewit Sons', Inc. that were
executed in connection with the Split-off. The effect of these adjustments was
to reduce certain Split-off costs and risks allocated to the Company.
Conversion of Class C Stock in January 1998
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).
MidAmerican Transaction
In January 1998, the Company and MidAmerican Energy Holding Co. (f/k/a as
CalEnergy Company, Inc.) ("MidAmerican") closed the sale of the Company's energy
assets to MidAmerican (the "MidAmerican Transaction"). The Company received
proceeds of approximately $1.16 billion and recognized an after-tax gain of $324
million in the first quarter of 1998. The after-tax proceeds from this
transaction of approximately $967 million are being used to fund in part the
Company's expansion of its information services business and the development of
an advanced, international, facilities-based communications network based on
Internet Protocol ("IP") technology.
Stock Options
The Company adopted the recognition provisions of Statement of Financial
Accounting Standards 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 period of the option. 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.
In April 1998, the company adopted an outperform stock option ("OSO")
program that was designed by the Company 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 options 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 options 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 an option holder may exceed the value of
non-qualified stock options.
The Company believes that the fair value method of accounting more
appropriately reflects the substance of the transaction between an entity that
issues stock options, or other stock-based instruments, and its employees and
consultants; that is, an entity has granted something of value to an employee
and consultants (the stock option or other instrument) generally in return for
their continued employment and services. The Company believes that the value of
the instrument granted to employees and consultants should be recognized in
financial statements because nonrecognition implies that either the instruments
have no value or that they are free to employees and consultants, neither of
which is an accurate reflection of the substance of the transaction. Although
the recognition of the value of the instruments results in compensation and
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 charge will be dependent upon a number of factors, including the
number of options granted and the fair value of each option estimated at the
time of its grant. The expense recognized for options granted to employees and
consultants for services performed for the year ended December 31, 1998, was $39
million. In addition to the expense recognized, the Company capitalized $5
million of non-cash compensation costs for employees directly involved in the
construction of the IP network and the development of the business support
systems.
Frontier Agreement
On March 23, 1998, the Company and Frontier Communications International,
Inc. ("Frontier") entered into an agreement ("Frontier Agreement") enabling the
Company to lease approximately 8,300 miles of network capacity on Frontier's new
13,000 mile SONET fiber optic, IP-capable network, currently under construction
for a period of up to five years. The leased network will initially connect 15
of the larger cities across the United States. While requiring an aggregate
minimum payment of $165 million over its five-year term, the Frontier Agreement
does not impose monthly minimum consumption requirements on the Company,
allowing the Company to order, alter or terminate circuits as it deems
appropriate. The Company recognized $4 million of costs in 1998 for leased
capacity on Frontier's network.
Union Pacific Rights-of-Way
On April 2, 1998, the Company announced it had reached a definitive
agreement with Union Pacific Railroad Company (the "Union Pacific Agreement")
granting the Company the use of approximately 7,800 miles of rights-of-way along
Union Pacific's rail routes for construction of the Company's North American
intercity network. The Company expects that the Union Pacific Agreement will
satisfy substantially all of its anticipated right-of-way requirements west of
the Mississippi River and approximately 50% of the right-of-way requirements for
its North American intercity network. The agreement provides for initial fixed
payments of up to $8 million to Union Pacific upon execution of the agreement
and throughout the construction period, recurring payments in the form of cash,
communications capacity, and other communications services based on the number
of conduits that are operational and certain construction obligations of the
Company to provide fiber or conduit connections for Union Pacific at the
Company's incremental cost of construction. In 1998, the Company recorded $9
million of payments made under this agreement in network
construction-in-progress.
XCOM Technologies, Inc. Acquisition
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. The purchase price
exceeded the fair value of the net assets acquired by $30 million which was
recognized as goodwill and is being amortized over five years.
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 and assumptions 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
related goodwill by $85 million. The goodwill associated with the XCOM
transaction is being amortized over a five year period.
XCOM's in-process research and development value is comprised primarily
of one project to develop an interface between an IP-based network and the
existing public switched telecommunications network. Remaining development
efforts for this project include various phases of design, development and
testing. The anticipated completion date for this project in progress is
expected to be over the next 12 months, at which time the Company expects to
begin generating the full economic benefit from the technology. Funding for
this project is expected to be obtained from internally generated
sources.
The value of the in-process research and development represents the
estimated fair value based on risk-adjusted cash flows related to the incomplete
project. At the date of acquisition, the development of the project had not
yet reached technological feasibility and the research and development ("R&D")
in progress had no alternative future uses. Accordingly, these costs were
expensed as of the acquisition date.
The Company used an independent third-party appraiser to assess and
allocate a value to the in-process research and development. The value assigned
to the asset was determined, using the income approach, by identifying
significant research projects for which technological feasibility had not been
established.
The nature of the efforts to develop the acquired in-process technology
into commercially viable products and services principally relate to the
completion of all planning, designing, prototyping, high-volume verification,
and testing activities that are necessary to establish that the proposed
technologies meet their design specifications including functional, technical,
and economic performance requirements.
The value assigned to purchased in-process technology was determined by
estimating the contribution of the purchased in-process technology to developing
a commercially viable product, estimating the resulting net cash flows from the
expected product sales over a 15 year period, and discounting the net cash flows
to their present value using a risk-adjusted discount rate of 30%, and
adjusting it for the estimated stage of completion.
The Company believes that the foregoing assumptions used in the forecast
were reasonable at the time of the acquisition. No assurance can be given,
however, that the underlying assumptions used to estimate expected project
sales, development costs or profitability, or the events associated with this
project, will transpire as estimated. For these reasons, actual results may vary
from the projected results.
Management expects to continue their support of this effort and believes
the Company has a reasonable chance of successfully completing the R&D program.
However, there is risk associated with the completion of the project and there
is no assurance that it will meet with either technological or commercial
success. If the XCOM project is not successful, the Company would not realize
its investment in XCOM and would be required to modify its business plan to
utilize alternative technologies which may increase the cost of its network.
The Company believes that its resulting charge for acquired research and
development conforms to the SEC's expressed guideline and methodologies.
However, no assurances can be given that the SEC will not require additional
adjustments.
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 (the "Senior Notes"). The Senior Notes are senior, unsecured obligations of
the Company, ranking pari passu with all existing and future senior unsecured
indebtedness of the Company. The Senior Notes contain certain covenants, which
among others, limit consolidated debt, dividend payments and transactions with
affiliates. The Company is using the net proceeds of the Senior Notes offering
in connection with the implementation of its Business Plan.
Debt issuances costs of $65 million have been capitalized and are being
amortized over the term of the Senior Notes.
Network Construction Contract
On June 18, 1998, Level 3 selected Peter Kiewit Sons', Inc. ("Kiewit") to
build a majority of its nearly 16,000 mile U.S. intercity communications
network. The overall cost of the project is estimated at $2 billion.
Construction of the network began in the third quarter of 1998 and is expected
to be completed during the first quarter of 2001. The contract provides that
Kiewit will be reimbursed for its costs relating to all direct and indirect
project level costs. In addition, Kiewit will have the opportunity to earn an
award fee that will be based on cost and speed of construction, quality, safety
and program management. The award fee will be determined by Level 3's assessment
of Kiewit's performance in each of these areas.
Burlington Northern Santa Fe Rights-of-Way
On June 23, 1998, the Company signed a master easement agreement with
Burlington Northern and Santa Fe Railroad Company ("BNSF"). The agreement grants
Level 3 right-of-way access to BNSF rail routes in as many as 28 states over
which to build its network. Under the easement agreement, Level 3 will make
annual payments to BNSF and provide communications capacity to BNSF for its
internal requirements. The amount of the annual payments is dependent upon the
number of conduits installed, the number of conduits with fiber, and the number
of miles of conduit installed along BNSF's route.
INTERNEXT Agreement
On July 20, 1998, Level 3 entered into a network construction cost-sharing
agreement with INTERNEXT, LLC, a subsidiary of NEXTLINK Communications, Inc.
valued at $700 million. The agreement provides for INTERNEXT to acquire the
right to use conduit, fibers and certain associated facilities along the entire
route of Level 3's nearly 16,000 mile intercity fiber optic network in the
United States. INTERNEXT paid $26 million in 1998 which was deferred and
included in other liabilities at December 31, 1998 and will pay the remaining
amounts as segments of the intercity network are completed and accepted. The
Company will recognize income as the segments of the network are completed and
accepted.
The agreement does not include the necessary electronics that allow the
fiber to carry communications transmissions. INTERNEXT will be restricted from
selling or leasing fiber to unaffiliated companies for four years following the
date of the agreement. Also, under the terms of the agreement, INTERNEXT has the
right to an additional conduit for its exclusive use and to share costs and
capacity in certain future fiber cable installations in Level 3 conduits.
Japan-US Cable Network
On August 3, 1998, Level 3 and a group of other global telecommunications
companies entered into an agreement to construct an undersea cable system
connecting Japan and the United States to be completed by mid-year 2000. The
parties to this agreement are investing in excess of $1 billion to build the
network, of which Level 3 is expected to contribute approximately $130 million.
Each party will have joint responsibility for the cost of network oversight,
maintenance and administration. The Company has recorded $24 million of costs
associated with this project in network construction-in-progress in 1998.
Commonwealth Telephone Enterprises, Inc.
On September 25, 1998, Commonwealth Telephone Enterprises, Inc.
("Commonwealth Telephone") announced that it was commencing a rights offering of
3.7 million shares of its common stock. Under the terms of the offering, each
stockholder received one right for every five shares of Commonwealth Telephone
Common Stock or Commonwealth Telephone Class B Common Stock held. The rights
enabled the holder to purchase Commonwealth Telephone Common Stock at a
subscription price of $21.25 per share. Each right also carried the right to
oversubscribe at the subscription price for the offered shares not purchased
pursuant to the initial exercise of rights.
Level 3, which owned approximately 48% of Commonwealth Telephone prior to
the rights offering, exercised 1.8 million rights it received with respect to
the subscription rights it held for $38 million. As a result of subscriptions
made by other stockholders, Level 3 maintained its 48% ownership interest in
Commonwealth Telephone after the rights offering.
GeoNet Communications, Inc. Acquisition
On September 30, 1998, Level 3 acquired GeoNet Communications, Inc.
("GeoNet"), a regional Internet service provider located in northern California.
The Company issued approximately 0.6 million shares and options in exchange for
GeoNet's capital stock, which valued the transaction at approximately $19
million. Liabilities exceeded assets acquired, and goodwill of $21 million was
recognized from this transaction which is being amortized over five years.
Global Crossing Agreement
On October 14, 1998, Level 3 announced that it had signed an agreement with
Global Crossing Ltd. ("Global") for trans-oceanic capacity on Global's fiber
optic cable network. The agreement, covering 25 years and valued at
approximately $108 million, will provide Level 3 with as-needed dedicated
capacity across the Atlantic Ocean. Level 3 also will have the option of
utilizing capacity on other segments of Global's worldwide network. In 1998, the
Company recorded as network construction-in-progress, $32 million of costs
associated with this agreement.
10.5 % Senior Discount Notes
On December 2, 1998, the Company announced that it sold $834 million
principal amount at maturity of 10.5% Senior Discount Notes Due 2008 in a
transaction exempt from registration under the Securities Act of 1933. These
notes are senior, unsecured obligations of the Company, ranking pari passu with
all existing and future senior unsecured indebtedness of the Company.
The net proceeds of $486 million after deducting anticipated offering
expenses, are intended to be used to accelerate the implementation of the
Company's business plan, primarily the funding for the increase in the committed
(prefunded) number of route miles of the Company's U.S. intercity network.
Debt issuance costs of $14 million have been capitalized and will be
amortized over the term of the Senior Discount Notes.
Equity Offering
Level 3 filed 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 through a primary offering. The net proceeds from the
offering of approximately $1.5 billion 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 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 IP technology.
IXC Communications Agreement
On December 18, 1998 Level 3 announced an agreement with IXC
Communications, Inc. ("IXC") to lease capacity on IXC's network. The dedicated
network will enhance the Company's ability to offer a wide array of data and
voice services to a greater number of customers in key U.S. markets. The
arrangement is unique in that IXC will reserve the network for the exclusive use
of Level 3, which expects to begin using the network increments beginning in
Spring, 1999. The Company paid IXC $40 million under this agreement in 1998 and
included this amount in property, plant and equipment.
BusinessNet Limited
On January 5, 1999 Level 3 acquired BusinessNet Limited, a leading
London-based Internet service provider in a largely stock-for-stock deal. After
completion of post-closing adjustments, the Company issued approximately 400,000
shares of Common Stock and paid approximately $1 million in exchange for
BusinessNet's capital stock. The transaction was valued at approximately $18
million and was accounted for as a purchase.
Results of Operations 1998 vs. 1997
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 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.
In 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 five
days in the 1998 fiscal year are reflected in the period ended December 31,
1998. There were 52 weeks in fiscal years 1997 and 1996.
Revenue for the years ended December 31, 1998 and December 27, 1997 is
summarized as follows (in millions):
1998 1997
---- ----
Communications and Information Services $144 $ 95
Coal Mining 228 222
Other 20 15
------ ------
$392 $332
==== ====
Communications and Information Services revenue increased 52% in 1998. The
IP business generated revenues of approximately $24 million in 1998, of which
$22 million is attributable to the acquisition of XCOM. Approximately 87% of
XCOM's revenue is attributable to reciprocal compensation agreements with
BellAtlantic ("BellAtlantic"). 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. In the absence of a federal rule,
the FCC determined that it would not be unreasonable for a state commission, in
some circumstances, to require payment of 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.
BellAtlantic has 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 of this matter may have a material adverse
effect to the Company.
The computer outsourcing business experienced significant revenue growth in
1998. The inclusion of a full year of revenue from customers which began service
in 1997 and an increase in revenue from the existing customer base, resulted in
a 26% increase in outsourcing revenue. The systems integration business
experienced a 27% increase in revenue in 1998. This increase is primarily
attributable to new acquisitions and a strong demand for Year 2000 renovation
during the first six months of 1998 and other systems reengineering services.
Revenue from coal mines increased slightly in 1998. An increase in
alternate source coal sales to Commonwealth Edison Company ("Commonwealth") was
partially offset by the expiration of a long-term contract also with
Commonwealth. In 1998 the Company and Commonwealth amended their contract to
allow Commonwealth to accelerate delivery of coal. The amended contract requires
Commonwealth to take delivery of its year 2001 coal commitments in 1998, 1999
and 2000. Of the 2001 commitments, 50% was taken in 1998 and 25% will be taken
in both 1999 and 2000. The expiration of the long-term contract was partially
offset by contracts with new customers in 1998. If current market conditions
continue, the Company will experience a significant decline in coal revenue and
earnings over the next several years as delivery requirements under long-term
contracts decline as these long-term contracts begin to expire.
Other revenue is primarily attributable to California Private
Transportation Company, L.P. ("CPTC") the owner operator of the SR91 tollroad in
southern California. Revenues increased in 1998 primarily due to higher traffic
counts and increases in toll rates.
Operating Expenses increased 22% from $163 million in 1997 to $199 million
in 1998 primarily due to expenses incurred in connection with the Company's
Business Plan to expand the communications and information services businesses.
Operating expenses related to communications and information services revenue in
1998 were $98 million up from $62 million in 1997. Costs attributable to the
XCOM and GeoNet acquisitions as well as costs associated with the Frontier lease
are responsible for an $11 million increase in operating expenses. Operating
expenses for the computer outsourcing and systems integration business increased
$5 million and $20 million in 1998, respectively. The increase in the computer
outsourcing operating expenses is primarily attributable to the startup expenses
associated with the second data center in Tempe, Arizona. Higher than expected
costs for Year 2000 work resulted in the significant increase in systems
integration operating expenses in 1998. The Company also incurred expenses to
refocus its efforts away from Year 2000 services to systems and software
reengineering for IP related applications. Operating expenses related to coal
mining were consistent with the prior year.
Depreciation and amortization expense has increased $46 million from $20
million in 1997. The primary reason for this increase is the $910 million of
capital expenditures in 1998, of which approximately $481 million was placed in
service in 1998. The majority of the assets placed in service are associated
with 15 gateway sites constructed for the expansion of the communications
business. Also contributing to the increase was the depreciation and
amortization on equipment purchased for computer outsourcing contracts, assets
acquired through business acquisitions in 1998 and the amortization of goodwill
related to these acquisitions. Depreciation and amortization will continue to
increase in 1999 as additional facilities are placed in service.
General and administrative expenses increased $226 million to $332 million
in 1998. This increase of 213% from 1997 is primarily attributable to the
implementation of the Business Plan, including additional communications and
information services personnel. The total number of communications and
information services employees at December 31, 1998 was approximately 2,200 as
compared to approximately 1,000 at December 27, 1997. Cash compensation included
in expense increased from $14 million in 1997 to $51 million in 1998. In
addition, $39 million of non-cash stock based compensation expense was recorded
in 1998, of which, $24 million was related to the Company's Outperform Stock
Option program introduced in the second quarter of 1998. These costs are
accounted for in accordance with SFAS No. 123, "Accounting for Stock - Based
Compensation." Professional fees increased $74 million in 1998 primarily for
legal costs associated with obtaining licenses, agreements and technical
facilities and other development costs associated with starting to offer
services in U.S. cities. Also included in professional fees is third party
software and associated development costs incurred in developing integrated
business support systems. These expenses were recorded in accordance with the
American Institute of Certified Public Accountant's ("AICPA") Statement of
Position 98-1, "Accounting for the Costs of Computer Software Developed or
Obtained for Internal Use", which specifically identifies those costs that
should be expensed or capitalized for internally developed software. General and
administrative expenses 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.
On April 23, 1998 the Company completed the acquisition of XCOM, a privately
held company that developed certain components necessary for the Company to
develop an interface between its IP based network and the existing public
switched telephone network.
The Company accounted for this transaction, valued at $154 million, as a
purchase. Of the total purchase price, $115 million was originally allocated
to acquired in-process research and development, and was taken as a
nondeductible charge to earnings in the second quarter of 1998. In October
1998, the SEC issued new guidelines for valuing acquired research and
development which are applied retroactively. Consequently, the Company has
reduced the charge by $85 million, which also increases goodwill by a
corresponding amount. Goodwill associated with the XCOM transaction is being
amortized over a 5 year period.
The Company believes that its resulting charge for acquired research and
development conforms to the SEC's expressed guideline and methodologies.
However, no assurances can be given that the SEC will not require additional
adjustments.
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. The Company
excludes noncash compensation due to its adoption of the expense recognition
provisions of SFAS No. 123. EBITDA decreased from $84 million in 1997 to
($100) in 1998 primarily due to 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 is not intended to represent cash flow for the periods.
See Consolidated Statements of Cash Flows.
Interest Income increased significantly in 1998 to $173 million from $33
million in 1997 as the Company's cash, cash equivalents and marketable
securities balances increased to $3.7 billion at December 31, 1998 from $765
million at December 27, 1997 as a result of the two debt offerings and the
proceeds from the sale of its energy business. Pending utilization of the cash
equivalents and marketable securities in implementing the Business Plan, the
Company intends to continue investing 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 $15 million in 1997 to
$132 million in 1998 due to the completion of the offering of $2 billion
aggregate principal amount of 9.125% Senior Notes Due 2008 issued on April 28,
1998 and $834 million aggregate principal amount at maturity of 10.5% Senior
Discount Notes Due 2008 issued on December 2, 1998. The amortization of a
portion of the $79 million of debt issuance costs associated with the Senior
Notes and Senior Discount Notes also increased interest expense in 1998. The
Company capitalized $15 million of interest expense on network construction and
business support systems development projects in 1998.
Equity Losses in Unconsolidated Subsidiaries increased to $132 million in
1998 primarily due to the equity losses attributable to RCN Corporation, Inc.
("RCN"). RCN is the largest single source, facilities-based provider of
communications services to the residential markets primarily in the Northeast
and the largest regional Internet service provider in the Northeast. RCN is also
incurring significant costs in developing its business plan including the
acquisitions of several Internet service providers. RCN's losses increased from
$52 million in 1997 to $205 million in 1998. The Company's proportionate share
of these losses, including goodwill amortization, was $92 million and $26
million in 1998 and 1997, respectively. In 1998, the Company elected to
discontinue its funding of Gateway Opportunity Fund, LP, ("Gateway"), which
provided venture capital to developing businesses. The Company recorded losses
of $28 million and $15 million in 1998 and 1997, respectively, to reflect Level
3's equity in losses of the underlying businesses of Gateway. Also included in
equity losses are equity earnings of Commonwealth Telephone Enterprises, Inc., a
Pennsylvania public utility providing telephone services, and equity losses of
Cable Michigan, Inc. ("Cable Michigan") prior to its sale in 1998, a cable
television operator in the State of Michigan.
Gain on Equity Investee Stock Transactions was $62 million in 1998. During
1998, RCN issued stock in a public offering and for certain acquisitions. These
transactions decreased the Company's ownership in RCN from 48% in 1997 to 41% in
1998, but increased its proportionate share of RCN's net assets. The Company
recorded a pre-tax gain of approximately $62 million to reflect this increase in
value.
Gains on Sale of Assets increased significantly in 1998 due to the sale of
Cable Michigan to Avalon Cable of Michigan, Inc. in November 1998. The Company
recognized a gain of approximately $90 million from the cash for stock
transaction. Also included in gains on the disposal of assets are $8 million and
$1 million of gains on the disposal of property, plant and equipment in 1998 and
1997 respectively, and $9 million of gains on the sale of marketable securities
in both periods.
Income Tax (Provision) Benefit differs from the expected statutory rate of
35% primarily due to the nondeductible write-off of the in process research and
development costs allocated in the XCOM transaction, losses incurred by the
Company's international subsidiaries which cannot be included in the
consolidated US federal income tax return and state income taxes. In 1997 the
effective rate was less than the expected statutory rate primarily due to prior
year tax adjustments, partially offset by the effect of nondeductible
compensation expense associated with the conversion of the information services
option and SAR plans to the Level 3 Stock Plan.
Discontinued Operations includes the one-time gain of $608 million
recognized upon the distribution of the Construction Group to former Class C
stockholders 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.
Results of Operations 1997 vs. 1996
In 1997, C-TEC Corporation ("C-TEC") announced that its board of directors
had approved the planned restructuring of C-TEC into three publicly traded
companies. The transaction was effective September 30, 1997. As a result of the
restructuring plan, the Company owned less than 50% of the outstanding shares
and voting rights of each entity, and therefore has accounted for each entity
using the equity method as of the beginning of 1997. In accordance with
generally accepted accounting principles, C-TEC's financial position, results of
operations and cash flows are consolidated in the 1996 financial statements.
Revenue for the years ended December 27, 1997 and December 28, 1996 is
summarized as follows (in millions):
1997 1996
---- ----
Communications and Information Services $ 95 $ 42
Coal Mining 222 234
Other 15 376
------ ------
$332 $ 652
==== =====
Communications and Information Services revenue increased $53 million or
126% to $95 million in 1997. Revenue from computer outsourcing services
increased 22% to $50 million in 1997 up from $41 million in 1996. The increase
was due to new computer outsourcing contracts signed in 1997. Revenue for
systems integration grew to $45 million in 1997 from $1 million in 1996. Strong
demand for Year 2000 renovation services fueled the growth for systems
integration's revenue.
Revenue from coal mines declined 5% in 1997 from $234 million in 1996.
Alternate source coal revenue declined by $16 million in 1997. The mine's
primary customer, Commonwealth Edison, accelerated its contractual commitments
in 1996 for alternate source, thus reducing its obligations in 1997. In addition
to the decline in tonnage shipped, the price of coal sold to Commonwealth
declined 1%. Revenue attributable to other contracts increased by approximately
$4 million. The actual amount of coal shipped to these customers increased 5% in
1997, but the price at which it sold was 4% lower than 1996.
In 1996 other revenue was comprised of $367 million of revenue attributable
to the C-TEC companies and $9 million of revenue attributable to CPTC. CPTC's
revenue increased to $15 million in 1997 as the tollroad became fully
operational in the second half of 1996 and traffic levels increased throughout
1997.
Operating Expenses declined 39% from $268 million in 1996 to $163 million
in 1997 due to the consolidation of C-TEC in 1996. Excluding C-TEC expenses of
$143 million, operating expenses actually increased 30% from $125 million to
$163 million in 1997. Operating expenses related to Communications and
Information Services increased $30 million as a result of up-front migration
costs associated with new contracts and significant increases in personnel costs
due to tightening supply of computer professionals in the computer outsourcing
business. Additional expenses were also incurred in 1997 due to the start up of
the systems integration business. Also contributing to the increase in operating
expenses was the decline in high margin alternate source coal sold to
Commonwealth Edison in 1997 and the absence of premium refunds received in 1996
from a captive insurance company that insured against black lung disease.
Depreciation and Amortization Expense decreased 84% to $20 million in 1997
primarily due to the change in accounting for C-TEC. Excluding $106 million of
such expense attributable to C-TEC, depreciation and amortization expense was
consistent with that of 1996.
General and Administrative Expenses. Excluding C-TEC, general and
administrative expenses increased 23% to $106 million in 1997. The increase was
primarily attributable to a $41 million increase in the information services
business' general and administrative expenses. The majority of the increase is
attributable to additional compensation expense that was incurred due to the
conversion of the information services' option and SAR plans to the Level 3
Stock Plan. The remainder of the increase relates to the increased expenses for
new sales offices established in 1997 for the systems integration business and
the additional personnel hired in 1997 to implement the Business Plan.
Exclusive of the information services business, general and administrative
expenses decreased 28% to $54 million in 1997. A decrease in professional
services and the mine management fees were partially offset by increased
compensation expense. Due to the favorable resolution of certain environmental
and legal matters, costs that were previously accrued for these issues were
reversed in 1997. Partially offsetting this reduction were legal, tax and
consulting expenses associated with the MidAmerican Transaction and the
separation of the Construction Group and Diversified Group.
Interest Income decreased $17 million from $50 million in 1996 due to the
change in accounting for C-TEC. In 1996, C-TEC accounted for $14 million
of interest income. The remaining decline in interest income was due to an
overall reduction of yields earned by the Kiewit Mutual Fund portfolios.
Interest Expense, Net. Interest expense increased significantly in 1997
after excluding $28 million of interest attributable to C-TEC in 1996. CPTC, the
owner-operator of a privatized tollroad in California, incurred interest costs
of approximately $9 million and $11 million in 1996 and 1997. In 1996, interest
of $5 million was capitalized due to the construction of the tollroad.
Construction was completed in August 1996, and all interest incurred subsequent
to that date was charged against earnings. Interest associated with the
financing of the Aurora, Colorado property of $1 million, also contributed to
the increase in interest expense.
Equity Losses in Unconsolidated Subsidiaries. The losses for the Company's
equity investments increased from $9 million in 1996 to $43 million in 1997. Had
the C-TEC entities been accounted for using the equity method in 1996, the
losses would have been $13 million. The expenses associated with the deployment
and marketing of the advanced fiber networks in New York, Boston and Washington
D.C., and the costs incurred in connection with the buyout of a marketing
contract with minority shareholders were primarily responsible for the increase
in equity losses attributable to RCN from $6 million in 1996 to $26 million in
1997. The Company's share of Cable Michigan's losses decreased slightly in 1997.
The Company also recorded $15 million of equity losses attributable to Gateway
in 1997.
Gains on Sale of Assets. Gains on the disposal of assets was consistent
with that of 1996, however, the composition of the gains changed. In 1996, the
gains primarily consisted of $6 million of gains recognized on the sale of
timberlands and $3 million of gains on the sale of marketable securities. In
1997, the Company did not recognize any gains on the disposition of timberlands
but realized $9 million of gains on the sale of marketable securities. In both
periods the Company recognized $1 million of gains on the disposal of property,
plant and equipment.
Income Tax Benefit (Provision). The effective income tax rate for 1997 is
less than the expected statutory rate of 35% due primarily to prior year tax
adjustments, partially offset by the effect of nondeductible compensation
expense associated with the conversion of the information services option and
SAR plans to the Level 3 Stock Plan. In 1996, the effective rate was also lower
than the statutory rate due to the prior year tax adjustments. These adjustments
were partially offset by nondeductible costs associated with goodwill
amortization and taxes on foreign operations. In 1997 and 1996, the Company
settled a number of disputed tax issues related to prior years that have been
included in prior year tax adjustments.
Discontinued Operations - Construction. Discontinued Operations -
Construction revenues increased significantly in 1997. Revenue attributable to
the construction segment increased $414 million, primarily due to the
consolidation of ME Holding Inc., which was consolidated in 1997 and several
large projects and joint ventures becoming fully mobilized and well into the
"peak" construction phase. The acquisitions of several small plant sites and
strong market conditions resulted in a $47 million increase in materials
revenue.
Earnings for the Construction Group increased 44% in 1997 as a result of
the favorable resolution of project uncertainties, several change order
settlements, and cost savings and early completion bonuses received during the
year.
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 for a more detailed discussion of the 1997 and 1996 results
of operations of the Construction Group.
Discontinued Operations - Energy. Income from discontinued operations
increased to $10 million in 1997 from $9 million in 1996. The acquisition of
Northern Electric in late 1996 and the commencement of operations at the
Mahanagdong geothermal facility in July, 1997 were the primary factors that
resulted in the increase.
In October 1997, MidAmerican sold approximately 19.1 million shares of its
common stock. This sale reduced the Company's ownership in MidAmerican to
approximately 24% but increased its proportionate share of MidAmerican's equity.
It is the Company's policy to recognize gains or losses on the sale of stock by
its investees. The Company recognized an after-tax gain of approximately $44
million from transactions in MidAmerican stock in the fourth quarter of 1997.
On July 2, 1997, the Labour Party in the United Kingdom announced the
details of its proposed "Windfall Tax" to be levied against privatized British
utilities. This one-time tax is 23% of the difference between the value of
Northern Electric, plc. at the time of privatization and the utility's current
value based on profits over a period of up to four years. CE Electric recorded
an extraordinary charge of approximately $194 million when the tax was enacted
in July, 1997. The total after-tax impact to Level 3, directly through its
investment in CE Electric and indirectly through its interest in MidAmerican,
was $63 million.
Financial Condition - December 31, 1998
The Company's working capital increased $2.1 billion during 1998 primarily
due to the significant financing activities described below.
Cash provided by operating activities decreased in 1998 primarily due to
the costs of implementing the Company's Business Plan.
Investing activities include using the proceeds from the debt offerings and
MidAmerican and Cable Michigan sales to purchase marketable securities, $67
million of investments, net of cash acquired, and $910 million of capital
expenditures, primarily for the expanding IP communications and information
services businesses. The investments include a $38 million investment in the
Commonwealth Telephone's rights offering, $14 million of investments in
information services businesses and $15 million of investments in Gateway.
Sources of financing in 1998 consisted primarily of the net proceeds of
$1.94 billion from the sale of Senior Notes in April and the net proceeds of
$486 million from the sale of 10.5% Senior Discount Notes in December.
Additional sources include the conversion of 2.3 million shares of Class C
Stock, with a redemption value of $122 million, into 21 million shares of Common
Stock in January, proceeds from the sale of Common Stock of $21 million and the
exercise of the Company's stock options for $10 million. In 1998, Level 3 issued
$183 million of stock for the acquisition of several IP businesses and reflected
in the equity accounts the $164 million fair value of the issuance and forced
conversion of the Class R Stock. The company repaid $12 million of long term
debt during 1998.
The Company also received $967 million of net proceeds from the sale of its
energy business to MidAmerican.
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 plans to expand substantially the business of its
subsidiary, PKS Information Services, Inc., ("PKSIS") and 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's capital expenditures in
connection with the Business Plan were $908 million in 1998 and are expected to
approximate $2.3 billion in 1999. Management believes the Company's liquidity at
December 31, 1998, in addition to the net proceeds of $1.5 billion from the
equity offering completed in March 1999, and the cost sharing agreement with
INTERNEXT, should be sufficient to fund the currently committed portions of the
Business Plan.
The Company currently estimates the implementation of the Business Plan, as
currently contemplated, will require between $8 and $10 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 sales or issuance of additional equity securities,
credit facilities and other borrowings, 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 available approximately $2 billion of unused securities
available under its "universal" shelf registration 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 sell or lease capacity, its
conduits 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 of 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 business,
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.
New Accounting Pronouncement
On June 15, 1998, the FASB issued Statement of Accounting Standards No.
133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS No.
133"). SFAS No. 133 is effective for fiscal years beginning after June 15, 1999
(January 1, 2000 for the Company). SFAS No. 133 requires that all derivative
instruments be recorded on the balance sheet at the fair value. Changes in the
fair value of derivatives are recorded each period in current earnings or other
comprehensive income, depending on whether a derivative is designated as part of
hedge transaction and, if it is, the type of hedge transaction. The Company
currently makes minimal use of derivative instruments as defined by SFAS No.
133. If the Company does not increase the utilization of these derivative
instruments by the effective date of SFAS No. 133, the adoption of this standard
is not expected to have a significant effect on the Company's results of
operations or its financial position.
Disclosure of Year 2000 Issues
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. This 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, L.L.C. ("Level 3 LLC")
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 LLC's operations. Level 3 LLC 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 LLC cable when
the network construction is complete. In the interim, services will be delivered
over both owned and leased lines.
Level 3 LLC faces two primary Year 2000 issues with respect to its
business. First, Level 3 LLC must assess the readiness of its systems that are
required to provide its customers communication's services ("Service Delivery
Systems"). Second, Level 3 LLC must evaluate the Year 2000 readiness of its
internal business support systems ("Internal Business Support Systems"). Level 3
LLC must also verify the readiness of the providers of the leased lines
currently in use.
Level 3 LLC, 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 LLC 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 the 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' 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 business of Level 3 is 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' 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, to including 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.
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 has completed its Year 2000 assessment of desktop
hardware and software, and, based on vendor representations, has determined that
material upgrades or replacements are not required. PKSSI is in the process of
communicating with its vendors to assess its servers and communications hardware
for Year 2000 readiness. This assessment is expected to be completed by
approximately April 1, 1999.
In fiscal year 1998, approximately 39% 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 Functions Current Areas of Focus Operational Impact Current Status
- - ---------------------------- ---------------------------- ------------------------- ---------------------
Computer Outsourcing Large & Mid-Range CPU Inability to continue Mid Phase III to
Service OEM Software critical processing of Phase V
OS Systems customer's systems
Network Equipment
Support Facilities
Internal Support Systems & Failures of Internal Mid Phase III to
Business Processes Support Services Phase V
Systems Integration Internal Support Systems & Failures of critical Assessment of
Services Business Processes Internal Support desktop hardware
Services and software has
been completed.
Assessment of
services and
communications
hardware is
expected to be
completed by
approximately April
1, 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 companies
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, PKS 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 PKS' 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 PKS 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 has 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 collateral 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.
ITEM 7A. MARKET RISK DISCLOSURE
Level 3 is subject to market risks arising from changes in interest rates,
equity prices and foreign exchange rates. Due to the Company's significant
marketable securities position at December 31, 1998, fluctuations in interest
rates could have a material effect on the value of these securities. However,
any fluctuation is partially mitigated by the Company's strategy of investing in
short-term government and government agency securities with maturities of one
year or less. A 50 basis point increase in the level of interest rates on the
Company's marketable securities portfolio at December 31, 1998 would have a $5
million impact on the value of these securities.
In 1998, the Company issued approximately $2.5 billion of Senior Notes and
Senior Discount Notes (the "Notes"). Fluctuations in interest rates will affect
the fair value of this debt but interest expense will not be affected due to the
fixed interest rates of the Notes. Level 3 has the ability to redeem all or a
portion of the Senior Notes and Senior Discount Notes beginning in 2003. If
interest rates decrease significantly, the amount of redemptions, if any, could
be affected. The Company continues to evaluate alternatives to limit interest
rate risk.
Level 3 has investments in several 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 $818 million
as of December 31, 1998, which is significantly higher than their carrying value
of $300 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 $162 million change 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 is implementing its Business Plan in Europe and as a result is
exposed to certain foreign currency risks. Exposure to these risks was not
significant at December 31, 1998 due to the limited amount of net assets
invested in Europe as of that date. In 1999, the Company will continue to expand
its presence in Europe and enter the Asian market, and will continue to analyze
risk management strategies to reduce foreign currency exchange risk.
The changes in interest rates, equity security prices and foreign exchange
rates are 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.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Financial statements and supplementary financial information for Level 3
Communications, Inc. (f/k/a Peter Kiewit Sons', Inc.) and Subsidiaries begin on
page F-1.
The financial statements of an equity method investee (RCN Corporation) are
required by Rule 3.09 and are incorporated by reference from RCN's Form 10-K for
the year ended December 31, 1998, filed under Commission No. 000-22825.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
The following information with regard to the Company's change of
independent accountants was first reported by the Company's filing of a Current
Report on Form 8-K on September 1, 1998.
The following information is provided in response to the requirements of
Item 304(a)(1) of Regulation S-K.
i) PricewaterhouseCoopers LLP (formerly Coopers & Lybrand L.L.P. which
became PricewaterhouseCoopers LLP on July 1, 1998) was dismissed as the
Company's independent accountants effective as of the close of business on
August 25, 1998.
ii) The reports of PricewaterhouseCoopers LLP on the consolidated financial
statements of the Company at December 27, 1997 and December 28, 1996, and for
the three years ended December 27, 1997 contain no adverse opinion or disclaimer
of opinion and were not qualified or modified as to uncertainty, audit scope or
accounting principle.
iii) The Company's Audit Committee participated in and approved the
decision to change independent accountants.
iv) In connection with its audits for the two most recent fiscal years and
through August 25, 1998 there were no disagreements with PricewaterhouseCoopers
LLP on any matter of accounting principle or practice, financial statement
disclosure, or auditing scope or procedure, which disagreements if not resolved
to the satisfaction of PricewaterhouseCoopers LLP, would have caused
PricewaterhouseCoopers LLP to make reference thereto in their report on the
financial statements for such years.
v) During the two most recent fiscal years and through August 25, 1998
there were no reportable events (as defined in Regulation S-K Item
304(a)(1)(v)).
The following information is provided in response to the requirements of
Item 304(a)(2) of Regulation S-K.
The Company engaged Arthur Andersen LLP as its new independent accountants
as of August 26, 1998. During the most recent two fiscal years and through
August 25, 1998, the Company has not consulted with Arthur Andersen LLP on items
which (1) were or should have been subject to an AICPA Statement on
Auditing Standards No. 50, "Reports on the Application of Accounting
Principles," or (2)concerned the subject matter of a disagreement or
reportable event with the Company's former auditor (both as set forth in
Regulation S-K Item 304(a)(2)).
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this Item 10 is incorporated by reference to
the Company's definitive proxy statement for the 1999 Annual Meeting of
Stockholders to be filed with the Securities and Exchange Commission, however
certain information is included above under the caption "Directors and Executive
Officers" under Item 1. Business.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this Item 11 is incorporated by reference to
the Company's definitive proxy statement for the 1999 Annual Meeting of
Stockholders to be filed with the Securities and Exchange Commission.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this Item 12 is incorporated by reference to
the Company's definitive proxy statement for the 1999 Annual Meeting of
Stockholders to be filed with the Securities and Exchange Commission.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this Item 13 is incorporated by reference to
the Company's definitive proxy statement for the 1999 Annual Meeting of
Stockholders to be filed with the Securities and Exchange Commission.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) Financial statements and financial statement schedules required to be filed
for the registrant under Items 8 or 14 are set forth following the index
page at page F1. Exhibits filed as a part of this report are listed below.
Exhibits incorporated by reference are indicated in parentheses.
Exhibit Number Description
3.1 Restated Certificate of Incorporation, effective January 8, 1992 (Exhibit
3.1 to Company's Form 10-K for 1991).
3.2 Certificate of Amendment of Restated Certificate of Incorporation of Peter
Kiewit Sons', Inc., effective December 8, 1997.
3.3 By-laws, composite copy, including all amendments, as of March 19, 1993
(Exhibit 3.4 to Company's Form 10-K for 1992).
10.1 Separation Agreement, dated December 8, 1997, by and among PKS, Kiewit
Diversified Group Inc., PKS Holdings, Inc. and Kiewit Construction Group
Inc. (Exhibit 10.1 to the Company's Form 10-K for 1997).
10.2 Amendment No. 1 to Separation Agreement, dated March 18, 1997, by and among
PKS, Kiewit Diversified Group Inc., PKS Holdings, Inc. and Kiewit
Construction Group Inc. (Exhibit 10.1 to the Company's Form 10-K for 1997).
10.3 Cost Sharing and IRU Agreement between Level 3 Communications, LLC and
INTERNEXT, LLC dated July 18, 1998 (Exhibit 10.1 to the Company's Quarter
Report on Form 10-Q for the three months ended September 30, 1998).
21 List of subsidiaries of the Company.
23.1 Consent of Arthur Andersen LLP
23.2 Consents of PricewaterhouseCoopers LLP
23.3 Consents of PricewaterhouseCoopers LLP
27 Financial data schedules.
(b) Reports on Form 8-K filed by the Company during the fourth quarter of 1997.
On October 1, 1998, the Company filed a Current Report on Form 8-K relating
to the issuance of an aggregate of 150,609 shares of Common Stock pursuant
to Regulation S in connection with the acquisition of miknet Internet Based
Services GmbH.
On October 5, 1998, the Company filed a Current Report on Form 8-K relating
to the issuance of an aggregate of 13,935 shares of Common Stock pursuant
to Regulation S in connection with the acquisition of GeoNet
Communications, Inc. The total number of shares issued in this acquisition
was 511,719.
On December 3, 1998, the Company filed a Current Report on Form 8-K
relating to the issuance of press releases announcing the offering and
completion of an offering of 10.5% Senior Discount Notes due 2008 in a
transaction exempt from registration under the Securities Act of 1933, as
amended.
On December 7, 1998, the Company filed a Current Report on Form 8-K
describing certain risks associated with the implementation of the
Company's business plan.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized, this 31st day of
March, 1999.
Level 3 Communications, Inc.
By: /s/ James Q. Crowe
----------------------------------
Name: James Q. Crowe
Title: President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
Name Title Date
/s/ Walter Scott, Jr. Chairman of the Board March 31, 1999
- - ---------------------------
Walter Scott, Jr.
President, Chief Executive Officer
/s/ James Q. Crowe and Director March 31, 1999
- - ---------------------------
James Q. Crowe
Executive Vice President, Chief
/s/ R. Douglas Bradbury Financial Officer and Director March 31, 1999
R. Douglas Bradbury (principal financial officer)
/s/ Eric J. Mortensen Controller (principal accounting March 31, 1999
- - --------------------------- officer)
Eric J. Mortensen
/s/ William L. Grewcock Director March 31, 1999
- - ---------------------------
William L. Grewcock
/s/ Philip B. Fletcher Director March 31, 1999
- - ---------------------------
Philip B. Fletcher
/s/ Richard R. Jaros Director March 31, 1999
- - ---------------------------
Richard R. Jaros
/s/ Robert E. Julian Director March 31, 1999
- - ---------------------------
Robert E. Julian
/s/ David C. McCourt Director March 31, 1999
- - ---------------------------
David C. McCourt
/s/ Kenneth E. Stinson Director March 31, 1999
- - ---------------------------
Kenneth E. Stinson
/s/ Michael B. Yanney Director March 31, 1999
- - ---------------------------
Michael B. Yanney
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Index to Consolidated Financial Statements
Reports of Independent Public Accountants
Financial Statements as of December 31, 1998 and December 27, 1997 and for the
three years ended December 31, 1998:
Consolidated Statements of Earnings
Consolidated Balance Sheets
Consolidated Statements of Cash Flows
Consolidated Statements of Changes in Stockholders' Equity
Consolidated Statements of Comprehensive Income
Notes to Consolidated Financial Statements
Schedules not indicated above have been omitted because of the absence of the
conditions under which they are required or because the information called for
is shown in the consolidated financial statements or in the notes thereto.
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors and Stockholders of
Level 3 Communications, Inc.:
We have audited the consolidated balance sheet of Level 3 Communications, Inc.
and subsidiaries (a Delaware corporation) as of December 31, 1998 and the
related consolidated statements of earnings, cash flows, changes in
stockholders' equity and comprehensive income for the year then ended. These
consolidated financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards.
Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Level 3
Communications, Inc. and subsidiaries as of December 31, 1998 and the
consolidated results of their operations and their cash flows for the year then
ended in conformity with generally accepted accounting principles.
Arthur Andersen LLP
Denver, Colorado
March 29, 1999
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
The Board of Directors and Stockholders
Level 3 Communications, Inc. and Subsidiaries
(formerly, Peter Kiewit Sons', Inc.)
We have audited the consolidated balance sheet of Level 3 Communications, Inc.
and Subsidiaries (formerly, Peter Kiewit Sons', Inc.) as of December 27, 1997
and the related consolidated statements of earnings, cash flows, changes in
stockholders' equity and comprehensive income for each of the two years in the
period ended December 27, 1997. These financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Level 3
Communications, Inc. and Subsidiaries as of December 27, 1997 and the
consolidated results of their operations and their cash flows for each of the
two years in the period ended December 27, 1997 in conformity with generally
accepted accounting principles.
Coopers & Lybrand LLP
Omaha, Nebraska
March 30, 1998
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Consolidated Statements of Earnings
For the three years ended December 31, 1998
(dollars in millions, except per share data) 1998 1997 1996
- - ------------------------------------------------------------------------------------------------------------------
Revenue $ 392 $ 332 $ 652
Cost and Expenses:
Operating expenses (199) (163) (268)
Depreciation and amortization (66) (20) (124)
General and administrative expenses (332) (106) (173)
Write-off of in process research and development (30) - -
-------- -------- --------
Total costs and expenses (627) (289) (565)
-------- -------- --------
Earnings (Loss) from Operations (235) 43 87
Other Income (Expense):
Interest income 173 33 50
Interest expense, net (132) (15) (33)
Equity losses in unconsolidated subsidiaries (132) (43) (9)
Gain on equity investee stock transactions 62 - -
Gain on sale of assets 107 10 10
Other, net 4 7 2
--------- ---------- ---------
Total other income (expense) 82 (8) 20
--------- ---------- ---------
Earnings (Loss) Before Income Taxes
and Discontinued Operations (153) 35 107
Income Tax Benefit (Provision) 25 48 (3)
--------- --------- ----------
Income (Loss) from Continuing Operations (128) 83 104
Discontinued Operations:
Gain on Split-off of Construction Group 608 - -
Construction operations net of income tax
expense of ($107) and ($72) - 155 108
Gain on disposition of energy business net of income tax
expense of $175 324 - -
Energy, net of income tax benefit (expense)
of $1 and ($9) - 10 9
-------- -------- --------
Income from discontinued operations 932 165 117
-------- -------- --------
Net Earnings $ 804 $ 248 $ 221
======== ======== ========
Earnings (Loss) Per Share of Level 3 Common Stock
(Basic and Diluted):
Continuing operations $ (.43) $ .33 $ .45
========= ========= =========
Discontinued operations excluding construction operations $ 3.09 $ .04 $ .03
======== ========= =========
Net earnings excluding construction operations $ 2.66 $ .37 $ .48
======== ========= =========
Net earnings excluding gain on
Split-off of Construction Group $ .64 $ .37 $ .48
========= ========= =========
See accompanying notes to consolidated financial statements.
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
December 31, 1998 and December 27, 1997
(dollars in millions) 1998 1997
- - ------------------------------------------------------------------------------------------------------------------
Assets
Current Assets:
Cash and cash equivalents $ 848 $ 87
Marketable securities 2,863 678
Restricted securities 26 22
Receivables, net 57 42
Investment in discontinued operations - energy - 643
Income taxes receivable 54 2
Other 29 20
------ -------
Total Current Assets 3,877 1,494
Net Property, Plant and Equipment 1,061 184
Investments 323 383
Investments in Discontinued Operations - Construction - 652
Other Assets, net 264 66
------ -------
$5,525 $ 2,779
======= =======
See accompanying notes to consolidated financial statements.
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
December 31, 1998 and December 27, 1997
(continued)
(dollars in millions) 1998 1997
- - ------------------------------------------------------------------------------------------------------------------
Liabilities and Stockholders' Equity
Current Liabilities:
Accounts payable $ 276 $ 31
Current portion of long-term debt 5 3
Accrued reclamation and other mining costs 16 19
Accrued interest 33 2
Deferred income taxes 2 15
Other 38 19
------- -------
Total Current Liabilities 370 89
Long-Term Debt, less current portion 2,641 137
Deferred Income Taxes 86 83
Accrued Reclamation Costs 96 100
Other Liabilities 167 140
Commitments and Contingencies
Stockholders' Equity:
Preferred stock, $.01 par value, authorized 10,000,000 shares in 1998,
250,000 shares in 1997: no shares outstanding in 1998 and 1997 - -
Common stock:
Common stock, $.01 par value in 1998 and $.0625 par value in 1997,
authorized 500,000,000 shares: 307,874,706 outstanding in
1998 and 271,034,280 outstanding in 1997 3 8
Class B, no shares outstanding in 1997 - -
Class C, 10,132,343 shares outstanding in 1997 - 1
Class R, $.01 par value, authorized 8,500,000 shares:
no shares outstanding in 1998 and 1997 - -
Additional paid-in capital 765 427
Accumulated other comprehensive income (loss) 4 (5)
Retained earnings 1,393 1,799
------- -------
Total Stockholders' Equity 2,165 2,230
------- -------
$ 5,525 $ 2,779
======= =======
See accompanying notes to consolidated financial statements.
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
For the three years ended December 31, 1998
(dollars in millions) 1998 1997 1996
- - -----------------------------------------------------------------------------------------------------------------
Cash Flows from Operating Activities:
Net Earnings $ 804 $ 248 $ 221
Less: Income from Discontinued Operations (932) (165) (117)
-------- -------- --------
Income (loss) from continuing operations (128) 83 104
Adjustments to reconcile income (loss) from
continuing operations to net cash provided
by continuing operations:
Write-off in process research and development 30 - -
Equity losses, net 132 43 9
Depreciation and amortization 66 20 124
Amortization of discounts on marketable securities (24) - -
Amortization of debt issuances costs 3 - -
Gain on sale of property, plant and
equipment and other assets (17) (10) (10)
Gain on equity investee's stock transactions (62) - -
Gain on sale of Cable Michigan (90) - -
Compensation expense attributable to stock awards 39 21 -
Federal income tax refunds 46 146 -
Deferred income taxes (50) (103) (68)
Accrued interest on marketable securities (39) - -
Change in working capital items:
Receivables (1) (9) (1)
Other current assets (10) (1) 6
Payables 239 (3) 9
Other liabilities 39 (5) 13
Other (3) - 3
-------- --------- ---------
Net Cash Provided by Continuing Operations 170 182 189
Cash Flows from Investing Activities:
Proceeds from sales and maturities of marketable
securities 3,214 167 378
Purchases of marketable securities (5,334) (452) (311)
Purchases of restricted securities (2) (2) (2)
Capital expenditures (910) (26) (117)
Investments and acquisitions, net of cash acquired (67) (42) (59)
Proceeds from sale of property, plant
and equipment, and other investments 27 1 14
Proceeds from sale of Cable Michigan 129 - -
Other - 3 (8)
-------- ---------- ----------
Net Cash Used in Investing Activities $(2,943) $ (351) $ (105)
See accompanying notes to consolidated financial statements.
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
For the three years ended December 31, 1998
(continued)
(dollars in millions) 1998 1997 1996
- - -----------------------------------------------------------------------------------------------------------------
Cash Flows from Financing Activities:
Long-term debt borrowings, net of issuance costs $ 2,426 $ 17 $ 38
Payments on long-term debt, including current portion (12) (2) (60)
Issuances of common stock 21 117 -
Exchange of Class C Stock for Class D Stock, net 122 72 20
Stock options exercised 11 21 -
Issuances of subsidiaries' stock - - 1
Repurchases of common stock (1) - (11)
Dividends paid - (12) (11)
-------- --------- ---------
Net Cash Provided by (Used in) Financing Activities 2,567 213 (23)
Cash Flows from Discontinued Operations:
Proceeds from sale of discontinued energy operations,
net of income tax payments of $192 million 967 - -
Discontinued energy operations - 3 5
Investments in discontinued energy operations - (31) (282)
-------- --------- --------
Net Cash Provided by (Used in) Discontinued Operations 967 (28) (277)
Cash and Cash Equivalents of C-TEC at the Beginning of 1997 - (76) -
-------- --------- -----------
Net Change in Cash and Cash Equivalents 761 (60) (216)
Cash and Cash Equivalents at Beginning of Year 87 147 363
-------- --------- --------
Cash and Cash Equivalents at End of Year $ 848 $ 87 $ 147
======== ========= ========
Supplemental Disclosure of Cash Flow Information:
Income taxes paid $ 246 $ 62 $ 55
Interest paid 104 13 38
Noncash Investing and Financing Activities:
Issuances of stock for acquisitions:
XCOM Technologies, Inc. $ 154 $ - $ -
GeoNet Communications, Inc. 19 - -
Others 10 - -
Conversion of MidAmerican convertible debentures
to common stock $ - $ - $ 66
The activities of the Construction Group have been removed from the consolidated
statements of cash flows. The Construction Group had cash flows of ($62)
million, $59 million and $79 million for the three months ended March 31, 1998,
(the date of the Split-off) and fiscal 1997 and 1996, respectively.
See accompanying notes to consolidated financial statements.
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Consolidated Statements of Changes in Stockholders'
Equity For the three years ended December 31, 1998
Class Accumulated
B&C Additional Other
Common Common Paid-in Comprehensive Retained
(dollars in millions) Stock Stock Capital Income (Loss) Earnings Total
- - ------------------------------------------------------------------------------------------------------------------
Balance at
December 30, 1995 $ 1 $ 1 $ 210 $ 11 $ 1,384 $ 1,607
Common Stock:
Issuances - - - - - -
Repurchases - - (1) - (10) (11)
Dividends(a) - - - - (12) (12)
Class C Stock:
Issuances - - 27 - - 27
Repurchases - - (1) - (4) (5)
Dividends (a) - - - - (13) (13)
Net Earnings - - - - 221 221
Other Comprehensive
Income - - - 5 - 5
----------- ----------- ----------- ---------- ----------- ----------
Balance at
December 28, 1996 1 1 235 16 1,566 1,819
Common Stock:
Issuances - - 117 - - 117
Stock options exercised - - 21 - - 21
Stock dividend - 7 (7) - - -
Stock option grants - - 27 - - 27
Class C Stock:
Issuances - - 33 - - 33
Repurchases - - - - (2) (2)
Dividends (b) - - - - (13) (13)
Conversion of
debentures - - 1 - - 1
Net Earnings - - - - 248 248
Other Comprehensive
Loss - - - (21) - (21)
----------- ----------- ----------- --------- ----------- ---------
Balance at
December 27, 1997 $ 1 $ 8 $ 427 $ (5) $ 1,799 $ 2,230
(a) Includes $.70 and $.05 per share for dividends on Class C and Common
Stock, respectively, declared in 1996 but paid in January 1997.
(b) Includes $.80 per share for dividends on Class C declared in 1997 but
paid in January 1998.
See accompanying notes to consolidated financial statements.
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Consolidated Statements of Changes in Stockholders' Equity
For the three years ended December 31,1998
(continued)
Class Accumulated
B&C Additional Other
Common Common Paid-in Comprehensive Retained
(dollars in millions) Stock Stock Capital Income (Loss) Earnings Total
- - ------------------------------------------------------------------------------------------------------------------
Balance at
December 27, 1997 $ 1 $ 8 $ 427 $ (5) $ 1,799 $ 2,230
Common Stock:
Issuances - 1 203 - - 204
Stock options exercised - 1 10 - (1) 10
Designation of par
value to $.01 - (8) 8 - - -
Stock dividend - 1 (1) - - -
Stock plan grants - - 44 - - 44
Income tax benefit from
exercise of options - - 19 - - 19
Class R Stock:
Issuance and forced
conversion - - 164 - (164) -
Class C Stock:
Repurchases - - (25) - - (25)
Conversion of debentures - - 10 - - 10
Net Earnings - - - - 804 804
Other Comprehensive Loss - - - (6) - (6)
Split-off of the Construction
& Mining Group (1) - (94) 15 (1,045) (1,125)
---------- ----------- --------- --------- ------- -------
Balance at
December 31, 1998 $ - $ 3 $ 765 $ 4 $ 1,393 $ 2,165
=========== ========== ======== ========== ======= =======
See accompanying notes to consolidated financial statements.
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Consolidated Statements of Comprehensive Income
For the three years ended December 31,1998
(dollars in millions) 1998 1997 1996
- - ------------------------------------------------------------------------------------------------------------------
Net Earnings $ 804 $ 248 $ 221
Other Comprehensive Income Before Tax:
Foreign currency translation adjustments 1 - (1)
Unrealized holding gains (losses) arising during period (2) (23) 12
Reclassification adjustment for gains
included in net earnings (9) (9) (3)
------- -------- --------
Other Comprehensive Income (Loss), Before Tax (10) (32) 8
Income Tax Benefit (Expense) Related to Unrealized
Holding Gains (Losses) 4 11 (3)
------- -------- --------
Other Comprehensive Income (Loss) Net of Taxes (6) (21) 5
------- -------- --------
Comprehensive Income $ 798 $ 227 $ 226
======= ======== ========
See accompanying notes to consolidated financial statements.
LEVEL 3 COMMUNICATIONS, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(1) Reorganization - Discontinued Construction Operations
In October 1996, the Board of Directors (the "Board") of Level 3 Communications,
Inc. ("Level 3" or the "Company"), directed management of the Company to pursue
a listing of the Company's Class D Diversified Group Convertible Exchangeable
Common Stock, par value $.0625 per share (the "Class D Stock"), as a way to
address certain issues created by the Company's then two-class capital stock
structure and the need to attract and retain the best management for the
Company's businesses. During the course of its examination of the consequences
of a listing of the Class D Stock, management concluded that a listing of the
Class D Stock would not adequately address these issues, and instead began to
study a separation of the construction operations ("Construction Group") from
the other businesses of the Company (the "Diversified Group"), thereby forming
two independent companies. At the time, the performance of the Diversified Group
was reflected by the Class D Stock. The performance of the Construction Group
was reflected by the Company's Class C Construction & Mining Group Restricted
Redeemable Convertible Exchangeable Common Stock, par value $.0625 per share
(the "Class C Stock"). At the regular meeting of the Board on July 23, 1997,
management submitted to the Board for consideration a proposal for the
separation of the Construction Group and the Diversified Group through a
split-off of the Construction Group (the "Split-off"). At a special meeting on
August 14, 1997, the Board approved the Split-off.
The separation of the Construction Group and the Diversified Group was
contingent upon a number of conditions, including the favorable ratification by
a majority of the holders of both the Company's Class C and the Class D Stock,
and the receipt by the Company of an Internal Revenue Service ruling or other
assurance acceptable to the Board that the separation would be tax-free to U.S.
stockholders. On December 8, 1997, the holders of Class C Stock and Class D
Stock approved the Split-off and on March 5, 1998, the Company received a
favorable private letter ruling from the Internal Revenue Service. The Split-off
was effected on March 31, 1998. In connection with the Split-off, (i) the
Company exchanged each outstanding share of Class C Stock for one share of
Common Stock of PKS Holdings, Inc. ("New PKS"), the Company formed to hold the
Construction Group, to which eight-tenths of a share of the Company's Class R
Convertible Common Stock, par value $.01 per share (the "Class R Stock"), was
attached to replace certain conversion features in the Class C Stock which would
terminate upon the Split-off (ii) New PKS was renamed "Peter Kiewit Sons', Inc."
(iii) the Company was renamed "Level 3 Communications, Inc.", and (iv) the Class
D Stock was designated as common stock, par value $.01 per share (the "Common
Stock"). As a result of the Split-off, the Company no longer owns any interest
in New PKS or 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 financial position of the Construction Group as of December 27, 1997, and
the results of operations for the two years ended December 27, 1997.
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, Level 3 and the Construction Group entered
into various agreements including a Separation Agreement, a Tax Sharing
Agreement and an amended Mine Management Agreement.
The Separation Agreement, as amended, provides for the allocation of certain
risks and responsibilities between Level 3 and the Construction Group and for
cross-indemnifications that are intended to allocate financial responsibility to
the Construction Group for liabilities arising out of the construction business
and to allocate to Level 3 financial responsibility for liabilities arising out
of the non-construction businesses. The Separation Agreement also allocates
certain corporate-level risk exposures not readily allocable to either the
construction business or the non-construction businesses.
Under the Tax Sharing Agreement, with respect to periods, or portions thereof,
ending on or before the Split-off, Level 3 and the Construction Group generally
will be responsible for paying the taxes relating to such returns, including any
subsequent adjustments resulting from the redetermination of such tax
liabilities by the applicable taxing authorities, that are allocable to the
non-construction businesses and construction businesses, respectively. The Tax
Sharing Agreement also provides that Level 3 and the Construction Group will
indemnify the other from certain taxes and expenses that would be assessed if
the Split-off were determined to be taxable, but solely to the extent that such
determination arose out of the breach by Level 3 or the Construction Group,
respectively, of certain representations made to the Internal Revenue Service in
connection with the private letter ruling issued with respect to the Split-off.
If the Split-off was determined to be taxable for any other reason, those taxes
would be allocated equally to Level 3 and the Construction Group. Finally, under
certain circumstances, Level 3 would make certain liquidated damage payments to
the Construction Group if the Split-off was determined to be taxable, in order
to indirectly compensate Class C stockholders for taxes assessed upon them in
that event.
In connection with the Split-off, the Mine Management Agreement, pursuant to
which the Construction Group provides mine management and related services to
Level 3's coal mining operations, was amended to provide the Construction Group
with a right of offer in the event that Level 3 were to determine to sell any or
all of its coal mining properties. Under the right of offer, Level 3 would be
required to offer to sell those properties to the Construction Group. If the
Construction Group were to decline to purchase the properties at that price,
Level 3 would be free to sell them to a third party for an amount greater than
or equal to that price. If Level 3 were to sell the properties to a third party,
thus terminating the Mine Management Agreement, it would be required to pay the
Construction Group an amount equal to the discounted present value of the Mine
Management Agreement determined, if necessary, by an appraisal process.
Following the Split-off, the Company's common stock began trading on The Nasdaq
National Market on April 1, 1998, under the symbol "LVLT". In connection with
the Split-off, the construction business was renamed "Peter Kiewit Sons', Inc."
and the Class D Stock became the common stock of Level 3 Communications, Inc.
("Common Stock"). Summarized financial information for the Construction Group is
presented below; however, the separate financial statements of Peter Kiewit
Sons', Inc. should be obtained to review the financial position of the
Construction Group as of December 27, 1997 and the results of operations for
each of the two years ended December 27, 1997.
The following is summarized financial information of the Construction Group:
Operations (in millions) 1997 1996
- - ------------------------------------------------------------------------------------------------------------------
Revenue $ 2,764 $ 2,303
Net Earnings 155 108
Financial Position (in millions) 1997
- - --------------------------------------------------------------------------------------------------------------------
Current Assets $ 1,057
Other Assets 284
--------
Total assets 1,341
Current Liabilities 579
Other Liabilities 99
Minority Interest 11
--------
Total liabilities 689
Net Assets $ 652
========
The following details the earnings per share calculations for Class C Stock:
Class C Stock 1997 1996
- - -------------------------------------------------------------------------------------------------------------------
Net Income Available to Common Shareholders (in millions) $ 155 $ 108
Add: Interest Expense, Net of Tax Effect Associated with
Convertible Debentures 1 -*
--------- --------
Net Income for Diluted Shares $ 156 $ 108
========= =========
Total Number of Weighted Average Shares Outstanding Used to Compute
Basic Earnings per Share (in thousands) 9,728 10,656
Additional Dilutive Shares Assuming Conversion of Convertible Debentures 441 437
--------- --------
Total Number of Shares Used to Compute Diluted Earnings Per Share 10,169 11,093
======== =======
Net Income
Basic earnings per share $ 15.99 $ 10.13
======== =======
Diluted earnings per share $ 15.35 $ 9.76
======== =======
*Interest expense attributable to convertible debentures was less than $1
million in 1996.
The Company's certificate of incorporation gave stockholders the right to
exchange their Class C Stock for Class D Stock under a set conversion formula.
That right was eliminated as a result of the Split-off. To replace that
conversion right, Class C stockholders received 6.5 million shares of a new
Class R Stock in January 1998, which was convertible into Common Stock in
accordance with terms ratified by stockholders in December 1997. The Company
reflected in the equity accounts the exchange of the conversion right and
issuance of the Class R Stock at its fair value of $92 million at the date of
the Split-off.
On May 1, 1998, the Board of Directors of Level 3 Communications, Inc.
determined to force conversion of all shares of the Company's Class R Stock into
shares of Common Stock, effective May 15, 1998. The Class R Stock was converted
into Common Stock in accordance with the formula set forth in the certificate of
incorporation of the Company. The formula provided for a conversion ratio equal
to $25, divided by the average of the midpoints between the high and low sales
prices for Common Stock on each of the fifteen trading days during the period
beginning April 9, 1998 and ending April 30, 1998. The average for that period
was $32.14, adjusted for the stock dividend issued August 10, 1998.
Accordingly, each holder of Class R Stock received .7778 of a share of Common
Stock for each share of Class R Stock held. In total 6.5 million shares of Class
R Stock were converted into 5.1 million shares of Common Stock. The value of the
Class R Stock at the time of the forced conversion was $25 times the 6.5 million
shares outstanding, or $164 million. The Company recognized the additional $72
million of value upon conversion of the Class R Stock to Common Stock in the
equity accounts. As a result of the forced conversion, certain adjustments were
made to the cost sharing and risk allocation provisions of the Separation
Agreement and Tax Sharing Agreement between the Company and Peter Kiewit Sons',
Inc. that were executed in connection with the Split-off. The effect of these
adjustments was to reduce certain Split-off costs and risks allocated to the
Company.
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 plant, property
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 plans to expand substantially the business of its PKS
Information Services, Inc. subsidiary and 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
"Business Plan"). The Company is designing the network based on Internet
Protocol ("IP") technology in order to leverage the efficiencies of this
technology to provide lower cost communications services.
(2) Summary of Significant Accounting Policies
Principles of Consolidation
The consolidated financial statements include the accounts of Level 3
Communications, Inc. and subsidiaries in which it has control, which are engaged
in enterprises primarily related to communications and information services, and
coal mining. Fifty-percent-owned mining joint ventures are consolidated on a pro
rata basis. Investments in other companies in which the Company exercises
significant influence over operating and financial policies are accounted for by
the equity method. All significant intercompany accounts and transactions have
been eliminated.
In 1997, the Company agreed to sell its energy assets to MidAmerican Energy
Holding Company (f/k/a CalEnergy Company, Inc.) ("MidAmerican") and to split-off
the Construction Group. Therefore, the assets and liabilities, and results of
operations, of these businesses have been classified as discontinued operations
on the consolidated balance sheet, statements of earnings and cash flows.
(See notes 1 and 3)
In 1997, C-TEC Corporation ("C-TEC") announced that its board of directors had
approved the planned restructuring of C-TEC into three publicly traded
companies. The transaction was effective September 30, 1997. As a result of the
restructuring plan, the Company owned less than 50% of the outstanding shares
and voting rights of each entity, and therefore has accounted for each entity
using the equity method as of the beginning of 1997. In accordance with
generally accepted accounting principles, C-TEC's financial position, results of
operations and cash flows are consolidated in the 1996 financial statements.
Communications and Information Services Revenue
Information services revenue is primarily derived from the computer outsourcing
business and the systems integration business. Level 3 provides outsourcing
service, typically through contracts ranging from 3-5 years, to firms that
desire to focus their resources on their core businesses. Under these contracts,
Level 3 recognizes revenue in the month the service is provided. The systems
integration business helps customers define, develop and implement
cost-effective information systems. Revenue from these services is recognized on
a time and materials basis or percentage of completion basis depending on the
extent of the services provided.
Revenue from communications services is recognized monthly as the services are
provided. Amounts billed in advance of the service month are recorded as
deferred revenue, however that amount is not material.
Concentration of credit risk with respect to accounts receivable are limited due
to the dispersion of customer base among geographic areas and remedies provided
by terms of contracts and statutes.
As noted previously, the investments in the three former C-TEC companies
have been accounted for using the equity method in 1998 and 1997.
Coal Sales Contracts
Level 3's coal is sold primarily under long-term contracts with electric
utilities, which burn coal in order to generate steam to produce electricity. A
substantial portion of Level 3's coal sales were made under long-term contracts
during 1998, 1997 and 1996. The remainder of Level 3's sales are made on the
spot market where prices are substantially lower than those in the long-term
contracts. As the long-term contracts expire, a higher proportion of Level 3's
sales will occur on the spot market.
The coal industry is highly competitive. Level 3 competes not only with other
domestic and foreign coal suppliers, some of whom are larger and have greater
capital resources than Level 3, but also with alternative methods of generating
electricity and alternative energy sources. Many of Level 3's competitors are
served by two railroads and, due to the competition, often benefit from lower
transportation costs than Level 3 which is served by a single railroad.
Additionally, many competitors have more favorable geological conditions than
Level 3, often resulting in lower comparative costs of production.
Level 3 is also required to comply with various federal, state and local laws
concerning protection of the environment. Level 3 believes its compliance with
environmental protection and land restoration laws will not affect its
competitive position since its competitors are similarly affected by such laws.
Level 3 and its mining ventures have entered into various agreements with its
customers which stipulate delivery and payment terms on the sale of coal. Prior
to 1993, one of the primary customers deferred receipt of certain commitments by
purchasing undivided fractional interest in coal reserves of Level 3 and the
mining ventures. Under the agreements, revenue was recognized when cash was
received. The agreements with this customer were renegotiated in 1992. In
accordance with the renegotiated agreements, there were no sales of interest in
coal reserves subsequent to January 1, 1993. Level 3 has delivered and has the
obligation to deliver the coal reserves to the customer in the future if the
customer exercises its option to take delivery of the coal. If the option is
exercised, Level 3 presently intends to deliver coal from unaffiliated mines. In
the opinion of the management, Level 3 has sufficient coal reserves to cover the
above sales commitments.
Level 3's coal sales contracts are with several electric utility and industrial
companies. In the event that these customers do not fulfill contractual
responsibilities, Level 3 would pursue the available legal remedies.
Depreciation and Amortization
Property, plant and equipment are recorded at cost. Depreciation and
amortization for the majority of the Company's property, plant and equipment are
computed on accelerated and straight-line methods based on the following useful
lives:
Facility and Leasehold Improvements 35 - 40 years
Operating Equipment 3 - 7 years
Network Construction Equipment 5 - 7 years
Furniture and Office Equipment 3 - 7 years
Other 2 - 10 years
Depletion of mineral properties is provided primarily on an units-of-extraction
basis determined in relation to coal committed under sales contracts.
Software Development Costs
On March 4, 1998, the American Institute of Certified Public Accountants
("AICPA") issued Statement of Position 98-1, "Accounting for the Costs of
Computer Software Developed or Obtained for Internal Use" ("SOP 98-1"). The
effective date of this pronouncement is for fiscal years beginning after
December 15, 1998, however, the Company has elected to account for internal
software development costs incurred in developing its integrated business
support systems in accordance with SOP 98-1 in 1998. The Company recognized $27
million of expense for the development of operating support systems in 1998 that
would have previously been capitalized prior to adoption of SOP 98-1.
Start-Up Costs
On April 3, 1998, the AICPA issued Statement of Position 98-5, "Reporting on the
Costs of Start-Up Activities", ("SOP 98-5"), which provides guidance on the
financial reporting for start-up and organization costs. It requires costs of
start-up activities and organization costs to be expensed as incurred. SOP 98-5
is effective for financial statements for fiscal years beginning after December
15, 1998, however, the Company elected to adopt SOP 98-5 in 1998. The adoption
of SOP 98-5 did not result in a significant charge to earnings in 1998.
Subsidiary and Investee Stock Activity
The Company recognizes gains and losses from the sale, issuance and repurchase
of stock by its subsidiaries and equity method investees in the statements of
earnings.
Earnings Per Share
Basic earnings per share have been computed using the weighted average number of
shares during each period. Diluted earnings per share is computed by including
stock options and other securities considered to be dilutive.
Intangible Assets
Intangible assets primarily include amounts allocated upon acquisitions of
businesses, franchises and subscriber lists. These assets are amortized on a
straight-line basis over the expected period of benefit.
For intangibles originating from IP or other information services related
acquisitions, the Company is amortizing these assets over a five year period.
Intangibles attributable to other acquisitions and investments are amortized
over periods which do not exceed 40 years.
Long Lived Assets
The Company reviews the carrying amount of long lived assets for impairment
whenever events or changes in circumstances indicate that the carrying amount
may not be recoverable. Measurement of any impairment would include a comparison
of estimated future operating cash flows anticipated to be generated during the
remaining life of the asset to the net carrying value of the asset.
Reserves for Reclamation
The Company follows the policy of providing an accrual for reclamation of mined
properties, based on the estimated total cost of restoration of such properties
to meet compliance with laws governing strip mining, by applying per-ton
reclamation rates to coal mined. These reclamation rates are determined using
the remaining estimated reclamation costs and tons of coal committed under sales
contracts. The Company reviews its reclamation cost estimates annually and
revises the reclamation rates on a prospective basis, as necessary.
Income Taxes
Deferred income taxes are provided for the temporary differences between the
financial reporting and tax bases of the Company's assets and liabilities using
enacted tax rates in effect for the year in which the differences are expected
to reverse.
Comprehensive Income
In June 1997, the Financial Accounting Standards Board ("FASB") issued Statement
of Financial Accounting Standards ("SFAS") No. 130, "Reporting Comprehensive
Income", which requires that changes in comprehensive income be shown in a
financial statement that is displayed with the same prominence as other
financial statements. The Company has adopted this statement in 1998 as the
Company has unrealized gains and losses on marketable securities classified as
available for sale and has operations in foreign countries and restated 1997 and
1996 to present information on a comparable basis.
Foreign Currencies
Generally, local currencies of foreign subsidiaries are the functional
currencies for financial reporting purposes. Assets and liabilities are
translated into U.S. dollars at year-end exchange rates. Revenue and expenses
are translated using average exchange rates prevailing during the year. Gains or
losses resulting from currency translation are recorded as a component of
accumulated other comprehensive income (loss) in stockholders' equity and in the
statements of comprehensive income.
Stock Dividend
Effective August 10, 1998 and December 26, 1997, the Company issued dividends of
one and four shares, respectively, of Common Stock (previously Class D Stock)
for each share of Level 3 Common Stock outstanding. All share information and
per share data have been restated to reflect these stock dividends.
Use of Estimates
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.
Segment Disclosures
In 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of an
Enterprise and Related Information" ("SFAS No. 131"), which changes the way
public companies report information about segments. SFAS No. 131, which is based
on the management approach to segment reporting, includes requirements to report
selected segment information quarterly, and entity wide disclosures about
products and services, major customers, and geographic data. The Company has
provided the information required by SFAS No. 131 in Note 14.
Recently Issued Accounting Pronouncements
On June 15, 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities" ("SFAS No. 133"). SFAS No. 133 is effective
for fiscal years beginning after June 15, 1999 (January 1, 2000 for the
Company). SFAS No. 133 requires that all derivative instruments be recorded on
the balance sheet at the fair value. Changes in the fair value of derivatives
are recorded each period in current earnings or other comprehensive income,
depending on whether a derivative is designated as part of hedge transaction
and, if it is, the type of hedge transaction. The Company currently makes
minimal use of derivative instruments as defined by SFAS No. 133. If the Company
does not increase the utilization of these derivative instruments by the
effective date of SFAS No. 133, the adoption of this standard is not expected to
have a significant effect on the Company's results of operations or its
financial position.
Fiscal Year
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 results of
operations for the additional five days in the 1998 fiscal year are reflected in
the Company's Form 10-K for the period ended December 31, 1998 and were not
material to the overall results of operations and cash flows. There were 52
weeks in fiscal years 1997 and 1996.
Reclassifications
Certain prior year amounts have been reclassified to conform to the current year
presentation.
(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 ("Energy
Projects"). 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.
The following is summarized financial information for discontinued energy
operations for the fiscal years ended December 27, 1997 and December 28, 1996
and as of December 27, 1997:
Income from Discontinued Operations (in millions) 1997 1996
- - --------------------------------------------------------------------------------------------------------------------
Operations
Equity in:
MidAmerican earnings, net $ 16 $ 20
CE Electric earnings, net 17 (2)
International energy projects earnings, net 5 (5)
Investment Income from MidAmerican - 5
Income Tax Expense (9) (9)
------- --------
Income from operations 29 9
MidAmerican Stock Transactions
Gain on Investee Stock Activity 68 -
Income Tax Expense (24) -
------- ---------
Gain on MidAmerican stock activity 44 -
Extraordinary Loss - Windfall Tax
Level 3's Share from MidAmerican (39) -
Level 3's Share from CE Electric (58) -
Income Tax Benefit 34 -
------- ---------
Extraordinary loss (63) -
------- ---------
Income from Discontinued Energy Operations $ 10 $ 9
======= ========
In order to fund the purchase of Level 3's energy assets, MidAmerican sold, in
1997 approximately 19.1 million shares of its common stock at a price of
$37.875 per share. This sale reduced Level 3's ownership in MidAmerican to
approximately 24% but increased its proportionate share of MidAmerican's
equity. Level 3 recognized an after-tax gain of approximately $44 million
from MidAmerican transactions in 1997.
In 1997 the Labour Party in the United Kingdom implemented a "Windfall Tax"
against privatized British utilities. This one-time tax was 23% of the
difference between the value of Northern Electric, plc at the time of
privatization and the utility's current value based on profits over a period of
up to four years. CE Electric recorded an extraordinary charge of approximately
$194 million when the tax was enacted in 1997. The total impact to Level 3
directly through its investment in CE Electric and indirectly through its
interest in MidAmerican, was $63 million.
Investments in Discontinued Operations (in millions) 1997
- - -------------------------------------------------------------------------------------------------------------------
Investment in MidAmerican $ 337
Investment in CE Electric 135
Investment in International Energy Projects 186
Restricted Securities 2
Deferred Income Tax Liability (17)
-------
Total $ 643
======
The following is summarized financial information of MidAmerican, CE Electric,
and the Energy Projects:
Operations (in millions) 1997 1996
- - ------------------------------------------------------------------------------------------------------------------
Revenue
MidAmerican $ 2,271 $ 576
CE Electric 1,564 37
Net Earnings (Loss)
MidAmerican $ (84) $ 92
CE Electric (136) -
Energy Projects 2 (12)
CE Energy
Financial Position at December 27, 1997 (in millions) MidAmerican Electric Projects
Current Assets $ 2,053 $ 419 $ 530
Other Assets 5,435 2,519 811
------- -------- --------
Total assets 7,488 2,938 1,341
Current Liabilities 1,440 1,166 172
Other Liabilities 4,494 1,265 737
Minority Interest 134 56 -
------- -------- --------
Total liabilities 6,068 2,487 909
------- -------- --------
Net Assets $ 1,420 $ 451 $ 432
======= ======== ========
(4) Earnings Per Share
The Company had a loss from continuing operations for the year ended December
31, 1998, therefore, no potential common shares related to Company stock options
and other dilutive securities have been included in the computation of the
diluted earnings per share because the resulting computation would be
anti-dilutive. For the two years ending December 27, 1997, potentially dilutive
stock options are calculated in accordance with the treasury stock method which
assumes that proceeds from exercise of all options are used to repurchase common
stock at the average market value. The number of shares remaining after the
proceeds are exhausted represent the potentially dilutive effect of the options.
The Company had 23,147,051 potentially dilutive securities outstanding that were
not included in the computation of diluted earnings per share because to do so
would have been anti-dilutive for the year ended December 31, 1998.
The following details the earnings (loss) per share calculations for Level 3
Common Stock. A calculation of the earnings per share for the Class C Stock in
1996 and 1997 can be found in Note 1 to the consolidated financial statements.
Years Ended
1998 1997 1996
Earnings (Loss) from Continuing Operations (in millions) $ (128) $ 83 $ 104
Earnings from Discontinued Energy Operations 324 10 9
Gain on Separation of Construction Operations 608 - -
--------- ------ ------
Net Earnings Excluding Discontinued Construction Operations $ 804 $ 93 $ 113
========= ====== =======
Total Number of Weighted Average Shares Outstanding used to
Compute Basic Earnings Per Share (in thousands) 301,976 249,293 232,012
Additional Dilutive Stock Options - 1,079 622
------- ------- -------
Total Number of Shares used to Compute Dilutive Earnings Per Share 301,976 250,372 232,634
======= ======= =======
Earnings (Loss) Per Share (Basic and Diluted):
Continuing operations $ (.43) $ .33 $ .45
========= ======= ========
Discontinued energy operations $ 1.07 $ .04 $ .03
========= ======= ========
Gain on split-off of discontinued construction operations $ 2.02 $ - $ -
========= ======= ========
Net earnings excluding discontinued construction operations $ 2.66 $ .37 $ .48
========= ======= ========
Net earnings excluding gain on split-off of construction operations $ .64 $ .37 $ .48
========= ======= ========
(5) Acquisitions
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 guide-
lines 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.
XCOM's in-process research and development value is comprised primarily of
one project to develop an interface between an IP-based network and the
existing public switched telecommunications network. Remaining development
efforts for this project include various phases of design, development and
testing. The anticipated completion date for the project in progress is
expected to be over the next 12 months, at which time the Company expects to
begin generating the full economic benefits from the technology. Funding for
this project is expected to be obtained from internally generated sources.
The value of the in-process research and development represents the estimated
fair value based on risk-adjusted cash flows related to the incomplete project.
At the date of acquisition, the development of this project had not yet reached
technological feasibility and the research and development ("R&D") in progress
had no alternative future uses. Accordingly, these costs were expensed as of the
acquisition date.
The Company used independent third-party appraisers to assess and allocate
the value to the in-process research and development. The value assigned to the
asset was determined, using the income approach, by identifying significant
research projects for which technological feasibility had not been established.
The nature of the efforts to develop the acquired in-process technology into
commercially viable products and services principally relate to the completion
of all planning, designing, prototyping, high-volume verification, and testing
activities that are necessary to establish that the proposed technologies meet
their design specifications including functional, technical, and economic
performance requirements.
The value assigned to purchased in-process technology was determined by
estimating the contribution of the purchased in-process technology to developing
a commercially viable product, estimating the resulting net cash flows from the
expected product sales over a 15 year period, and discounting the net cash flows
to their present value using a risk-adjusted discount rate of 30%, and adjusting
it for the estimated stage of completion.
The Company believes that the foregoing assumptions used in the forecasts were
reasonable at the time of the acquisition. No assurance can be given, however,
that the underlying assumptions used to estimate expected project sales,
development costs or profitability, or the events associated with such projects,
will transpire as estimated. For these reasons, actual results may vary from the
projected results.
Management expects to continue their support of this effort and believes the
Company has a reasonable chance of successfully completing the R&D project.
However, there is risk associated with the completion of the project and there
is no assurance that it will meet with either technological or commercial
success. If the XCOM project is not successful, the Company would not realize
its investment in XCOM and would be required to modify its business plan to
utilize alternative technologies which may increase the cost of its network.
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.
On September 30, 1998, Level 3 acquired GeoNet Communications, Inc. ("GeoNet"),
a regional Internet service provider located in Northern California. The Company
issued approximately 0.6 million shares and options in exchange for GeoNet's
capital stock, which valued the transaction at approximately $19 million.
Acquired liabilities exceeded assets, and goodwill of $21 million was recognized
from this transaction which is being amortized over five years.
XCOM's and GeoNet's 1997 and 1998 operating results prior to the acquisitions
were not significant relative to the Company's 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 Company
does not believe that the final purchase price allocation will vary
significantly from the preliminary estimates.
(6) Disclosures about Fair Value of Financial Instruments
The following methods and assumptions were used to determine classification and
fair values of financial instruments:
Cash and Cash Equivalents
Cash equivalents generally consist of funds invested in highly liquid
instruments purchased with an original maturity of three months or less. The
securities are stated at cost, which approximates fair value.
Marketable and Restricted Securities
Level 3 has classified all marketable and restricted securities as
available-for-sale. Restricted securities primarily include investments in
mutual funds that are restricted to fund certain reclamation liabilities of its
coal mining ventures. The amortized cost of the securities used in computing
unrealized and realized gains and losses is determined by specific
identification. Fair values are estimated based on quoted market prices for the
securities on hand or for similar investments. Net unrealized holding gains and
losses are included in accumulated other comprehensive income within
stockholders' equity, net of tax.
At December 31, 1998 and December 27, 1997 the amortized cost, unrealized
holding gains and losses, and estimated fair values of marketable and restricted
securities were as follows:
Unrealized Unrealized
Amortized Holding Holding Fair
(dollars in millions) Cost Gains Losses Value
1998:
Marketable Securities:
U.S. Treasury securities $ 2,147 $ 8 $ - $ 2,155
U.S. Government Agency securities 639 1 - 640
Equity securities 54 - (3) 51
Other securities 20 - (3) 17
--------- ----------- ---------- ---------
$ 2,860 $ 9 $ (6) $ 2,863
======= ========== ========== =======
Restricted Securities:
Wilmington Trust:
Intermediate term bond fund $ 13 $ - $ - $ 13
Equity fund 10 3 - 13
--------- ---------- ----------- ---------
$ 23 $ 3 $ - $ 26
========= ========== =========== =========
1997:
Marketable Securities:
Kiewit Mutual Fund:
Short-term government $ 234 $ - $ - $ 234
Intermediate term bond 195 3 - 198
Tax exempt 154 3 - 157
Equity 7 4 - 11
Equity securities 48 9 - 57
Other securities 20 1 - 21
--------- ---------- ----------- ---------
$ 658 $ 20 $ - $ 678
======== ========= =========== ========
Restricted Securities:
Kiewit Mutual Fund:
Intermediate term bond $ 10 $ - $ - $ 10
Equity 12 - - 12
--------- ----------- ----------- ---------
$ 22 $ - $ - $ 22
========= =========== =========== =========
For debt securities, amortized costs do not vary significantly from principal
amounts. Realized gains and losses on sales of marketable and equity securities
were $10 million and $1 million in 1998, $9 million and $- million in 1997, and
$3 million and $- million in 1996, respectively.
At December 31, 1998, the contractual maturities of the debt securities are as
follows:
(dollars in millions) Amortized Cost Fair Value
U.S. Treasury Securities:
Less than 1 year $ 2,147 $ 2,155
======= =======
U.S. Government Agency Securities:
Less than 1 year $ 639 $ 640
======== ========
Other Securities:
10+ years $ 20 $ 17
========= =========
Maturities for the equity and restricted securities have not been presented as
they do not have a single maturity date.
Long-Term Debt
The fair value of long-term debt was estimated using the Company's incremental
borrowing rates for debt of similar maturities.
The carrying amount and estimated fair values of Level 3's financial instruments
are as follows:
1998 1997
------------------- -------------------
Carrying Fair Carrying Fair
(dollars in millions) Amount Value Amount Value
Cash and Cash Equivalents (Note 6) $ 848 $ 848 $ 87 $ 87
Marketable Securities (Note 6) 2,863 2,863 678 678
Restricted Securities (Note 6) 26 26 22 22
Investment in C-TEC Entities (Note 8) 300 818 335 776
Investments in Discontinued Energy Operations (Note 3) - - 643 854
Long-term Debt (Note 10) 2,646 2,613 140 140
(7) Property Plant and Equipment
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. These costs are not yet being depreciated, as
the assets have not yet been placed in service. As segments of the network
become operational, 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 will be amortized over its useful life of 3 years.
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 & Equipment below.
Accumulated Book
(dollars in millions) Cost Depreciation Value
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 32 (2) 30
Construction-in-Progress 430 - 430
------- -------- -------
$ 1,315 $ (254) $ 1,061
======= ======== =======
1997
Land and Mineral Properties $ 15 $ (11) $ 4
Facility and Leasehold Improvements
Communications - - -
Information Services 12 (2) 10
Coal Mining 19 (15) 4
CPTC 91 (4) 87
Operating Equipment
Communications - - -
Information Services 42 (23) 19
Coal Mining 190 (159) 31
CPTC 17 (3) 14
Furniture and Office Equipment 11 (5) 6
Other 14 (6) 8
Construction-in-Progress 1 - 1
-------- -------- -------
$ 412 $ (228) $ 184
======== ======== =======
Depreciation expense was $48 million in 1998, $20 million in 1997 and $124
million in 1996.
(8) Investments
In 1997, C-TEC announced that its Board of Directors had approved the planned
restructuring of C-TEC into three publicly traded companies effective September
30, 1997. Under the terms of the restructuring C-TEC stockholders received stock
in the following companies:
Commonwealth Telephone Enterprises, Inc., ("Commonwealth Telephone")
containing the local telephone group and related engineering business.
RCN Corporation ("RCN") which consists of RCN Telecom Services; C-TEC,
existing cable systems in the Boston-Washington D.C. corridor; and the
investment in Megacable S.A. de C.V., a cable operator in Mexico. RCN
Telecom Services is a provider of packaged local and long distance
telephone, video and internet access services provided over fiber optic
networks to residential customers.
Cable Michigan, Inc. ("Cable Michigan") containing the cable
television operation.
As a result of the restructuring, Level 3 owned less than 50% of each of the
outstanding shares and voting rights of each entity, and therefore began
accounting for each entity using the equity method as of the beginning of 1997.
The following is summarized financial information of the Company had C-TEC been
accounted for utilizing the equity method for the fiscal year ended December 28,
1996. Fiscal years 1998 and 1997 include C-TEC accounted for utilizing the
equity method and are presented here for comparative purposes only.
(dollars in millions) 1998 1997 1996
- - ------------------------------------------------------------------------------------------------------------------
Revenue $ 392 $ 332 $ 285
Costs and Expenses:
Operating expenses (199) (163) (125)
Depreciation and amortization (66) (20) (18)
General and administrative expenses (332) (106) (86)
Write-off of in process research and development (30) - -
------- ----------- -----------
Total costs and expenses (627) (289) (229)
------- ----------- -----------
Earnings (Loss) from Operations (235) 43 56
Other Income (Expense):
Interest income 173 33 36
Interest expense (132) (15) (5)
Equity losses (132) (43) (13)
Gain on investee stock transactions 62 - -
Gain on disposal of assets 107 10 10
Other, net 4 7 9
---------- ---------- ----------
Total other income (expense) 82 (8) 37
--------- ---------- ---------
Earnings (Loss) before Income Taxes and
Discontinued Operations (153) 35 93
Income Tax Benefit 25 48 11
--------- --------- ---------
Income (Loss) from Continuing Operations (128) 83 104
Income from Discontinued Operations 932 165 117
-------- -------- --------
Net Earnings $ 804 $ 248 $ 221
======== ======== ========
On June 4, 1998, Cable Michigan announced that its Board of Directors had
reached a definitive agreement to sell the company to Avalon Cable of Michigan,
Inc. for $40.50 per share in a cash-for-stock transaction. Level 3 received
approximately $129 million when the transaction closed on November 6, 1998 and
recognized a pre-tax gain of approximately $90 million in the fourth quarter.
The $90 million gain was calculated using the Company's carrying value as of
September 30, 1998, as Cable Michigan's results of operations for the period
October 1, 1998 through November 6, 1998 were not considered significant
relative to the Company's results.
On September 25, 1998, Commonwealth Telephone announced that it was commencing a
rights offering of 3.7 million shares of its common stock. Under the terms of
the offering, each stockholder received one right for every five shares of
Commonwealth Telephone Common Stock or Commonwealth Telephone Class B Common
Stock held. The rights enabled the holder to purchase Commonwealth Telephone
Common Stock at a subscription price of $21.25 per share. Each right also
carried the right to oversubscribe at the subscription price for the offered
shares not purchased pursuant to the initial exercise of rights.
Level 3, which owned approximately 48% of Commonwealth Telephone prior to the
rights offering, exercised its 1.8 million rights it received with respect to
the shares it held for $38 million. As a result of subscriptions made by other
stockholders, Level 3 maintained its 48% ownership interest in Commonwealth
Telephone after the rights offering.
The following is summarized financial information of the three entities created
as a result of the C-TEC restructuring for each of the three years ended
December 31, 1998 and as of December 31, 1998 and December 27, 1997 (in
millions):
Year Ended
Operations: 1998 1997 1996
- - ------------------------------------------------------------------------------------------------------------------
Commonwealth Telephone Enterprises, Inc.:
Revenue $ 226 $ 197 $ 186
Net income available to common shareholders 8 20 20
Level 3's Share:
Net income 4 10 10
Goodwill amortization (2) (1) (1)
-------- -------- --------
Equity in net income $ 2 $ 9 $ 9
======== ======== ========
RCN Corporation:
Revenue $ 211 $ 127 $ 105
Net loss available to common shareholders (205) (52) (6)
Level 3's Share:
Net loss (91) (26) (3)
Goodwill amortization (1) - (3)
-------- ------ ------
Equity in net loss $ (92) $ (26) $ (6)
======= ======= ======
Cable Michigan, Inc.*:
Revenue $ 66 $ 81 $ 76
Net loss available to common shareholders (9) (4) (8)
Level 3's Share*:
Net loss (4) (2) (4)
Goodwill amortization (3) (4) (4)
-------- ------ ------
Equity in net loss $ (7) $ (6) $ (8)
======== ======= =======
*1998 revenue and net loss amounts are through September 30, 1998.
Commonwealth
Telephone RCN Cable
Enterprises, Inc. Corporation Michigan, Inc.
Financial Position: 1998 1997 1998 1997 1997
- - ---------------------------------------------------------------------------------------------------------------
Current Assets $ 79 $ 71 $ 1,092 $ 703 $ 23
Other Assets 354 303 816 448 120
-------- -------- ------- -------- --------
Total assets 433 374 1,908 1,151 143
Current Liabilities 85 76 178 70 16
Other Liabilities 223 260 1,282 708 166
Minority Interest - - 77 16 15
-------- -------- ------- -------- --------
Total liabilities 308 336 1,537 794 197
-------- -------- ------- -------- --------
Net assets (liabilities) $ 125 $ 38 $ 371 $ 357 $ (54)
======== ======== ======= ======== ========
Level 3's Share:
Equity in net assets (liabilities) $ 60 $ 18 $ 150 $ 173 $ (26)
Goodwill 56 57 34 41 72
--------- --------- --------- --------- ---------
$ 116 $ 75 $ 184 $ 214 $ 46
======== ========= ======== ======== =========
The Company recognizes gains from the sale, issuance and repurchase of stock by
its subsidiaries and equity method investees in its statements of earnings.
During 1998, RCN issued stock in a public offering and for certain acquisitions
which diluted the Company's ownership of RCN from 48% at December 27, 1997 to
41% at December 31, 1998. 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
$62 million for the Company in 1998.
The market value of the Company's investment in Commonwealth Telephone and RCN
on December 31, 1998, was $352 million, and $466 million,respectively, based on
the closing stock price of each company on December 31, 1998.
Investments also include $23 million for the Company's investment in an office
building in Aurora, Colorado.
(9) Other Assets
At December 31, 1998 and December 27, 1997 other assets consisted of the
following:
(in millions) 1998 1997
- - ------------------------------------------------------------------------------------------------------------------
Goodwill:
XCOM, net of accumulated amortization of $15 $ 100 $ -
GeoNet, net of accumulated amortization of $1 20 -
Other, net of accumulated amortization of $1 21 -
Deferred Debt Issuance Costs 67 -
Deferred Development and Financing Costs 15 21
Unrecovered Mine Development Costs 15 16
Leases 9 11
Timberlands 6 7
Other 11 11
-------- --------
Total other assets $ 264 $ 66
======= ========
Goodwill amortization expense, excluding amortization expense attributable to
the equity method investees, was $18 million in 1998 and $- in 1997 and 1996.
(10) Long-Term Debt
At December 31, 1998 and December 27, 1997, long-term debt was as follows:
(dollars in millions) 1998 1997
- - ------------------------------------------------------------------------------------------------------------------
Senior Notes
(9.125% due 2008) $ 2,000 $ -
Senior Discount Notes
(10.5% due 2008) 504 -
CPTC Long-term Debt (with recourse only to CPTC):
Bank Note
(7.6% due 2008) 64 65
Institutional Notes
(9.45% due 2017) 35 35
OCTA Debt
(9.0% due 2004) 9 8
Subordinated Debt
(9.3-9.5% no maturity) 8 6
------- --------
116 114
Other:
Pavilion Towers Debt (8.4% due 2007) 15 15
Capitalized Leases 8 6
Other 3 5
------- --------
26 26
------- --------
2,646 140
Less current portion (5) (3)
------- --------
$ 2,641 $ 137
======= ========
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 annum and will be
payable in cash semiannually in arrears.
The Senior Notes are subject to redemption at the option of the Company, in
whole or in part, at any time or from time to time on or after May 1, 2003, plus
accrued and unpaid interest thereon to the redemption date, if redeemed during
the twelve months beginning May 1, of the years indicated below:
Year Redemption Price
2003 104.563%
2004 103.042%
2005 101.521%
2006 and thereafter 100.000%
In addition, at any time or from time to time prior to May 1, 2001, the Company
may redeem up to 35% of the original aggregate principal amount of the Senior
Notes at a redemption price equal to 109.125% of the principal amount of the
Senior Notes so redeemed, plus accrued and unpaid interest thereon to the
redemption date. The Senior Notes are senior, unsecured obligations of the
Company, ranking pari passu with all existing and future senior unsecured
indebtedness of the Company. The Senior Notes contain certain covenants, which
among other things, limit consolidated debt, dividend payments, and transactions
with affiliates. The Company is using the net proceeds of the Senior Notes
offering in connection with the implementation of its Business 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 IP technology.
Debt issuance costs of $65 million were capitalized and are being amortized over
the term of the Senior Notes.
10.5% Senior Discount Notes
On December 2, 1998, the Company sold $834 million principal amount 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 will accrete 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, in which case the outstanding principal amount at maturity of
each Senior Discount Note will on the elected commencement date be reduced to
the accreted value of the Senior Discount Note as of that date and cash interest
shall be payable on that Note on June 1 and December 1 thereafter. Commencing
June 1, 2004, interest on the Senior Discount Notes will accrue at the rate of
10.5% per annum and will be payable in cash semiannually in arrears.
The Senior Discount Notes will be subject to redemption at the option of the
Company, in whole or in part, at any time or from time to time on or after
December 1, 2003 at the following redemption prices (expressed as percentages of
accreted value) plus accrued and unpaid interest thereon to the redemption date,
if redeemed during the twelve months beginning December 1, of the years
indicated below:
Year Redemption Price
2003 105.25%
2004 103.50%
2005 101.75%
2006 and thereafter 100.00%
In addition, at any time or from time to time prior to December 1, 2001, the
Company may redeem up to 35% of the original aggregate principal amount at
maturity of the Notes at a redemption price equal to 110.50% of the accreted
value of the notes so redeemed, plus accrued and unpaid interest thereon to the
redemption date. These notes are senior unsecured obligations of the Company,
ranking pari pasu with all existing and future senior unsecured indebtedness of
the Company. The Senior Discount Notes contain certain covenants which, among
other things, restrict the Company`s ability to incur additional debt, make
certain restricted payments, pay dividends, enter into sale and leaseback
transactions, enter into transactions with affiliates, and sell assets or merge
with another company.
The net proceeds of $486 million are intended to be used to accelerate the
implementation of its Business Plan, primarily the funding for the increase in
committed number of route miles of the Company's U.S. intercity network.
Debt issuance costs of $14 million have been capitalized and are being amortized
over the term of the Senior Discount Notes.
The Company capitalized $15 million of interest expense and amortized debt
issuance costs related to network construction and business systems development
projects for the year ended December 31, 1998.
CPTC:
In August 1996, California Private Transportation Company, L.P. ("CPTC")
converted its construction financing note into a term note with a consortium of
banks ("Bank Note"). The interest rate on the Bank Note is based on LIBOR plus a
varying rate with interest payable quarterly. Upon completion of the SR91 toll
road, CPTC entered into an interest rate swap agreement with the same parties.
The swap agreement expires in January 2004 and fixes the interest rate on the
Bank Debt from 9.21% to 9.71% during the term of the swap agreement.
The institutional notes are held by Connecticut General Life Insurance Company,
a subsidiary of CIGNA Corporation and Lincoln National Life Insurance Company.
The note converted to a term loan upon completion of the SR91 toll road.
Substantially all the assets of CPTC and the partners' equity interest in CPTC
secure the term debt.
Orange County Transportation Authority ("OCTA") holds $9 million of subordinated
debt which is due in varying amounts through 2004. Interest accrues at 9% and is
payable quarterly beginning when CPTC generates sufficient cash flows to cover
operating expenses and other debt requirements.
In July 1996, CPTC borrowed from the partners $2 million to facilitate the
completion of the project. In 1998 and 1997, CPTC borrowed an additional $2
million and $4 million, respectively, from the partners in order to comply with
equity maintenance provisions of the contracts with the State of California and
its lenders. The debt is generally subordinated to all other debt of CPTC.
Interest on the subordinated debt compounds annually at 9.3-9.5% and is payable
only as CPTC generates excess cash flows.
In 1996, CPTC capitalized $5 million of interest prior to completing
construction of the SR91 tollroad.
Other:
In June 1997, a mortgage loan was obtained from Metropolitan Life. The Pavilion
Towers building in Aurora, Colorado collateralizes this debt.
Scheduled maturities of long-term debt are as follows (in millions):1999 -$5;
2000 - $6; 2001 - $6; 2002 - $9; 2003 - $9 and $2,611 thereafter.
(11) 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 in accordance with FASB Interpretation No. 28 "Accounting for Stock
Appreciation Rights and Other Variable Stock Option or Award Plans"("FIN 28").
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.
The Company believes that the fair value method of accounting more appropriately
reflects the substance of the transaction between an entity that issues stock
options, or other stock-based instruments, and its employees and consultants;
that is, an entity has granted something of value to an employee and consultants
(the stock option or other instrument) generally in return for their continued
employment and services. The Company believes that the value of the instrument
granted to employees and consultants should be recognized in financial
statements because nonrecognition implies that either the instruments have no
value or that they are free to employees and consultants, neither of which is an
accurate reflection of the substance of the transaction. Although the
recognition of the value of the instruments 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 charge 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.
On a pro forma basis, adopting SFAS No. 123 would not have had a material effect
on the results of operations for the years ended December 27, 1997 and December
28, 1996.
Non-qualified Stock Options and Warrants
In December 1997, stockholders approved amendments to the 1995 Level 3 Stock
Plan ("the Plan"). The amended plan, among other things, increases the number of
shares reserved for issuance upon the exercise of stock based awards to
70,000,000; increases the maximum number of options granted to any one
participant to 10,000,000; provides for the acceleration of vesting in the event
of a change in control; allows for the grant of stock based awards to directors
of Level 3 and other persons providing services to Level 3; and allows for the
grant of nonqualified stock options ("NQSO") with an exercise price less than
the fair market value of Common Stock. In December 1997, Level 3 converted both
option and stock appreciation rights plans of a subsidiary, to the Plan. This
conversion resulted in the issuance of 7.4 million options to purchase Common
Stock at $4.50 per share. Level 3 recognized an expense and a corresponding
increase in equity as a result of the transaction. The increase in equity and
the conversion of the stock appreciation rights liability to equity are
reflected as option activity in the Statement of Changes in Stockholders'
Equity. The options vest over three or five years with a five or ten year life.
In addition to 7,466,247 NQSOs granted in 1998, 1,898,036 warrants were granted
to third parties to acquire shares of Common Stock at exercise prices ranging
from $18.50 - $20.00 per share. The warrants vest quarterly through June 30,
2001.
The expense recognized in accordance with SFAS No. 123 for NQSOs and warrants in
1998 was $6 million and $5 million, respectively. In addition to the expense
recognized, the Company capitalized $2 million of non-cash compensation costs
related to NQSOs for employees directly involved in the construction of the IP
network and the development of the business support systems.
The fair value of NQSOs and warrants granted was calculated using the
Black-Scholes method with a risk free interest rate of 5.5% and expected life of
75% of the total life of the NQSOs and warrants. The Company used an expected
volatility rate of 25% except for when the minimum volatility of .001%, was used
by the Company prior to becoming publicly traded in April 1998. The fair value
of the NQSO and warrants granted in 1998, in accordance with SFAS No. 123 was
$28 million.
The Company exchanged approximately 700,000 options and 100,000 options,
ranging in prices from $0.12 to $1.76 and primarily from $0.90 to $1.79 for
the XCOM and GeoNet acquisitions, respectively.
Transactions involving stock options granted under the NQSO plan are summarized
as follows:
Weighted
Exercise Price Average
Shares Per Share Exercise Price
Balance December 30, 1995 2,680,000 $ 4.04 $ 4.04
Options granted 1,790,000 4.95 4.95
Options cancelled (30,000) 4.04 4.04
Options exercised - - -
-----------
Balance December 28, 1996 4,440,000 $ 4.04 - $ 4.95 $ 4.40
================= =========
Options granted 14,990,930 $ 4.50 - $ 5.42 $ 4.96
Options cancelled (106,000) 4.95 4.95
Options exercised (4,636,930) 4.04 - 4.95 4.46
-----------
Balance December 27, 1997 14,688,000 $ 4.04 - $ 5.42 $ 4.95
================= =========
Options granted 7,466,247 $ 0.12 - $41.25 $ 8.67
Options cancelled (668,849) 0.12 - 34.69 5.52
Options exercised (2,506,079) 0.12 - 34.69 4.22
-----------
Balance December 31, 1998 18,979,319 $ 0.12 - $41.25 $ 6.50
========== ================ =========
Options exercisable
December 28, 1996 530,000 $ 4.04 $ 4.04
December 27, 1997 2,590,538 $ 4.04 - $ 4.95 $ 4.35
December 31, 1998 5,456,640 $ 0.12 - $ 41.25 $ 4.67
The weighted average remaining contractual life for the 18,979,319 options
outstanding on December 31, 1998 is 8.47 years.
Options Outstanding Options Exercisable
Weighted Weighted
Number Average Average Number Weighted
Range of Outstanding Remaining Exercise Price Exercisable Average
Exercise Prices as of 12/31/98 Life (years) Outstanding as of 12/31/98 Exercise Price
$ 0.12 - $ 0.12 187,036 9.04 $ 0.12 39,558 $ 0.12
0.90 - 0.90 34,764 6.26 0.90 21,230 0.90
1.76 - 1.79 78,010 8.50 1.77 19,060 1.79
4.04 - 5.43 12,965,014 8.51 5.04 5,331,448 4.71
6.20 - 8.50 4,875,600 9.06 6.98 45,100 6.82
17.50 - 25.03 272,374 4.62 19.42 - -
26.80 - 39.13 500,521 4.48 31.37 244 34.69
40.38 - 41.25 66,000 4.62 40.59 - -
---------- ---------
18,979,319 8.47 $ 6.50 5,456,640 $ 4.67
========== ==== ======== ========= ========
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 has a two-year moratorium on exercising. Once a
participant is 100% vested, the two year moratorium is lifted. Therefore, each
grant has an exercise window of two years.
The fair value and expense recognized under SFAS No. 123 for OSOs granted to
employees and consultants for services performed in 1998 was $64 million and $24
million, respectively. In addition, $3 million that was capitalized for
employees directly involved in the construction of the IP network and
development of business support systems.
The fair value of the options granted was calculated by applying the
Black-Scholes method with an S&P 500 expected dividend yield rate of 1.8% and an
expected life of 2.5 years. The Company used a blended volatility rate of 24%
between the S&P 500 expected volatility rate of 16% and the Level 3 Common Stock
expected volatility rate of 25%. The expected correlation factor of 0.4 was used
to measure the movement of Level 3 stock relative to the S&P 500.
Transactions involving stock awards granted in 1998 under the OSO plan are
summarized below:
Weighted
Option Price Average
Shares Per Share Option Price
Options granted 2,139,075 $29.78 - $37.13 $ 34.28
Options cancelled (46,562) 29.78 - 37.13 35.53
Options exercised - - -
----------
Balance December 31, 1998 2,092,513 $29.78 - $37.13 $ 34.25
========== =============== =========
Options vested but not exercisable as of
December 31, 1998 234,305 $29.78 - $37.13 $ 34.85
======== =============== =========
The weighted average remaining contractual life for the 2,092,513 outperform
options outstanding on December 31, 1998 is 3.6 years.
Restricted Stock
In 1998, 177,183 shares of restricted stock were granted to employees. The
restricted stock shares are granted to employees at no cost. The shares vest
immediately; however, the employees are restricted from selling these shares for
3 years. The fair value of restricted stock of $6 million was calculated using
the value of the Common Stock the day prior to the grant. The expense recognized
in 1998 under SFAS No. 123 for restricted stock grants was $3 million.
Shareworks - Level 3 has designed its compensation programs with particular
emphasis on equity-based, long-term incentive programs. The Company has
developed two plans under its Shareworks program: the Match Plan and the Grant
Plan.
Match Plan - The Match Plan allows eligible employees to defer between 1% and 7%
of their eligible compensation to purchase Common Stock at the average stock
price for the quarter. Any full time employee is considered eligible on the
first day of the calendar quarter after their hire. The Company matches the
shares purchased by the employee on a one-for-one basis. Stock purchased with
payroll deductions is fully vested. Stock purchased with the Company's matching
contributions vests three years after the end of the quarter in which it was
made.
The Company's quarterly matching contribution is amortized over 36 months. In
1998, the Company's matching contribution was $2 million under the Match Plan.
The compensation expense recognized in 1998 under this plan was less than $1
million.
Grant Plan - The Grant Plan enables the Company to grant shares of Common Stock
to eligible employees based upon a percentage of that employee's eligible salary
up to a maximum of 3%. Level 3 employees on December 31 of each year, who are
age 21 or older with a minimum of 1,000 hours credited service are considered
eligible. The shares granted are valued at the fair market value as of the last
business day of the calendar year. All prior and future grants vest immediately
upon the employees' third anniversary of joining the Shareworks Plan.
The annual grant is expensed in the year of the grant. Compensation expense
recorded for the Shareworks Grant Plan for 1998 was approximately $1 million. In
addition to the compensation expense recognized, the Company capitalized less
than $1 million of non-cash compensation costs related to the Shareworks Plans
for employees directly involved in the construction of the IP network and the
development of the business support systems.
401(k) Plan
The Company and its subsidiaries offer its qualified employees the opportunity
to participate in a defined contribution retirement plan qualifying under the
provisions of Section 401(k) of the Internal Revenue Code. Each employee was
eligible to contribute, on a tax deferred basis, a portion of annual earnings
not to exceed $10,000 in 1998. The Company does not match employee contributions
and therefore does not incur any expense related to the 401(k) plan.
(12) Income Taxes
An analysis of the income tax (provision) benefit attributable to earnings
(loss) from continuing operations before income taxes for the three years ended
December 31, 1998 follows:
(dollars in millions) 1998 1997 1996
- - ------------------------------------------------------------------------------------------------------------------
Current:
U.S. federal $ (15) $ (54) $ (61)
Foreign - - (4)
State (10) (1) (6)
-------- --------- ---------
(25) (55) (71)
Deferred:
U.S. federal 50 103 67
State - - 1
---------- ---------- ---------
50 103 68
-------- ------- --------
$ 25 $ 48 $ (3)
======== ======== =========
The United States and foreign components of earnings (loss) from continuing
operations before income taxes follows:
(dollars in millions) 1998 1997 1996
- - ------------------------------------------------------------------------------------------------------------------
United States $ (142) $ 35 $ 106
Foreign (11) - 1
-------- ---------- ---------
$ (153) $ 35 $ 107
======= ======== =======
A reconciliation of the actual income tax (provision) benefit and the tax
computed by applying the U.S. federal rate (35%) to the earnings (loss) from
continuing operations, before income taxes for the three years ended December
31, 1998 follows:
(dollars in millions) 1998 1997 1996
- - -----------------------------------------------------------------------------------------------------------------
Computed Tax at Statutory Rate $ 53 $ (12) $ (37)
State Income Taxes (7) (1) (3)
Write-off of In Process Research & Development (11) - -
Coal Depletion 2 3 3
Goodwill Amortization (5) - (3)
Tax Exempt Interest - 2 2
Prior Year Tax Adjustments - 62 44
Compensation Expense Attributable to Options - (7) -
Taxes on Unutilized Losses of Foreign Operations (4) - (2)
Other (3) 1 (7)
--------- --------- ---------
$ 25 $ 48 $ (3)
======== ======== =========
During the two years ended December 27, 1997, the Company settled a number of
disputed tax issues related to prior years that have been included in prior year
tax adjustments.
The components of the net deferred tax liabilities for the years ended December
31, 1998 and December 27, 1997 were as follows:
(dollars in millions) 1998 1997
- - -----------------------------------------------------------------------------------------------------------------
Deferred Tax Liabilities:
Investments in securities $ 2 $ 7
Investments in joint ventures 27 33
Asset bases - accumulated depreciation 83 53
Coal sales 32 41
Other 20 16
-------- --------
Total Deferred Tax Liabilities 164 150
Deferred Tax Assets:
Compensation - and related benefits 35 25
Investment in subsidiaries 14 8
Provision for estimated expenses 14 7
Foreign and general business tax credits - 3
Other 13 9
-------- ---------
Total Deferred Tax Assets 76 52
-------- --------
Net Deferred Tax Liabilities $ 88 $ 98
======== ========
(13) Stockholders ' Equity
Issuances of Common Stock, for sales, conversions, option exercises and
acquisitions, and repurchases of common shares for the three years ended
December 31, 1998 are shown below. Prior to the Split-off, the Company was
obligated to repurchase Class D shares from stockholders. The Level 3 Stock Plan
permits option holders to tender shares to the Company to cover income taxes due
on option exercises.
December 30, 1995 230,249,740
Shares Issued -
Shares Repurchased (2,552,160)
Issuances for Class C Stock Conversions 4,104,850
--------------
December 28, 1996 231,802,430
Shares Issued 21,589,100
Shares Repurchased (29,610)
Issuances for Class C Stock Conversions 13,035,430
Option Activity 4,636,930
--------------
December 27, 1997 271,034,280
Shares Issued 2,240,467
Shares Repurchased (30,506)
Issuances for Class C Stock Conversions 20,934,244
Issuances for Class R Stock Conversions 5,084,568
Option Activity 2,506,079
Shares Issued for Acquisitions 6,105,574
--------------
December 31, 1998 307,874,706
===========
(14) Industry and Geographic Data
In the fourth quarter of 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. It also
establishes standards for disclosures about products and services and geographic
areas. 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 CPTC, the C-TEC investments
and other corporate investments and overhead not attributable to a specific
segment.
Industry and geographic 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 expenses) 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.
In 1998, 1997, and 1996 Commonwealth Edison Company, a coal mining customer,
accounted for 34%, 43%, and 23% of Level 3's revenues.
Industry segment financial information follows. Certain prior year information
has been reclassified to conform with the 1998 presentation.
Communications & Information Services
Computer Systems Coal
(dollars in millions) Communications Outsourcing Integration Mining Other Total
1998
Revenue $ 24 $ 63 $ 57 $ 228 $ 20 $ 392
EBITDA (139) 14 (23) 92 (44) (100)
Identifiable Assets 999 59 42 429 3,996 5,525
Capital Expenditures 818 25 4 2 61 910
Depreciation and
Amortization 37 8 3 5 13 66
1997
Revenue $ - $ 50 $ 45 $ 222 $ 15 $ 332
EBITDA - 13 1 88 (18) 84
Identifiable Assets - 42 19 499 924 1,484
Capital Expenditures - 9 5 3 9 26
Depreciation and
Amortization - 6 2 5 7 20
1996
Revenue $ - $ 41 $ 1 $ 234 $ 376 $ 652
EBITDA - 12 (5) 103 101 211
Capital Expenditures - 8 3 2 104 117
Depreciation and
Amortization - 5 2 9 108 124
The following table presents a geographic breakout for revenue, EBITDA, and
identifiable assets:
Communications & Information Services
Computer Systems Coal
(dollars in millions) Communications Outsourcing Integration Mining Other Total
1998
Revenue:
United States $ 23 $ 62 $ 56 $ 228 $ 20 $ 389
Other 1 1 1 - - 3
---------- ---------- ---------- ----------- ----------- ----------
$ 24 $ 63 $ 57 $ 228 $ 20 $ 392
========= ========= ========= ======== ========= ========
EBITDA:
United States $ (128) $ 14 $ (23) $ 92 $ (44) $ (89)
Other (11) - - - - (11)
--------- ----------- ----------- ----------- ----------- ---------
$ (139) $ 14 $ (23) $ 92 $ (44) $ (100)
======== ========= ========= ========= ========= ==========
Identifiable Assets:
United States $ 886 $ 59 $ 42 $ 429 $ 3,996 $ 5,412
Other 113 - - - - 113
-------- ----------- ----------- ----------- ----------- --------
$ 999 $ 59 $ 42 $ 429 $ 3,996 $ 5,525
======== ========= ========= ======== ======= =======
1997
Revenue:
United States $ - $ 50 $ 45 $ 222 $ 15 $ 332
Other - - - - - -
----------- ----------- ----------- ----------- ----------- -----------
$ - $ 50 $ 45 $ 222 $ 15 $ 332
=========== ========= ========= ======== ========= ========
EBITDA:
United States $ - $ 13 $ 1 $ 88 $ (18) $ 84
Other - - - - - -
----------- ----------- ----------- ----------- ----------- -----------
$ - $ 13 $ 1 $ 88 $ (18) $ 84
=========== ========= ========== ========= ========= =========
Identifiable Assets:
United States $ - $ 42 $ 19 $ 499 $ 924 $ 1,484
Other - - - - - -
----------- ----------- ----------- ----------- ----------- -----------
$ - $ 42 $ 19 $ 499 $ 924 $ 1,484
=========== ========= ========= ======== ======== =======
1996
Revenue:
United States $ - $ 41 $ 1 $ 234 $ 376 $ 652
Other - - - - - -
----------- ----------- ----------- ----------- ----------- -----------
$ - $ 41 $ 1 $ 234 $ 376 $ 652
=========== ========= ========== ======== ======== ========
EBITDA:
United States $ - $ 12 $ (5) $ 103 $ 101 $ 211
Other - - - - - -
----------- ----------- ----------- ----------- ----------- -----------
$ - $ 12 $ (5) $ 103 $ 101 $ 211
=========== ========= ========== ======== ======== ========
The following information provides a reconciliation of EBITDA to income from
continuing operations for the three years ended December 31, 1998:
(in millions) 1998 1997 1996
- - ------------------------------------------------------------------------------------------------------------------
EBITDA $ (100) $ 84 $ 211
Depreciation and Amortizaqtion Expense (66) (20) (124)
Non-Cash Compensation Expense (39) (21) -
Write-off of In Process Research and Development (30) - -
--------- --------- ---------
Earnings (Loss) from Operations (235) 43 87
Other Income (Expense) 82 (8) 20
Income Tax Benefit (Provision) 25 48 (3)
--------- --------- ----------
Income (Loss) from Continuing Operations $ (128) $ 83 $ 104
======== ========= ========
(15) Commitments and Contingencies
On March 23, 1998, the Company and Frontier Communications International, Inc.
("Frontier") entered into an agreement ("Frontier Agreement") enabling the
Company to lease for a period of up to five years approximately 8,300 miles of
network capacity on Frontier's new 13,000 mile fiber optic, IP-capable network,
currently under construction. The leased network will initially connect 15 of
the larger cities across the United States. While requiring an aggregate minimum
payment of $165 million over its five-year term, the Frontier Agreement does not
impose monthly minimum consumption requirements on the Company, allowing the
Company to order, alter or terminate circuits as it deems appropriate. The
Company recognized $4 million of operating expenses in the second half of 1998
as portions of the network became operational.
On April 2, 1998, the Company announced it had reached a definitive agreement
with Union Pacific Railroad Company ("Union Pacific") granting the Company
rights-of-way along Union Pacific's rail routes for construction of the
Company's North American intercity network. The Company expects that the Union
Pacific agreement will satisfy substantially all of its anticipated right-of-way
requirements west of the Mississippi River and approximately 50% of the
right-of-way requirements for its North American intercity network. The
agreement provides for initial fixed payments of up to $8 million to Union
Pacific upon execution of the agreement and throughout the construction period,
and recurring payments in the form of cash, communications capacity, and other
communications services based on the number of conduits that are operational and
certain construction obligations of the Company to provide fiber or conduit
connections for Union Pacific at the Company's incremental cost of construction.
In 1998, the Company recorded $9 million of payments made under this agreement
in network construction-in-progress.
On June 18, 1998, Level 3 selected Peter Kiewit Sons', Inc. ("Kiewit") to build
the majority of its nearly 16,000 mile U.S. intercity communications network.
The overall cost of the project is estimated at $2 billion. Construction of the
network began in the third quarter of 1998 and is expected to be completed
during the first quarter of 2001. The contract provides that Kiewit will be
reimbursed for its costs relating to all direct and indirect project level
costs. In addition, Kiewit will have the opportunity to earn an award fee that
will be based on cost and speed of construction, quality, safety and program
management. The award fee will be determined by Level 3's assessment of Kiewit's
performance in each of these areas.
On June 23, 1998, the Company signed a master easement agreement with Burlington
Northern and Santa Fe Railway Company ("BNSF"). The agreement grants Level 3
right-of-way access to BNSF rail routes in as many as 28 states, over which to
build its network. Under the easement agreement, Level 3 will make annual
payments to BNSF and provide communications capacity to BNSF for its internal
requirements. The amount of the annual payments is dependent upon the number of
conduits installed, the number of conduits with fiber, and the number of miles
of conduit installed along BNSF's route.
On July 20, 1998, Level 3 entered into a network construction cost-sharing
agreement with INTERNEXT, LLC, a subsidiary of NEXTLINK Communications, Inc.
valued at $700 million. The agreement provides for INTERNEXT to acquire the
right to use conduits, fibers and certain associated facilities installed along
the entire route of Level 3's nearly 16,000 mile intercity fiber optic network
in the United States. INTERNEXT paid Level 3 $26 million in 1998 which was
deferred and included in other liabilities as of December 31, 1998 and will pay
the remaining balance as segments of the intercity network are completed. The
Company will recognize income as the segments of the network are completed and
accepted.
The network as provided to INTERNEXT will not include the necessary electronics
that allow the fiber to carry communications transmissions. INTERNEXT will be
restricted from selling or leasing fiber to unaffiliated companies for four
years following the date of the agreement. Also, under the terms of the
agreement, INTERNEXT has the right to an additional conduit for its exclusive
use and to share costs and capacity in certain future fiber cable installations
in Level 3 conduits.
On August 3, 1998, Level 3 and a group of other global telecommunications
companies entered into an agreement to construct an undersea cable system
connecting Japan and the United States by mid-year 2000. The parties to this
agreement are investing in excess of $1 billion to build the network, of which
Level 3 expects to contribute approximately $130 million. Each party will have
joint responsibility for the cost of network oversight, maintenance and
administration. The Company has recorded $24 million of costs associated with
this project in network construction-in-progress at December 31, 1998.
On October 14, 1998, Level 3 announced it signed an agreement with Global
Crossing Ltd. ("Global") for trans-oceanic capacity on Global Crossing's fiber
optic cable network. The agreement, covering 25 years and valued at
approximately $108 million, will provide Level 3 with as-needed dedicated
capacity across the Atlantic Ocean. Additionally, Level 3 will have the option
of utilizing capacity on other segments of Global's worldwide network. In 1998,
the Company recorded as network construction-in-progress, $32 million of costs
associated with this agreement.
On December 18, 1998 Level 3 announced an agreement with IXC Communications,
Inc. ("IXC") to lease capacity on IXC's network. The dedicated network will
enhance the Company's ability to offer a wide array of data and voice services
to a greater number of customers in key U.S. markets. The arrangement is unique
in that IXC will reserve the network for the exclusive use of Level 3, which
expects to begin running traffic across the network beginning in Spring 1999.
The Company paid IXC $40 million under this agreement in 1998 and recorded this
amount in property, plant and equipment.
Operating Leases
The Company is leasing rights of way, communications capacity and premises under
various operating leases which, in addition to rental payments, require payments
for insurance, maintenance, property taxes and other executory costs related to
the lease. Certain leases provide for adjustments in lease cost based upon
adjustments in the consumer price index and increases in the landlord's
management costs. The lease agreements have various expiration dates through
2014.
In addition to the items described above, future minimum payments for the next
five years, under the non-cancelable operating leases with initial or remaining
terms of one year or more, consist of the following at December 31, 1998 (in
millions):
1999 $ 35
2000 34
2001 31
2002 24
2003 24
Thereafter 182
------
$ 330
======
Rent expense under these lease agreements was $18 million in 1998, $1 million
in 1997 and $3 million in 1996.
(16) Related Party Transactions
Peter Kiewit Sons', Inc. acted as the general contractor on several projects for
the Company in 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 $130 million of
construction services related to these projects in 1998.
In 1999, the Company entered into an agreement with RCN whereby RCN will lease
cross country capacity on Level 3's nationwide network. 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 Peter Kiewit Sons',
Inc. The expense for these services was $34 million for 1998, $32 million for
1997, and $37 million for 1996, and is recorded in general and administrative
expenses. The revenue earned by Peter Kiewit Sons', Inc. in 1997 and 1996 is
included in discontinued operations.
(17) 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.
It is customary in Level 3's industries to use various financial instruments in
the normal course of business. These instruments include items such as letters
of credit. Letters of credit are conditional commitments issued on behalf of
Level 3 in accordance with specified terms and conditions. As of December 31,
1998, Level 3 had outstanding letters of credit of approximately $22 million.
The Company does not believe it is practicable to estimate the fair value of the
letters of credit and does not believe exposure to loss is likely.
(18) Subsequent Events
On January 5, 1999 Level 3 acquired BusinessNet Limited, a leading London-based
Internet service provider in a largely stock-for-stock transaction. The Company
granted approximately 400,000 shares of Common Stock and paid $1 million in cash
in exchange for BusinessNet's capital stock. The transaction was valued at
approximately $18 million and will be accounted for as a purchase.
Level 3 filed 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 through a primary offering. The net proceeds from the offering of
approximately $1.5 billion 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.
On February 25, 1999 the Board approved an increase in the number of authorized
shares outstanding from 500 million to 1 billion. This is subject to approval of
the shareholders which will be voted on at the Company's 1999 Annual Meeting.
(19) Unaudited Quarterly Financial Data:
(in millions except March June September December
per share data) 1998 1997 1998 1997 1998 1997 1998 1997
- - ------------------------------------------------------------------------------------------------------------------
Revenue $ 87 $ 80 $ 103 $ 81 $ 106 $ 81 $ 96 $ 90
Earnings (Loss) from
Operations (9) 20 (41) 16 (52) 13 (133) (6)
Net Earnings (Loss) 926 35 (34) 56 (49) (10) (39) 167
Earnings (Loss) per Share
(Basic and Diluted):
Continuing Operations $ (.02) $ .06 $ (.11) $ .06 $ (.16) $ .03 $ (.13) $ .18
Discontinued Operations
Excluding Construction
Operations 3.19 .02 - .03 - (.21) - .18
Net Earnings Excluding
Construction Operations 3.17 .08 (.11) .09 (.16) (.18) (.13) .36
Net Earnings Excluding Gains
On Split-Off of Construction
Group 1.09 .08 (.11) .09 (.16) (.18) (.13) .36
Earnings (loss) per share was calculated for each three-month period on a
stand-alone basis. As a result of all the stock transactions, the sum of the
earnings (loss) per share for the four quarters of each year may not equal
the earnings(loss) per share for the twelve month periods.
The earnings (loss) per share amounts above are those of Level 3 Common Stock.
On January 2, 1998 the Company completed the sale of its energy assets to
MidAmerican, as discussed in Note 3, and recognized an after-tax gain on the
disposition of $324 million.
On March 31, 1998, as a result of the Split-off as discussed in Note 1, the
Company recognized a gain of $608 million 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. No
taxes were provided on this gain due to the tax-free nature of the Split-off.
The Company reflected the fair value of the Construction Group as a distribution
to the Class C stockholders.
As described in Note 5, the Company reduced its charge for the acquired in-
process research and development rlated to it acquisition of XCOM, which was
originally recorded in the second quarter of 1998, from $115 million to $30
million, and increased the related goodwill $85 million. The unaudited quarterly
financial data above reflects that revision as if it occurred in the seocnd
quarter of 1998. As a result, the amounts presented above differ from those
reported in the Company's 1998 Forms 10-Q for the second and third quarters.
Loss from operations, net loss and losses per share as reported in the second
quarter Form 10-Q were $123 million, $116 million and $0.39, respectively, a
change of $82 million, $82 million and $.28 per share, respectively, from
the information presented above due to the reduced charge for in-process
research and development and an increase in goodwill amortization. Loss from
operations, net loss and losses per share as reported in the third quarter
Form 10-Q were $48 million, $45 million and $0.15, respectively, a change of
$4 million, $4 million and $0.01 per share, respectively, from the information
presented above due to an increase in goodwill amortization.