SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
[X] Annual Report Pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934
For the fiscal year ended December 31, 1996
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: 0-20763
McLEOD, INC.
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(Exact name of registrant as specified in its charter)
Delaware 58-421407240
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
221 Third Avenue SE, Suite 500
Cedar Rapids, IA 52401
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(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (319) 364-0000
Securities registered pursuant to Section 12(b) of the Act:
Not Applicable
Securities registered pursuant to Section 12(g) of the Act:
Class A Common Stock, par value $.01 per share
------------------------------------------------
Title of Class
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 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. [_]
The aggregate market value of the voting stock held by non-affiliates of the
registrant, based upon the closing price of the registrant's common stock as of
March 19, 1997 is $328,114,167. */
-
The number of shares outstanding of each of the registrant's classes of common
stock, as of the latest practicable date is:
Class A Common Stock, par value $.01 per share, outstanding as of March 19,
1997: 36,989,242
Class B Common Stock, par value $.01 per share, outstanding as of March 19,
1997: 15,625,929
DOCUMENTS INCORPORATED BY REFERENCE
List hereunder the following documents incorporated by reference and the Part
of the Form 10-K into which the document is incorporated:
(1) Portions of the definitive proxy statement for the Annual Meeting of
Stockholders to be held on May 29, 1997, to be filed within 120 days after
the end of the registrant's fiscal year, are incorporated by reference into
Part III, Items 10 - 13 of this Form 10-K.
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*/ Solely for the purposes of this calculation, all directors and executive
- -
officers of the registrant and all stockholders beneficially owning more than 5%
of the registrant's common stock are considered to be affiliates.
TABLE OF CONTENTS
Page
PART I Item 1. Business............................................... 1
Item 2. Properties............................................. 36
Item 3. Legal Proceedings...................................... 36
Item 4. Submission of Matters to a Vote of Security Holders.... 39
PART II Item 5. Market for Registrant's Common Equity and Related
Stockholder Matters.................................... 39
Item 6. Selected Financial Data................................ 41
Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations.................... 42
Item 8. Financial Statements and Supplementary Data............ 49
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure.................... 50
PART III Item 10. Directors and Executive Officers of the Registrant..... 50
Item 11. Executive Compensation................................. 50
Item 12. Security Ownership of Certain Beneficial Owners and
Management............................................. 50
Item 13. Certain Relationships and Related Transactions......... 51
PART IV Item 14. Exhibits, Financial Statement Schedules, and Reports on
Form 8-K............................................... 51
GLOSSARY.................................................................. 61
SIGNATURES................................................................ 64
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS................................ F-1
INDEPENDENT AUDITOR'S REPORT ON THE FINANCIAL STATEMENT SCHEDULES......... S-1
This Form 10-K contains certain forward-looking statements that
involve risks and uncertainties. The Company's actual results could differ
materially from those anticipated in these forward-looking statements as a
result of certain factors, including those set forth under the caption
"Business--Risk Factors" and elsewhere in this Form 10-K. Unless the context
suggests otherwise, references in this Form 10-K to the "Company" mean McLeod,
Inc. and its subsidiaries and predecessors. Unless otherwise indicated, the
information in this Form 10-K reflects the recapitalization, effective May 2,
1996, in which shares of the Company's Class A Common Stock, $.01 par value
per share (the "Class A Common Stock"), and Class B Common Stock, $.01 par
value per share (the "Class B Common Stock"), were split on the basis of 3.75
for one. Unless otherwise indicated, dollar amounts over $1 million have been
rounded to one decimal place and dollar amounts less than $1 million have been
rounded to the nearest thousand. See the "Glossary" appearing elsewhere herein
for definitions of certain terms used in this Form 10-K.
PART I
Item 1. Business.
Overview
The Company is a provider of integrated telecommunications services to
small and medium-sized businesses and, since June 1996, residential customers,
primarily in Iowa and Illinois. The Company derives its telecommunications
revenue from (i) the sale of "bundled" local, long distance and other
telecommunications services to end users, (ii) telecommunications network
maintenance services, (iii) competitive access services, including special
access and private line services, and (iv) ancillary services, including
direct marketing and telemarketing services, the sale of advertising space in
telephone directories and the sale of business telephone systems. As of
December 31, 1996, the Company served over 17,800 telecommunications customers
in 92 cities and towns.
The Company offers "one-stop" integrated telecommunications services,
including local, long distance, voice mail, paging and Internet access
services, tailored to the customer's specific needs. For business customers,
this approach simplifies telecommunications procurement and management and
makes available customized services, such as "least-cost" long distance
pricing and enhanced calling features, that might not otherwise be directly
available to such customers on a cost-effective basis. For residential
customers, this approach provides integrated local, long distance and other
telecommunications services, flat-rate long distance pricing and enhanced
calling features as part of the Company's basic PrimeLine(R) residential
services. The Company also offers a variety of special access and private line
services to large businesses, institutional customers and interexchange
carriers, primarily in Des Moines, Iowa. In addition, the Company provides
network maintenance services for the State of Iowa's fiber optic network.
The Company was formed on June 6, 1991 as McLeod Telecommunications, Inc.
It began operations in November of 1992, providing fiber optic maintenance
services for the Iowa Communications Network. The Iowa Communications Network
is a fiber optic network that links certain of the State of Iowa's schools,
libraries and other public buildings. On August 1, 1993, the Company was
reincorporated in the State of Delaware. McLeodUSA Telecommunications
Services, Inc., a wholly owned subsidiary of the Company ("McLeodUSA
Telecommunications"), received regulatory approvals in Iowa and Illinois to
offer local and long distance services in December 1993 and began providing
such services in January 1994. In April 1995, July 1996, September 1996 and
January 1997, respectively, the Company acquired MWR Telecom, Inc. ("MWR")
(now part of McLeodUSA Network Services, Inc. ("McLeodUSA Network Services")),
a competitive access provider in Des Moines, Iowa, Ruffalo, Cody & Associates,
Inc. ("Ruffalo, Cody"), a telemarketing company, Telecom*USA Publishing Group,
Inc. (now known as McLeodUSA Media Group, Inc. ("McLeodUSA Publishing")), a
publisher of telephone directories, and Digital Communications of Iowa, Inc.
("Digital Communications"), a telephone equipment company.
The Company is organized as a holding company and operates primarily
through wholly owned subsidiaries. Since September 1996, the Company's
business has been organized into four operational groups: (i) Business
Services, which develops, markets and sells the Company's telecommunications
services to business customers; (ii) Consumer Services, which markets and
sells the Company's PrimeLine(R) service to residential customers and engages
in various direct marketing and telemarketing activities; (iii) Network
Services, which designs, constructs, and operates the Company's fiber optic
network and engages in the Company's network maintenance activities; and (iv)
Publishing Services, which publishes and distributes telephone directories.
As of the date hereof, the Company is offering integrated
telecommunications services to business and residential customers located
primarily in Iowa and Illinois. The Company has recently begun sales of
integrated telecommunications services in a number of markets in Minnesota and
Wisconsin. The Company plans to begin offering integrated telecommunications
services in markets in South Dakota, North Dakota, Colorado and Wyoming in
1997. Over the next several years, depending on competitive and other factors,
the Company also intends to offer integrated telecommunications services in
Montana, Idaho, Utah and Nebraska. The Company also offers long distance
service in Alabama, Arizona, Arkansas, California, Colorado, Delaware,
Georgia, Idaho, Indiana, Kansas, Kentucky, Maine, Maryland, Massachusetts,
Mississippi, Michigan, Missouri, Montana, Nebraska, Nevada, New Hampshire, New
Jersey, Ohio, Oregon, Pennsylvania, Rhode Island, Texas, Utah, Virginia,
Washington and Wyoming.
On January 15, 1997, the Federal Communications Commission ("FCC")
notified the Company that it was the successful bidder for 26 "D" and "E"
block frequency personal communications services ("PCS") licenses in 24
markets covering areas of Iowa, Illinois, Minnesota, Nebraska and South
Dakota. The Company bid an aggregate of approximately $32.8 million for these
PCS licenses, which the Company will be required to pay to the FCC following
grant of the licenses, anticipated to occur during the second or third quarter
of 1997. The PCS licenses encompass approximately 110,000 square miles and a
population of approximately 6.5 million. The Company is assessing its
technological options and beginning to design and engineer its proposed PCS
system. The Company expects to begin constructing its PCS network by the end
of 1997 and offering PCS services as part of its integrated telecommunications
services in 1998. See "--Risk Factors--PCS System Implementation Risks."
The statements in the foregoing paragraphs about the Company's expansion
plans and proposed PCS services are "forward-looking statements" within the
meaning of the safe harbor provisions of the Private Securities Litigation
Reform Act of 1995. These plans may be revised, and the Company's actual
geographic expansion and wireless services may differ materially from that
indicated by its current plans, in each case as a result of a variety of
factors, including: (i) the availability of financing and regulatory
approvals; (ii) the number of potential customers in a target market; (iii)
the existence of strategic alliances or relationships; (iv) technological,
regulatory or other developments in the Company's business; (v) changes in the
competitive climate in which the Company operates; and (vi) the emergence of
future opportunities.
As of the date hereof, the Company believes it is the first
telecommunications provider in most of its markets to offer "bundled" local,
long distance and other telecommunications services. As a result, the Company
believes that it is well-positioned to take advantage of fundamental changes
occurring in the telecommunications industry resulting from the
Telecommunications Act of 1996 (the "Telecommunications Act") and to challenge
incumbent local carriers. The Company provides local service using existing
telephone lines obtained from incumbent local exchange carriers, which allows
customers to switch to local service provided by the Company without changing
existing telephone numbers. The Company provides long distance services by
purchasing bulk capacity from a long distance carrier. Using the Company's
sophisticated proprietary software, known as Raterizer(R), each business
customer subscribing to the Company's integrated telecommunications services
receives the lowest long distance rate available each month from among the
pricing plans of AT&T Corp. ("AT&T"), MCI Communications Corporation ("MCI")
and Sprint Corporation ("Sprint") that generally are most popular with the
Company's business customers, and, in certain cases, rates specifically
identified by a
2
business customer and agreed to by the Company. The Company also provides
paging and Internet access services.
The Company's principal executive offices are located at 221 Third Avenue
SE, Suite 500, Cedar Rapids, Iowa 52401, and its phone number is (319)
364-0000.
Recent Transactions
On July 15, 1996, the Company acquired Ruffalo, Cody by means of a merger
of Ruffalo, Cody with and into a newly formed wholly owned subsidiary of the
Company. As consideration for the acquisition, the Company paid approximately
$4.8 million in cash and issued an aggregate of 361,420 shares of Class A
Common Stock to the shareholders of Ruffalo, Cody, and granted options to
purchase an aggregate of 158,009 shares of Class A Common Stock to the holders
of options to purchase shares of Ruffalo, Cody common stock. An additional
$50,782 in cash and 113,387 shares of Class A Common Stock were placed into
escrow to be delivered to certain of the shareholders of Ruffalo, Cody over a
period of 18 months, contingent upon the fulfillment of certain conditions
relating to Ruffalo, Cody's ongoing revenues from a material agreement with a
major long distance carrier to provide telemarketing services. The major long
distance carrier terminated this agreement, effective December 31, 1996. A
total of $50,782 and 37,107 shares of Class A Common Stock were distributed
pursuant to the escrow agreement in January 1997 and the Company expects one
additional distribution of 19,070 shares of Class A Common Stock to occur in
April 1997.
Ruffalo, Cody specializes in direct marketing and telemarketing services,
including telecommunications sales, as well as a variety of fund-raising
services for colleges, universities and other non-profit organizations
throughout the United States.
On September 20, 1996, the Company acquired McLeodUSA Publishing by means
of a merger of a newly formed wholly owned subsidiary of the Company with and
into McLeodUSA Publishing. As consideration for the acquisition, the Company
paid approximately $74.1 million in cash and an additional amount estimated as
of the date hereof to be approximately $1.6 million to be paid to certain
employees of McLeodUSA Publishing as part of an incentive plan. At the time of
the acquisition, McLeodUSA Publishing had outstanding debt of approximately
$6.6 million.
McLeodUSA Publishing publishes and distributes "white page" and "yellow
page" telephone directories in nineteen states in the midwestern and Rocky
Mountain regions of the United States, including most of the Company's target
markets. McLeodUSA Publishing derives its revenues primarily from the sale of
advertising space in its telephone directories.
On December 9, 1996, the Company, through McLeodUSA Telecommunications,
acquired the customer base of Total Communication Systems, Inc. ("TCSI") for
an aggregate cash purchase price of approximately $534,000. TCSI is an Iowa
corporation that offered local and long distance service in Iowa by
partitioning central office switches of U S WEST Communications, Inc. ("U S
WEST"). TCSI managed approximately 1,600 local and long distance lines in Iowa
prior to the acquisition.
McLeodUSA Publishing entered into an option agreement with Fronteer
Directory Company, Inc. ("Fronteer") on April 27, 1995 pursuant to which
Fronteer granted to McLeodUSA Publishing the right and option to acquire nine
telephone directories published by Fronteer (the "Fronteer Option"). On
January 27, 1997, McLeodUSA Publishing exercised the Fronteer Option to
acquire six of the telephone directories at a price to be determined based on
the sum of the revenues derived from the last Fronteer editions of the
directories. The purchase price is estimated as of the date hereof to be
approximately $4 million. The transaction was consummated on February 25,
1997.
On January 30, 1997, the Company acquired Digital Communications by means
of a merger of a newly formed wholly owned subsidiary of the Company with and
into Digital Communications. As consideration for the acquisition, the Company
issued an aggregate of 84,430 shares of Class A
3
Common Stock to the shareholders of Digital Communications. Digital
Communications sells, installs and services telephone systems primarily to
small businesses in eastern Iowa.
On February 27, 1997, McLeodUSA Publishing entered into an agreement with
Indiana Directories, Inc. to acquire 26 telephone directories published by
Indiana Directories, Inc. at a price to be determined based on the sum of the
revenues derived from the last Indiana Directories, Inc. editions of the
directories. The purchase price is estimated as of the date hereof to be
approximately $10.5 million. Closing of the transaction is expected to occur on
March 31, 1997.
On March 4, 1997, the Company completed a private offering of $500
million aggregate principal amount at maturity of 10 1/2% senior discount
notes due March 1, 2007 (the "Notes"). The Notes were priced at a discount and
the Company received net proceeds of approximately $289.5 million.
Business Strategy
The Company's objective is to become a leading provider of integrated
wireline and wireless telecommunications services in Iowa, Illinois,
Minnesota, Wisconsin, South Dakota, North Dakota, Colorado, Wyoming, Montana,
Utah, Idaho and Nebraska. The Company intends to increase its penetration of
its current markets and expand into new markets by: (i) aggressively capturing
market share and generating revenues using leased network capacity and (ii)
concurrently constructing additional network infrastructure to more cost-
effectively serve its customers.
The principal elements of the Company's business strategy include:
. Provide Integrated Telecommunications Services. The Company believes
that there is substantial demand among business and residential
customers in its target markets for an integrated package of wireline
and wireless telecommunications services that meets all of the
customer's telecommunications needs. The Company believes that, by
bundling a variety of telecommunications services, it will position
itself to become an industry leader in offering "one-stop" integrated
telecommunications services, to penetrate rapidly its target markets
and to build customer loyalty. The Company intends to add PCS services
to its current array of integrated telecommunications services
beginning in 1998.
. Build Market Share Through Branding and Customer Service. The
Company believes that, by branding its telecommunications services
with the trade name *McLeodUSA in combination with the distinctive
black-and-yellow motif of the McLeodUSA Publishing directories, it
will create and strengthen brand awareness in all of the Company's
markets. The Company also believes that the key to revenue growth in
its target markets is capturing and retaining customers through an
emphasis on marketing, sales and customer service. The Company's
customer-focused software and network architecture allow immediate
access to the Company's customer data by Company personnel, enabling a
quick and effective response to customer requests and needs at any
time. This software permits the Company to present its customers with
one fully integrated monthly billing statement for local, long
distance, 800, international, voice mail, paging, Internet access and
travel card services, and will permit the Company to include
additional services, such as PCS, when available. The Company believes
that its customer-focused software platform is an important element in
the marketing of its telecommunications services and gives it a
competitive advantage in the marketplace. The Company has been
successful in obtaining long-term commitments from its business
customers and responding rapidly and creatively to customer needs.
. Focus on Small and Mid-sized Markets. The Company principally
targets small and mid-sized markets (cities and towns with a
population between 8,000 and 350,000) in its service areas. The
Company estimates that its current and planned target markets have a
combined population of approximately 9.5 million. The Company strives
to be the first to market integrated telecommunications services in
its principal markets and expects that intense
4
competition in bundled telecommunications services will be slower to
develop in these markets than in larger markets.
. Expand its Fiber Optic Network. The Company is constructing a state-
of-the-art digital fiber optic telecommunications network designed to
serve markets in Iowa. In the future, the Company expects to expand
its fiber optic network to include additional markets. The Company's
decision to expand its fiber optic network will be based on various
economic factors, including: (i) the number of its customers in a
market; (ii) the anticipated operating cost savings associated with
such construction; and (iii) any strategic relationships with owners
of existing infrastructure (e.g., utilities and cable operators). As
of March 21, 1997, the Company owned approximately 2,500 route miles
of fiber optic network and, subject to the foregoing factors, expects
to construct approximately 5,000 additional route miles of fiber optic
network during the next three years. Through its strategic
relationships with its electric utility stockholders and its contracts
to build the final links of the Iowa Communications Network and lease
a portion of the capacity on those links to the State of Iowa, the
Company believes that it will be able to achieve capital efficiencies
in constructing its fiber optic network in a rapid and cost-effective
manner. The Company also believes that its fiber optic network in
combination with its proprietary software will create an attractive
customer-focused platform for the provision of local, long distance,
wireless and enhanced services.
. Transition into Local Switched Services Business. When certain
judicial and regulatory proceedings are resolved, and assuming the
economics are favorable to the Company, the Company intends to begin
offering facilities-based switched services by using its existing high
capacity digital AT&T switch and installing additional switches. In
August 1996, the FCC released a decision implementing the
interconnection portions of the Telecommunications Act (the
"Interconnection Decision"). Certain provisions of the Interconnection
Decision have been stayed by an October 1996 court decision, and will
be subject to further judicial and regulatory proceedings. The Company
believes that these proceedings should be substantially resolved, and
that the Company could begin offering local facilities-based switched
services, during the next three years. In March 1995 and April 1996,
respectively, the Company received state regulatory approval in Iowa
and Illinois to offer local switched services in Cedar Rapids, Iowa
and in Illinois cities other than Chicago. The Company intends to seek
regulatory approval to provide such services in other cities and towns
in Iowa and other states targeted by the Company when the economic
terms of interconnection with the incumbent local exchange carrier
make the provision of local switched services cost-effective.
. Explore Potential Acquisitions and Strategic Alliances. The Company
believes that its strategic alliances with two utilities in its Iowa
markets provide it with access to rights-of-way and other resources on
favorable terms. The Company believes that its acquisitions of
Ruffalo, Cody and McLeodUSA Publishing during 1996 will increase the
Company's penetration of its current markets and accelerate its entry
into new markets. As part of its expansion strategy, the Company
contemplates additional acquisitions, joint ventures and strategic
alliances with businesses that are related or complementary to its
current operations. The Company believes that the addition of such
related or complementary businesses will help it to expand its
operations into its target markets. As a result, the Company plans to
consider acquisitions, joint ventures and strategic alliances in areas
such as wireline and wireless services, directory publishing, network
construction and infrastructure and Internet access.
. Leverage Proven Management Team. The Company has recruited a team of
veteran competitive telecommunications managers, led by entrepreneur
Clark McLeod, who have together in the past successfully implemented a
similar customer-focused telecommunications strategy in the same
regions. Seven of the nine executive officers of the Company served as
officers of Teleconnect Company ("Teleconnect") or its successor,
Telecom*USA, Inc. ("Telecom*USA"). Teleconnect began providing long
distance services
5
in Iowa in 1982 and rapidly expanded into dozens of cities and towns
in the Midwest. Telecom*USA was the fourth-largest U.S. long distance
provider when MCI purchased it in 1990 for $1.25 billion.
Market Potential
The telecommunications industry is undergoing substantial changes due to
statutory, regulatory and technological developments. The Company believes
that it is well-positioned to take advantage of these fundamental changes.
Wireline Services. The market for local exchange services consists of a
number of distinct service components. These service components are defined by
specific regulatory tariff classifications including: (i) local network
services, which generally include basic dial tone, local area charges,
enhanced calling features and private line services (dedicated point-to-point
intraLATA service); (ii) network access services, which consist of access
provided by local exchange carriers to long distance network carriers; (iii)
long distance network services, which include intraLATA long distance calls;
and (iv) other varied services, including the publication of "white page" and
"yellow page" telephone directories and the sale of business telephone
equipment. Industry sources have estimated that the 1995 aggregate revenues of
all local exchange carriers approximated $95 billion. Until recently, there
was virtually no competition in the local exchange markets.
Until 1984, AT&T largely monopolized local and long distance telephone
services in the United States. Technological developments gradually enabled
others to compete with AT&T in the long distance market. In 1984, largely as
the result of a court decree, AT&T was required to divest its local telephone
systems (the "Divestiture"), which created the present structure of the
telecommunications industry. The Divestiture and subsequent related
proceedings divided the country into 201 Local Access and Transport Areas
("LATAs"). As part of the Divestiture, AT&T's former local telephone systems
were organized into seven independent Regional Bell Operating Companies. The
Regional Bell Operating Companies were given the right to provide local
telephone service, local access service and intraLATA long distance service,
but were prohibited from providing interLATA service. AT&T retained its long
distance services operations. The separation of the Regional Bell Operating
Companies from AT&T's long distance business created two distinct
telecommunications market segments: local exchange and long distance. The
Divestiture decreed direct, open competition in the long distance segment, but
continued the regulated monopoly environment in local exchange services.
In 1984, a separate court decree (the "GTE Decree") required the local
exchange operations of the General Telephone Operating Companies to be
structurally separated from the competitive operations of GTE Corp., their
parent company. As a result, the GTE Decree also prohibited the General
Telephone Operating Companies from providing interLATA services.
On February 8, 1996, the Telecommunications Act was enacted. The
Telecommunications Act removed the restrictions in the Divestiture and the GTE
Decree concerning the provision of interLATA service by the Regional Bell
Operating Companies and the General Telephone Operating Companies. These
decree restrictions have been replaced, with respect to the Regional Bell
Operating Companies, by provisions of the Telecommunications Act setting forth
the conditions under which the Regional Bell Operating Companies may enter
formerly prohibited markets. The Telecommunications Act requires all local
exchange carriers to "unbundle" their local network offerings and allow other
providers of telecommunications services to interconnect with their facilities
and equipment. Most significantly, the incumbent local exchange carriers will
be required to complete local calls originated by the Company's customers and
switched by the Company and to deliver inbound local calls to the Company for
termination to its customers, assuring customers of unimpaired local calling
ability. Although there can be no assurance, the Company believes that it
should also be able to obtain access to incumbent carrier "loop" facilities
(the transmission lines connecting customers' premises to the public telephone
network) on an unbundled basis at reasonable and non-discriminatory rates. In
addition, local exchange carriers are obligated to provide local number
portability and dialing parity upon request and make their local services
available for resale by competitors. Local exchange carriers also are required
to allow
6
competitors non-discriminatory access to local exchange carrier poles, conduit
space and other rights-of-way. Moreover, states may not erect "barriers to
entry" of local competition, although they may regulate such competition.
The Company believes that each of these requirements is likely, when
fully implemented, to increase competition among providers of local
telecommunications services and simplify the process of switching from local
exchange carrier services to those offered by competitive access
provider/competitive local exchange carriers. However, the Telecommunications
Act also offers important benefits to the incumbent local exchange carriers.
The incumbent local exchange carriers have been granted substantial new
pricing flexibility. Regional Bell Operating Companies and General Telephone
Operating Companies have regained the ability to provide long distance
services under specified conditions and have new rights to provide certain
cable TV services. The Telecommunications Act, however, also provides for
certain safeguards to attempt to protect against anticompetitive abuses by the
Regional Bell Operating Companies. Among other protections, the ability of the
Regional Bell Operating Companies to market jointly interLATA and local
services is limited under certain circumstances.
Prior to the enactment of the Telecommunications Act, several factors
served to promote competition in the local exchange market, including: (i)
rapidly growing customer demand for an alternative to the local exchange
carrier monopoly, spurred partly by the development of competitive activities
in the long distance market; (ii) advances in the technology for transmission
of data and video, which require greater capacity and reliability levels than
many local exchange carrier networks (which principally are copper-based) can
accommodate; (iii) the development of fiber optic and digital electronic
technology, which reduced network construction costs while increasing
transmission speeds, capacity and reliability as compared to the local
exchange carriers' copper-based network; (iv) the significant access charges
interexchange carriers are required to pay to local exchange carriers to
access the local exchange carriers' networks; and (v) a willingness on the
part of legislators to enact and regulators to enforce legislation and
regulations permitting and promoting competition in the local exchange market.
Competitors in the local exchange market, designated as competitive
access providers by the FCC, were first established in the mid-1980s.
Initially, competitive access providers were allowed to compete for only the
non-switched special access/private line service of the local exchange market.
In New York City, Chicago and Washington, D.C., newly formed companies
provided dedicated non-switched services by installing fiber optic facilities
capable of connecting points of presence of interexchange carriers within a
metropolitan area, connecting two or more customer locations with private line
service and, in some cases, connecting business and government users with
interexchange carriers. Competitive access providers used the substantial
capacity and economies of scale inherent in fiber optic cable to offer
customers service that was generally less expensive and of higher quality than
could be obtained from the local exchange carriers due, in part, to copper-
based facilities used in many local exchange carrier networks. In addition,
competitive access providers offered shorter installation and repair intervals
and improved reliability in comparison to the local exchange carriers.
Most of the early competitive access providers 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, including interexchange carrier to interexchange carrier
traffic, was located. The provision of competitive access services, however,
need not be confined to large metropolitan areas. The Company believes that,
through proper design and installation of its network in its targeted markets,
it can effectively provide integrated local and long distance services not
only to interexchange carriers and large users, but also to residential and
small to medium-sized business customers.
As a result of regulatory changes and competitive trends, competitive
local telecommunications companies and access providers appear to be
positioned for dramatic growth. Effective in early 1994, FCC decisions
announced in September 1992 and August 1993, as modified by subsequent FCC and
court decisions (the "Initial Interconnection Decisions"), opened additional
segments of the market by permitting competitive access providers expanded
authority to interconnect with and use facilities owned by local exchange
companies for interstate traffic. The Company believes that the Initial
Interconnection
7
Decisions, together with other statutory and regulatory initiatives in the
telecommunications industry (including the Telecommunications Act), recently
introduced to foster competition in the local exchange markets, have
stimulated demand for competitive local services. In August 1996 the FCC
released the Interconnection Decision implementing the interconnection
portions of the Telecommunications Act. The Interconnection Decision
establishes rules for negotiating interconnection agreements and guidelines
for review of such agreements by state public utilities commissions. Certain
provisions of the Interconnection Decision have been stayed by an October 1996
court decision, and will be subject to further judicial and regulatory
proceedings. Although this judicial stay does not prevent the Company from
negotiating interconnection agreements, it does create uncertainty about the
rules governing pricing, terms and conditions of interconnection agreements
and will likely delay the execution of these agreements. If the Company can
negotiate favorable interconnection agreements, and subject to the resolution
of judicial and regulatory proceedings necessary to implement such agreements,
the Company believes that it could begin offering local facilities-based
switched services within three years.
As of December 31, 1996, a number of states, including Iowa, Illinois,
Minnesota, Wisconsin and North Dakota, have taken regulatory and legislative
action to open local telecommunications markets to various degrees of
competition. State regulatory agencies in other states within the Company's
target market area, including South Dakota, Nebraska, Colorado, Montana, Idaho
and Wyoming, are conducting administrative proceedings to investigate opening
local telecommunications markets to competition. The Telecommunications Act
preempts any remaining state prohibitions of local competition and also
forbids unreasonable restrictions on resale of local services. The Company
expects that continuing pro-competitive regulatory changes, together with
increasing customer demand, will create more opportunities for competitive
service providers to introduce additional services, expand their networks and
address a larger customer base.
Wireless Services. Demand for wireless communications has grown rapidly
over the past decade. According to the Cellular Telecommunications Industry
Association ("CTIA"), the number of wireless telephone subscribers nationwide
has grown from approximately 680,000 in 1986 to an estimated 38.2 million as
of June 30, 1996, with a compound annual growth rate in excess of 45% from
1990 through 1995. Wireless communication revenues for the 12-month period
ended June 30, 1996 are estimated by CTIA to have totaled over $21 billion, a
31% increase over the prior 12-month period. The Company believes that the
demand for wireless communications will continue to grow dramatically, and
that PCS will capture a significant share of the wireless market, due to
anticipated declines in costs of service, increased function versatility, and
increased awareness of the productivity, convenience and safety benefits
associated with such services. The Company also believes the rapid growth of
notebook computers and personal digital assistants, combined with emerging
software applications for wireless delivery of electronic mail, fax and
database searching, will further stimulate demand for wireless service. BIA
Consulting, Inc. estimates that the number of wireless service subscriptions
will reach 90.5 million by the year 2000, with PCS accounting for
approximately 23.1 million of such subscriptions.
Current Products and Services
The Company has historically derived revenue from: (i) the sale of local
and long distance telecommunications services, (ii) special access and private
line services and (iii) telecommunications network maintenance services. As a
result of the acquisition by the Company of Ruffalo, Cody, McLeodUSA
Publishing and Digital Communications in July 1996, September 1996 and January
1997, respectively, the Company also derives revenue from ancillary services,
including direct marketing and telemarketing services, the sale of advertising
space in telephone directories and the sale of business telephone systems. For
the year ended December 31, 1996, these services represented 51%, 13%, 7% and
29%, respectively, of the Company's total revenues.
Integrated Telecommunications Services. As of December 31, 1996, the
Company was providing service, on a retail basis, to approximately 65,000
lines in its Iowa and Illinois markets, primarily to small and medium-sized
business customers. Since beginning sales activities in January 1994, the
Company has increased its revenue approximately 800% from the sale of local
and long distance telecommunications services from $4.6 million for the year
ended December 31, 1994 to $41.4 million for
8
the year ended December 31, 1996. In order to provide integrated
telecommunications services to its business and residential customers, the
Company, pursuant to agreements with U S WEST for its Iowa and Minnesota
customers and Ameritech Corporation ("Ameritech") for its Illinois and
Wisconsin customers, partitions part of the central office switches serving
the communities in which the Company provides such services ("Centrex"
services). The Company's customers' telephone lines and numbers are assigned
to the Company's portion of the switch. U S WEST or Ameritech, as the case may
be, bills the Company for all the lines that the Company has assigned to the
Company's customers and provides the Company with call detail reports, which
enable the Company to verify its customers' bills for both local and long
distance service.
The Company believes that these services are superior to a standard
business or residential telephone line, since the Company can offer features,
such as three-way calling, consultation hold and call transfer, at no extra
charge to the end user. Certain other custom calling features are also
available at additional cost to the end user. Because the Company has also
purchased the "Centrex Management System" and the "Centrex Mate Service" from
U S WEST and Ameritech, respectively, Company personnel have on-line access to
U S WEST and Ameritech facilities and may make changes to the customers'
services electronically and quickly.
In March 1996, the Company entered into a settlement agreement with U S
WEST in connection with a complaint brought against U S WEST by the Company
before the Iowa Utilities Board. The settlement agreement permits the Company
to obtain access to the partitioned portion of U S WEST central office
switches in Iowa until March 18, 2001 and contains rates that may not be
increased by U S WEST unless the rates are renegotiated by the parties based
on U S WEST's rates for access to unbundled elements of its network. See
"Legal Proceedings." As of the date hereof, the Company is purchasing Centrex
service in Minnesota from U S WEST on a month-to-month basis while negotiating
a term agreement. The Company has seven-year Centrex agreements with Ameritech
that extend through 2001 or 2002 in Illinois and 2003 in Wisconsin. These
agreements provide for stabilized rates that may not be unilaterally increased
by Ameritech.
The Company provides long distance service by purchasing capacity, in
bulk, from WorldCom Network Services, Inc., d/b/a Wiltel ("WilTel"), a wholly
owned subsidiary of WorldCom, Inc. ("WorldCom"), and routing its customers'
long distance traffic over this capacity. The Company is subject to certain
minimum monthly purchase requirements under its agreement with WilTel. If the
Company fails to meet the minimum purchase requirement in any month, it is
obligated to pay WilTel the difference between its actual purchases and the
minimum commitment. The Company has consistently met the minimum purchase
requirements under its agreement with WilTel. The Company believes that it
will be able to continue to meet such requirements in the future. Because of
the many potential suppliers of wholesale long distance services in the
marketplace, the Company expects, as of the date hereof, that it will be able
to continue to obtain favorable wholesale long distance pricing.
The Company has also developed and installed state-of-the-art, "customer-
focused" software for providing integrated telecommunications services. This
software permits the Company to present its customers with one fully
integrated monthly billing statement for local, long distance, 800,
international, voice mail, paging, Internet access and travel card services,
and will permit the Company to include additional services, such as PCS, when
available. The Company believes that its customer-focused software platform is
an important element in the marketing of its telecommunications services and
gives it a competitive advantage in the marketplace.
Business Services. End-user business customers in each of the 91 cities
and towns in which the Company offers its integrated telecommunications
services as of the date hereof can obtain local, long distance and ancillary
(such as three-way calling and call transfer) services directly from the
Company. By using Centrex service instead of a private branch exchange ("PBX")
to direct their telecommunications traffic, business customers can also avoid
the large investment in equipment required and the fixed costs associated with
maintaining a PBX network infrastructure. The Company's telemanagement
services allow small to medium-sized business customers, which may lack the
9
resources to support their own PBX, to benefit from a sophisticated
telecommunications system managed by industry experts.
Business customers subscribing to the Company's integrated
telecommunications services generally receive local service at prices that are
substantially similar to the published retail local exchange carrier rates for
basic business service provided by the incumbent local exchange carrier. Long
distance rates for such business customers generally are calculated by
totaling each business customer's monthly calls and comparing the total
charges that would be applicable to that customer's calls under each of the
pricing plans of the major long distance carriers that generally are most
popular with the Company's business customers. The Company then bills the
customer the lowest long distance charges identified in this comparison.
Specifically, the Company's billing software, known as Raterizer(R), enables
the Company to calculate the monthly charges that each customer would be
billed based on the customer's actual calls under each of several long
distance plans offered by AT&T, MCI and Sprint and, in certain instances,
other rates specifically identified by a customer and agreed to by the
Company. The customer is then billed an amount equal to such "lowest cost"
monthly charges calculated using this software, minus any discount to which
the customer may be entitled as a result of having made a long-term commitment
to use the Company's services. As of the date hereof, the Company compares the
monthly calls of business customers subscribing to the Company's integrated
telecommunications services to the following plans offered by other long
distance carriers:
Outbound Products. AT&T Commercial Long Distance; AT&T CustomNet;
AT&T ProWATS/Plan Q; AT&T Megacom; AT&T Uniplan; MCI Commercial Dial 1;
MCI Prism Plus; MCI Preferred; MCI Vision (Switched Access); MCI Vision
(Dedicated Access); MCI Prism I; Sprint Business Sense; Sprint Business
Sense ($200 minimum usage required); Sprint Clarity "Most for Business";
Sprint Clarity (Dedicated Access); and Sprint UltraWATS.
800 Service Products. AT&T Readyline; AT&T Starterline (Plan K);
AT&T Megacom 800; AT&T Uniplan 800; MCI Business Line 800; MCI Preferred
800; MCI Vision 800; MCI 800; Sprint FONline 800; Sprint Business Sense
($0 commitment); Sprint Business Sense ($200 minimum usage required);
Sprint Clarity 800; and Sprint Ultra 800.
The Company has developed the software that performs its long distance
rating analysis. Like other Company software, it is designed around the
customer rather than around a given product. The Company believes that its
method of computing long distance service rates is an important factor in
attracting and retaining business customers. As of March 21, 1997, the
Company's average integrated telecommunications service contract for business
customers had an approximately 40-month term.
The Company also offers other long distance rates to certain business
customers, based on the customer's particular needs. Furthermore, in certain
states, including states outside of its target markets, the Company offers
business customers long distance service only, in order to enhance the
Company's ability to attract business customers that have offices outside of
the Company's target markets. In the markets in which the Company offers long
distance service only, business customers generally receive flat-rate long
distance pricing at rates ranging from $.115 to $.185 per minute as of the
date hereof.
Residential Services. In June 1996, the Company introduced its
PrimeLine(R) service to residential and certain small business customers in
the Cedar Rapids and Iowa City, Iowa markets. The Company expanded its
PrimeLine(R) service to Cedar Falls and Waterloo, Iowa in January 1997, Des
Moines, Iowa in February 1997, and Ames, Davenport and Bettendorf, Iowa in
March 1997. The Company intends to begin offering PrimeLine(R) service in all
of its Iowa markets and in Illinois, Minnesota and Wisconsin in the near
future. PrimeLine(R) service includes local and long distance telephone
service, paging, voice mail, Internet access and travel card services, as well
as enhanced features such as three-way calling, call transfer and consultation
hold. As of the date hereof, PrimeLine(R) customers may choose from five
integrated telecommunications service packages generally ranging in price from
$16.95 to $39.95 per month. Per minute long distance rates for PrimeLine(R)
customers range from $.12 to $.15, depending on monthly calling volumes. These
rates are applied 24 hours a day, seven days a week for all
10
calls within the continental United States. The Company's standard
PrimeLine/(R)/ service contract has either a month-to-month or a 12-month
term.
Special Access and Private Line Services. The Company provides, on a
private carrier basis, a wide range of special access and private line
services to its interexchange carrier and end-user (including two cable
television company) customers. These services include POP-to-POP special
access, end user/interexchange carrier special access and private line
services. POP-to-POP special access services provide telecommunications lines
that link the POPs of one interexchange carrier, or the POPs of different
interexchange carriers, in a market, allowing these POPs to exchange
telecommunications traffic for transport to final destinations. End
user/interexchange carrier special access services provide telecommunications
lines that connect an end user (such as a large business) to the local POP of
its selected interexchange carrier. Private line services provide
telecommunications lines that connect various locations of a customer's
operation to transmit internal voice, video and/or data traffic.
To provide these services, the Company offers various types of highly
reliable fiber optic lines that operate at different speeds and handle varying
amounts of traffic to provide tailor-made solutions to meet its customers'
needs. These lines include:
DS-0. A dedicated line that meets the requirements of everyday
business communications, with transmission capacity of up to 64 kilobits
of bandwidth per second (one voice-grade equivalent circuit). This
service offers a basic low-capacity dedicated digital channel for
connecting telephones, fax machines, personal computers and other
telecommunications equipment.
DS-1. A high-speed channel typically linking high volume customer
locations to interexchange carriers or other customer locations. Used for
voice transmissions as well as the interconnection of local area
networks, DS-1 service accommodates transmission speeds of up to 1.544
megabits per second, the equivalent of 24 voice-grade equivalent
circuits. The Company offers this high-capacity service for customers who
need a larger communications pipeline.
DS-3. A very high-capacity digital channel with transmission
capacity of 45 megabits per second, which is equivalent to 28 DS-1
circuits or 672 voice-grade circuits. This is a digital service used by
interexchange carriers for central office connections and by some large
commercial users to link multiple sites.
The Company's networks are designed to support this wide range of
communications services, provide increased network reliability and reduce
costs for its customers. The Company's network consists of fiber optic cables,
which typically contain between 24 and 144 fiber strands, each of which is
capable of providing many telecommunications circuits. As of the date hereof,
a single pair of fibers on the Company's network can transmit 32,256
simultaneous voice conversations, whereas a typical pair of copper wires can
carry a maximum of 24 digitized simultaneous voice conversations. The Company
expects that continuing developments in compression technology and
multiplexing equipment will increase the capacity of each fiber, thereby
providing more capacity at relatively low incremental cost.
Network Maintenance Services. In 1990, the State of Iowa authorized
construction of the initial fiber optic links of the Iowa Communications
Network (the "Part I and II segments"). The Part I and II segments, which were
completed in 1993 and are owned by the State of Iowa, provide fiber optic
connections to over 100 classrooms or other meeting facilities in Iowa, and
are used primarily for interactive distance learning, telemedicine and the
State's own long distance telephone traffic. The Company maintains the Part I
and II segments of the 2,900 miles of the Iowa Communications Network pursuant
to a fiber optic maintenance contract (the "Iowa Communications Network
Maintenance Contract"). The Company's maintenance activities under the Iowa
Communications Network Maintenance Contract are available on a 24-hour-per-
day, 365-days-per-year basis, and consist of alarm monitoring, repair services
(include splicing, digital circuit card replacement, cable relocation and
circuit installation
11
testing) and cable location services. The Iowa Communications Network
Maintenance Contract expires in 2004.
For its services under the Iowa Communications Network Maintenance
Contract, the Company receives approximately $3.2 million per year, plus an
additional amount based on an hourly rate for certain overtime, equipment and
repair supervision activities. The Company believes that the expertise in
fiber optic maintenance developed through the maintenance of the Iowa
Communications Network will provide significant advantages in maintenance of
the Company's own network facilities. Because commercial telecommunications
use of the Part I and II segments is forbidden, however, neither the Company
nor any other telecommunications carrier may use capacity on the Part I and II
segments to provide telecommunications services to customers.
Ancillary Services. Through McLeodUSA Publishing, the Company publishes
and distributes annual "white page" and "yellow page" telephone directories to
local telephone subscribers in nineteen states in the midwestern and Rocky
Mountain regions of the United States, including most of the Company's target
markets. In its fiscal year 1996, McLeodUSA Publishing published and
distributed an aggregate of over 7 million copies of 80 telephone directories
and had revenues of $52.1 million, primarily from the sale of advertising
space in its telephone directories to approximately 85,000 advertisers.
In addition, the Company provides direct marketing and telemarketing
services through Ruffalo, Cody. Such services include telecommunications
sales, as well as a variety of fund-raising services for colleges,
universities and other non-profit organizations throughout the United States.
Ruffalo, Cody derived approximately 40% of its revenues in 1996 from an
agreement with a major long distance carrier to provide telemarketing
services. The major long distance carrier terminated this agreement, effective
December 31, 1996. As a result, the Company is redirecting telemarketing
resources towards selling the Company's local, long distance and other
telecommunications services.
The Company believes that its telephone directories and its direct
marketing and telemarketing services will provide valuable marketing
opportunities and expertise for its telecommunications services, particularly
with respect to potential residential customers. The Company intends to
utilize McLeodUSA Publishing's sales force of 260 direct sales personnel and
telemarketers to sell both advertising space in the Company's telephone
directories and, where available, the Company's telecommunications services.
Furthermore, by December 31, 1996, 52 of the Company's 206 full-time
telemarketing sales personnel at its Ruffalo, Cody subsidiary were engaged in
sales of the Company's PrimeLine(R) residential services. See "--Sales and
Marketing."
The Company also sells, installs and services telephone systems,
primarily to small businesses in eastern Iowa, through Digital Communications,
which the Company acquired in January 1997. The Company believes that these
services will provide valuable expertise for and complement its
telecommunications services offerings.
Expansion of Certain Facilities-based Services
The Company is constructing a fiber optic network that will enable it,
upon receipt of all necessary regulatory approvals, to serve its end-user
customers on a local switched basis as well as to serve other wireline and
wireless carriers on a wholesale basis.
The Company has leased and is testing a state-of-the-art high-capacity
digital AT&T switch and plans to acquire additional switches in the future.
Although, as of the date hereof, the Company is not engaged in negotiations to
acquire additional switches, such products are readily available from several
suppliers, and the Company does not believe it will experience any
difficulties or delays when it determines to acquire additional switches. It
is anticipated that these switches will provide the switching platform for the
local exchange switched telephone and long distance services to be offered by
the Company. Given the size and regional concentration of the Company's
markets, available technology and current cost structures, the Company plans
ultimately to deploy a hubbed switching strategy, whereby one or more central
switches would serve multiple markets via remote switching modules.
12
In March 1995, the Iowa Utilities Board approved the Company's
application for authorization to provide competitive switched local telephone
service to business and residential customers in Cedar Rapids, Iowa. In April
1996, the Company received similar approval from the Illinois Commerce
Commission to offer such service in Illinois cities other than in Chicago
(which was not included in the Company's application). The Company intends to
seek authorizations from the appropriate public utilities commissions to
provide similar services in other markets served by the Company.
The Company's plans to provide local switched services are dependent upon
obtaining favorable interconnection agreements with local exchange carriers.
In August 1996, the FCC released the Interconnection Decision implementing the
interconnection portions of the Telecommunications Act. Certain provisions of
the Interconnection Decision have been appealed in proceedings before the U.S.
Eighth Circuit Court of Appeals. In October 1996, the U.S. Eighth Circuit
Court of Appeals temporarily stayed the effectiveness of portions of the
Interconnection Decision, including provisions establishing a pricing
methodology and a procedure permitting new entrants to "pick and choose" among
various provisions of existing interconnection agreements, pending a decision
on the merits. Although the judicial stay of the Interconnection Decision does
not prevent the Company from negotiating interconnection agreements with local
exchange carriers, it does create uncertainty about the rules governing
pricing, terms and conditions of interconnection agreements, and could make
negotiating such agreements more difficult and protracted. The FCC applied to
the U.S. Supreme Court to vacate the judicial stay, but the U.S. Supreme
Court, on November 12, 1996, refused to do so. The U.S. Eighth Circuit Court
of Appeals heard oral arguments on the merits of the challenges to the
Interconnection Decision on January 17, 1997, but as of the date hereof had
not ruled in the case. Further appeals are possible. There can be no assurance
that the Company will be able to obtain interconnection agreements on terms
acceptable to the Company.
Although the Company has made no final determinations as to its target
markets for facilities-based switched services, the Company intends initially
to provide facilities-based switched services in Cedar Rapids, Des Moines,
Waterloo, Cedar Falls, Dubuque, Sioux City, Council Bluffs, and Iowa City,
Iowa and the Quad Cities of Iowa/Illinois (Davenport, Bettendorf, Rock Island
and Moline), among other places. The Company plans to expand its facilities-
based services to other cities as its network develops and its market
penetration increases. The foregoing statements are "forward-looking
statements" within the meaning of the Private Securities Litigation Reform Act
of 1995 and where the Company actually provides such services will depend on
factors such as the outcome of the judicial proceedings regarding the
Interconnection Decision. See "--Regulation."
For a detailed description of the expansion of the Company's fiber optic
network, see "--Network Facilities."
Wireless Services
The Company believes that the market for wireless telecommunications
services is likely to expand significantly as equipment costs and service
rates continue to decline, equipment becomes more convenient and functional
and wireless services become more diverse. The Company also believes that
wireline and wireless markets are converging, and that providers of wireless
services increasingly will offer, in addition to products that supplement a
customer's wireline communications (similar to cellular telephone services in
use today), wireline replacement products that may result in wireless services
becoming the customer's primary mode of communication. The Company anticipates
that in the future there could potentially be eight wireless competitors in
each of its proposed PCS markets: two existing cellular providers, five other
PCS providers and one enhanced specialized mobile radio ("ESMR") provider.
Wireless telecommunications networks use a variety of radio frequencies
to transmit voice and data in place of, or in addition to, standard wireline
telephone networks. Wireless telecommunications technologies include one-way
radio applications, such as paging or beeper services, and two-way radio
applications, such as cellular and PCS telephone networks. In 1993, the FCC
allocated 140 MHz of the radio spectrum (and subsequently allocated an
additional 10 MHz of spectrum) for the provision of a new
13
wireless communications service, commonly known as PCS. PCS differs from
traditional cellular telephone service principally in that PCS systems will
operate at a higher frequency band and employ advanced digital technology.
Relative to existing cellular service, these features are expected to enable
PCS system operators to offer customers lower cost service options, lighter
handsets with longer battery lives, and new and enhanced service offerings.
To accommodate a wide range of services and technologies with different
spectrum requirements and to facilitate the entry of small business and rural
telephone companies, the FCC divided the 150 MHz of PCS spectrum into three 10
MHz blocks, three 30 MHz blocks and 30 MHz of unlicensed spectrum. The FCC
adopted the following frequency plan.
Block A: 30 MHz (1850-1865/1930-1945 MHz)
Block B: 30 MHz (1870-1885/1950-1965 MHz)
Block C: 30 MHz (1895-1910/1975-1990 MHz)
Block D: 10 MHz (1865-1870/1945-1950 MHz)
Block E: 10 MHz (1885-1890/1965-1970 MHz)
Block F: 10 MHz (1890-1895/1970-1975 MHz)
The FCC divided service areas based upon the 51 Major Trading Areas
("MTA") and the 493 Basic Trading Areas ("BTA"), as defined by Rand McNally
Commercial Atlas and Marketing Guide. Two 30 MHz frequency blocks were
designated for MTA operation, and one 30 MHz frequency block was designated
for BTA operation. The FCC determined that providing two frequency blocks on
an MTA basis will provide economies of scale and scope necessary for the
development of low-cost PCS equipment. The remaining three 10 MHz frequency
blocks are designated for BTA operation. The FCC concluded that a combination
of these frequency blocks and BTA service areas will minimize the start-up
costs likely to result from competitive bidding, and therefore provide greater
opportunity for participation by small businesses, rural telephone companies
and others.
On January 15, 1997, the FCC notified the Company that it was the
successful bidder for 26 "D" and "E" block frequency PCS licenses in 24 BTAs
covering all of Iowa, seven cities in Illinois, three cities in southern
Minnesota, Omaha, Nebraska and Sioux Falls, South Dakota. The Company bid an
aggregate of approximately $32.8 million for these PCS licenses, which the
Company will be required to pay to the FCC following grant of the licenses,
anticipated to occur during the second or third quarter of 1997. The Company
is assessing its technological options and beginning to design and engineer
its proposed PCS system. The Company expects to begin constructing its PCS
network by the end of 1997 and offering PCS services as part of its integrated
telecommunications services in 1998.
The infrastructure of a PCS system generally consists of digital
switches, base station transmitters and receivers, and related equipment.
Additional costs are attributable to site acquisition and preparation, and
installation services. The Company expects to begin selecting and acquiring
sites for transmitters by the end of 1997. Sites will be selected on the basis
of their coverage of targeted customers and on frequency propagation
characteristics. In many cases, the Company may be required to obtain zoning
approval or other permits. The use of existing towers and other facilities
occupied by other telecommunications service providers and utility companies
is also expected to facilitate this process. The Company has entered into
long-term agreements with its electric utility stockholders (MidAmerican
Energy Holdings Company (collectively with its predecessors and subsidiaries,
"MidAmerican") and IES Industries Inc. (collectively with its subsidiaries,
"IES")), and may negotiate similar agreements with other companies, that will
enable the Company to install PCS base stations and other equipment on such
companies towers. See "--Network Facilities." For new sites, the Company
estimates that the site acquisition process may take three to twelve months.
Once sites are acquired and the requisite governmental approvals are obtained,
preparation of each site, including grounding, ventilation and air
conditioning, equipment installation, testing and optimization, generally will
require an additional two to four months. In addition to system design and
site acquisitions, the implementation of the proposed PCS system will require
frequency planning, construction and equipment procurement, installation and
testing. The Company will be required to make significant expenditures to
develop, construct and operate a PCS system.
14
In order to build and operate a PCS system, the Company will be required
to select from among competing and potentially incompatible technologies.
Digital signal transmission is accomplished through the use of frequency
management technologies, or "protocols." These protocols "manage" the radio
channel either by dividing it into distinct time slots (a method known as Time
Division Multiple Access, or "TDMA") or by assigning specific coding
instructions to each packet of digitized data that comprises a signal (a
method known as Code Division Multiple Access, or "CDMA"). While the FCC has
established compatible analog signaling protocols for licensed cellular
systems in the U.S., there is no required universal digital signaling
protocol. As of the date hereof, two principal competing, incompatible
signaling protocols have been proposed by various vendors for use in PCS
systems: Global System for Mobile Communications ("GSM") (a TDMA-based
protocol) and CDMA. Because these protocols are incompatible, a subscriber of
a system that relies on GSM technology, for example, will be unable to use a
GSM handset when traveling in an area served only by CDMA-based wireless
operators, unless it is a dual-mode handset that permits the subscriber to use
the cellular system in that area. For this reason, the success of each
protocol will depend both on its ability to offer enhanced wireless service
and on the extent to which its users will be able to use their handsets when
roaming outside their service area. Each of the two principal PCS signaling
protocols have been adopted by at least one PCS licensee, and each offers
certain advantages and disadvantages.
The Company has not yet selected one of the digital signaling protocols
for its planned PCS network. The Company anticipates that its decision will be
based primarily on an assessment of the signaling protocols selected by PCS
licensees in the markets in which the Company wishes to offer roaming services
as well as the technical advantages and disadvantages of each protocol.
The Company intends to provide roaming service in its proposed PCS
markets by establishing suitable roaming arrangements with other PCS operators
in other markets constructing systems compatible with the digital protocol
technology to be selected by the Company. The Company cannot predict when, or
whether, it will be able to enter into such roaming agreements with local
providers. Future subscribers to the Company's proposed PCS services will not
be able to roam in markets without at least one PCS licensee using the
protocol selected by the Company unless the subscriber uses a dual-mode
telephone that would permit the subscriber to use the existing cellular
wireless system in such other market. Such dual-mode phones are heavier and
more expensive than single-mode phones.
The Company plans to operate a fully digital PCS system. As of the date
hereof, most cellular services transmit voice and data signals over analog-
based systems, which use one continuous electronic signal that varies in
amplitude or frequency over a single radio channel. Digital systems, on the
other hand, convert voice or data signals into a stream of digits that is
compressed before transmission, enabling a single radio channel to carry
multiple simultaneous signal transmissions. The Company believes that this
enhanced capacity, along with improvements in digital protocols, will allow
the Company's proposed PCS system to offer new and enhanced services,
including:
. Secure Communications. Sophisticated encryption algorithms
provide increased call security, encouraging users to make private
professional and personal calls that they might otherwise have made
only on wireline telephones.
. Sophisticated Call Management. The Company expects that it will
be able to offer call screening, routing and forwarding, caller I.D.,
message waiting, call hold, call transfer, voice activated dialing and
selective call screening, rejection and forwarding through a digital
PCS system.
. Enhanced Battery Performance. While analog handsets transmit
continuous electronic signals, digital handsets transmit messages in
segments, turning the handset off between transmissions. (Because the
handset is turned on and off hundreds of times each second, this
switching is not noticed by the user.) As a result, the handset is
effectively turned off for almost 90 percent of each call, thereby
extending the amount of time a battery can be used
15
without having to be recharged. Digital handsets are also capable of
entering into "sleep" and "hibernation" modes when not in use, which
will significantly extend the handset's battery life.
. Single Number Service. This service provides subscribers with a
convenient way to transfer all incoming calls between primary wireline
and wireless locations automatically. When a subscriber's handset is
activated, the network will route all incoming calls to the
subscriber's wireless number. When the handset is deactivated, all
calls will be directed to the subscriber's primary wireline location.
Such service will enable subscribers to direct their incoming calls to
one of several alternative locations (wireline telephone, paging
system handset, mailbox, etc.) on an ongoing basis.
. Enhanced Wireless Data Transmission. Digital networks will offer
simultaneous voice and data communications. The Company believes that,
as data transmission technologies develop, a number of potential uses
for such services will merge, including short message service, "mobile
office" applications (e.g., facsimile, electronic mail and connecting
notebook computers with computer/data networks), access to stock quote
services, transmission of text such as maps and manuals, transmission
of photographs, connections of wireless point-of-sale terminals to
host computers, monitoring of alarm systems, automation of meter
reading and monitoring of status and inventory levels of vending
machines.
. SIM Card. Credit card-sized Subscriber Identity Module ("SIM")
cards, programmed with the user's billing information and a specified
service package, will allow subscribers to open accounts and obtain
PCS connectivity automatically, simply by inserting their SIM cards
into compatible PCS handsets. With roaming agreements between the
local providers and the Company, SIM cards could also enable
subscribers to roam wherever the digital protocol technology selected
by the Company is deployed by using their SIM cards with handsets
compatible with the local system as they travel.
The Company intends to offer a variety of wireless telecommunications
services, ranging from wireline enhancement services that supplement the
customer's wireline telephone (much like cellular) to wireline replacement
services that will serve as the customer's primary mode of communication. An
example of the latter service is "enhanced cordless" handsets, which operate
as cordless wireline telephones when used in or near the customer's home and
operate as wireless PCS handsets when used elsewhere.
As the wireline and wireless markets converge, the Company believes that
it can also identify other opportunities to generate revenues from the
wireless industry on both a retail and a wholesale basis. On a retail basis,
the Company believes that it will be able to enter into "bundling/branding"
arrangements with both cellular and PCS companies on favorable economic terms.
On a wholesale basis, these opportunities may include (i) leasing tower sites
to wireless providers, (ii) switching wireless traffic through the Company's
switching platform and (iii) transporting wireless traffic using the Company's
fiber optic network to interconnect wireless providers' cell sites or to
connect such sites to either the Company's switches or to switches of other
providers of wireline services. In May 1996, the Company entered into an
agreement with a paging company to provide access to several of the towers
controlled by the Company.
The statements in the foregoing paragraphs about the Company's plans to
own, develop, construct and operate a PCS system are "forward-looking
statements" within the meaning of the Private Securities Litigation Reform Act
of 1995. These plans may be revised, and the Company's actual wireless
services may differ materially from that indicated by its current plans, in
each case as a result of a variety of factors, including: (i) the availability
of financing and regulatory approvals; (ii) the number of potential customers
in a target market; (iii) the existence of strategic alliances or
relationships; (iv) technological, regulatory or other developments in the
Company's business; (v) changes in the competitive climate in which the
Company operates; and (vi) the emergence of future opportunities. See "--Risk
Factors--PCS System Implementation Risks."
16
Network Facilities
As the incumbent local exchange carriers are compelled, by regulatory
changes and competitive forces, to "unbundle" their network components and to
permit resale of their products, the Company expects to be able to provide its
customers with a full range of telecommunications services using a combination
of its own network, the networks of the incumbent local exchange carriers and
the networks of other competitive carriers.
In April 1995, as part of its overall business strategy, the Company
acquired MWR from MidAmerican. MWR, which is now part of McLeodUSA Network
Services, is a competitive access provider which owns and operates a fiber
optic network and offers special access and private line services to large
businesses, institutional customers and interexchange carriers, primarily in
Des Moines, Iowa. As a result of this strategic acquisition, the Company
believes that it is the only competitive access provider in the Des Moines
market. The Company believes the already-installed MWR network is an important
aspect of its efforts to become the first state-wide integrated
telecommunications provider.
In 1995, the Iowa General Assembly passed legislation to extend the Iowa
Communications Network to 543 more "endpoints" (which are usually located in
schools or public libraries) throughout the state (the "Part III segments").
The majority of these fiber optic links, unlike the Part I and II segments of
the Iowa Communications Network, are not to be owned by the State of Iowa, but
are to be leased from a private entity, such as the Company. As a result of
public bidding, the Company has the right to build and then lease capacity to
the State of Iowa on 265 of such segments. Under its lease agreements with the
State of Iowa, the Company is constructing a "fiber-rich" broadband network,
on which the State of Iowa has agreed to lease one DS-3 circuit for a period
of seven years for a total aggregate lease cost of approximately $30.5
million. Upon completion of installation of each segment, the leases provide
that the State of Iowa will make a one-time up-front lease payment to the
Company for the capacity, with nominal monthly lease payments thereafter. At
the end of a seven-year period, the leases may be extended, upon terms to be
mutually agreed upon. During the term of the leases, the State may order
additional DS-3 circuits at a mutually agreed upon price.
The Company has reached agreements with its electric utility stockholders
(MidAmerican and IES) that allow the Company to make use of those utilities'
underground conduits, distribution poles, transmission towers and building
entrances in exchange for rights by such stockholders to use certain capacity
on the Company's network. These agreements give the Company access to rights-
of-way in Iowa and in certain portions of Illinois for installation of the
Company's wireline and wireless networks. The Company's access to these
rights-of-way are expected to have a significant positive impact on the
Company's capital costs for network construction and the speed with which the
Company can construct its networks. The Company believes that its strategic
relationships with its electric utility stockholders give it a significant
competitive advantage.
Concurrently with construction of the Part III segments, the Company is
also installing low-cost network facilities that are expected to form a series
of fiber optic "self-healing rings" intended to enable the Company to provide
facilities-based local and long distance service to most significant cities
and towns in Iowa. Thus, the Company believes it is well positioned to become
the first facilities-based state-wide integrated provider of competitive
telecommunications services in the Midwest.
As of March 21, 1997, the Company owned approximately 2,500 route miles
of fiber optic network and expects to construct approximately 5,000 additional
route miles of fiber optic network during the next three years. The Company
expects that approximately half of this fiber capacity will be in the State of
Iowa, with the balance built throughout the Company's other target markets.
The Company will decide whether to begin construction of fiber optic network
in a market based on various economic factors, including: (i) the number of
its customers in a market, (ii) the anticipated operating cost savings
associated with such construction and (iii) any strategic relationships with
owners of existing infrastructure (e.g., utilities and cable operators).
17
Sales and Marketing
Until June 1996, the Company directed its telecommunications sales
efforts primarily toward small and medium-sized businesses. In June 1996, the
Company began marketing its PrimeLine(R) services to residential customers.
Marketing of the Company's integrated telecommunications services is
handled by a sales and marketing group composed of direct sales personnel and
telemarketers. The Company's sales force is trained to emphasize the Company's
customer-focused sales and customer service efforts, including its 24-hours-
per-day, 365-days-per-year customer service center, which a customer may call
with any question or problem regarding the Company's services. The Company's
employees answer customer service calls directly rather than requiring
customers to use an automated queried message system. The Company believes
that its emphasis on a "single point of contact" for meeting the customer's
telecommunications needs, as well as its ability to provide one fully
integrated monthly billing statement for local, long distance, 800,
international, voice mail, paging, Internet access and travel card service, is
very appealing to its prospective customers.
As of March 21, 1997, marketing of the Company's integrated
telecommunications services to business customers was conducted by 210 direct
sales personnel, located at the Company's headquarters in Cedar Rapids, Iowa
and in 43 branch sales offices in Iowa, Illinois, Minnesota, Wisconsin, South
Dakota, North Dakota and Colorado. The sales personnel make direct calls to
prospective and existing business customers, conduct analyses of business
customers' call usage histories, and demonstrate that the Company's software
systems will rate the customers' calls by comparison to the lowest cost plan
of the most popular business calling plans offered by AT&T, MCI and Sprint.
Marketing of the Company's integrated telecommunications services to
residential customers was conducted as of March 21, 1997 by 168 telemarketers
from the Company's Ruffalo, Cody subsidiary. The Company plans to increase
this number in the future. The telemarketers emphasize the PrimeLine(R)
integrated package of telecommunications services and its flat-rated per
minute pricing structure for long distance service. The Company uses Ruffalo,
Cody's information database to identify attractive sales opportunities and
pursues those opportunities through a variety of methods, including calls from
Ruffalo, Cody's telemarketing personnel.
The Company believes that its acquisition of McLeodUSA Publishing in
September 1996 will further the Company's sales and marketing efforts of its
residential services in several ways. First, it gives the Company an immediate
presence in states where it is initiating service (Minnesota and Wisconsin)
and also in states where it does not yet provide integrated telecommunications
service but expects to do so in the future (such as South Dakota, North
Dakota, Colorado, Wyoming, Montana, Utah and Idaho). Second, the Company
believes that the acquisition will increase the Company's penetration of
current markets and accelerate its entry into new markets. The telephone
directories published and distributed by McLeodUSA Publishing will serve as
"direct mail" advertising for the Company's telecommunications products. The
directories will contain detailed product descriptions and step-by-step
instructions on the use of the Company's telecommunications products. The
Company believes that telephone directories are commonly used sources of
information that potentially provide the Company with a long-term marketing
presence in millions of households and businesses that receive a McLeodUSA
Publishing directory. By using the directories to market its products, the
Company can reach more customers than would be possible if the acquisition had
not occurred. Third, the Company believes that combining the directories'
distinctive black-and-yellow motif with the trade name McLeodUSA will create
and strengthen brand awareness in all of the Company's markets.
In 1997, the Company expects to expand its telecommunications sales and
marketing efforts primarily by opening new branch sales offices in Minnesota,
Wisconsin, South Dakota, North Dakota and Colorado, by continuing its
expansion in Iowa and Illinois and by increasing its sales of long distance
service in Omaha, Nebraska. The Company also expects to begin sales and
marketing efforts in 1997 in Wyoming. Over the next several years, depending
on competitive and other factors, the Company also
18
intends to begin sales and marketing efforts in Montana, Idaho, Utah and
Nebraska. See "Legal Proceedings." In addition, the Company expects to expand
its long distance sales and marketing efforts in 1997 to the remaining states
in the continental United States. The foregoing statements are "forward-
looking statements" within the meaning of the Private Securities Litigation
Reform Act of 1995 and the results of the Company's actual expansion efforts
may be materially different, depending on a variety of other factors,
including: (i) the availability of financing and regulatory approvals; (ii)
the number of potential customers in a target market; (iii) the existence of
strategic alliances or relationships; (iv) technological, regulatory or other
developments in the Company's business; (v) changes in the competitive climate
in which the Company operates; and (vi) the emergence of future opportunities.
Sales and marketing of the Company's competitive access services are
handled as of the date hereof by a small sales staff located in Des Moines,
Iowa. These sales people work closely with the Company's network engineers to
design and market special access and private line services.
Competition
Wireline Competition. The telecommunications industry is highly
competitive. The Company faces intense competition from local exchange
carriers, including the Regional Bell Operating Companies (primarily U S WEST
and Ameritech) and the General Telephone Operating Companies, which, as of the
date hereof, dominate their local telecommunications markets. The Company also
competes with long distance carriers in the provision of long distance
services. The long distance market is dominated by three major competitors,
AT&T, MCI and Sprint. Hundreds of other companies also compete in the long
distance marketplace. Other competitors of the Company may include cable
television companies, competitive access providers, microwave and satellite
carriers, wireless telecommunications providers, teleports and private
networks owned by large end-users. In addition, the Company competes with the
Regional Bell Operating Companies and other local exchange carriers, numerous
direct marketers and telemarketers, equipment vendors and installers, and
telecommunications management companies with respect to certain portions of
its business. Many of the Company's existing and potential competitors have
financial and other resources far greater than those of the Company.
The local and access telephone services offered by the Company compete
principally with the services offered by the incumbent local exchange carrier
serving each of the Company's markets. Incumbent local exchange carriers have
long-standing relationships with their customers and have the potential to
subsidize competitive services from less competitive service revenues.
In addition, a continuing trend toward business combinations and
strategic alliances in the telecommunications industry may create significant
new competitors. For example, the national long distance carrier WorldCom
acquired MFS Communications Company, Inc., a competitive access provider, in
December 1996. Moreover, in November 1996, British Telecommunications plc, an
international telecommunications company, announced its agreement to acquire
the national long distance carrier MCI. The ability of these or other
competitors of the Company to enter into strategic alliances could put the
Company at a significant disadvantage.
The Company may, in the future, face competition in the markets in which
it operates from one or more competitive access providers operating fiber
optic networks, in many cases in conjunction with the local cable television
operator. Each of AT&T, MCI and Sprint has indicated its intention to offer
local telecommunications services, either directly or in conjunction with
other competitive access providers or cable television operators. Like the
Company, MCI holds a certificate of public convenience and necessity to offer
local and long distance service in Iowa through partitioning of U S WEST's
central office switch. One other small telecommunications company also holds
such a certificate in Iowa. On July 26, 1996, the Iowa Utilities Board
approved AT&T's application to offer local service in Iowa on both a resale
and facilities-based basis, subject to certain additional filing requirements.
During the past twelve months, AT&T has received certification to provide
local service in all of the Company's current and target markets. There can be
no assurance that these firms, and others, will not enter the small and mid-
sized markets where the Company focuses its sales efforts.
19
The Company believes that the Telecommunications Act and state
legislative and regulatory initiatives and developments in Illinois, Iowa and
other states within the Company's target markets, as well as a recent series
of transactions and proposed transactions between telephone companies, long
distance carriers and cable companies, increase the likelihood that barriers
to local exchange competition will be substantially reduced or removed. These
initiatives include requirements that the Regional Bell Operating Companies
negotiate with entities such as the Company to provide interconnection to the
existing local telephone network, to allow the purchase, at cost-based rates,
of access to unbundled network elements, to establish dialing parity, to
obtain access to rights-of-way and to resell services offered by the incumbent
local exchange carriers.
The Company's plans to provide local switched services are dependent upon
obtaining favorable interconnection agreements with local exchange carriers.
In August 1996, the FCC released the Interconnection Decision implementing the
interconnection portions of the Telecommunications Act. Certain provisions of
the Interconnection Decision implementing the interconnection portions of the
Telecommunications Act have been stayed by the U.S. Eighth Circuit Court of
Appeals, which may limit or delay the development of competition in the local
exchange switched services market. There can be no assurance that the Company
will be able to obtain interconnection agreements on terms acceptable to the
Company.
The Telecommunications Act provides the incumbent local exchange carriers
with new competitive opportunities. The Telecommunications Act removes
previous restrictions concerning the provision of long distance service by the
Regional Bell Operating Companies and also provides them with increased
pricing flexibility. Under the Telecommunications Act, the Regional Bell
Operating Companies will, upon the satisfaction of certain conditions, be able
to offer long distance services that would enable them to duplicate the "one-
stop" integrated telecommunications approach used by the Company. The Company
believes that it has certain advantages over these companies in providing its
telecommunications services, including management's prior experience in the
competitive telecommunications industry and the Company's emphasis on
marketing (primarily using a direct sales force for sales to business
customers and telemarketing for sales to residential customers) and on
responsive customer service. However, there can be no assurance that the
anticipated increased competition will not have a material adverse effect on
the Company. The Telecommunications Act provides that rates charged by
incumbent local exchange carriers for interconnection to the incumbent
carrier's network are to be nondiscriminatory and based upon the cost of
providing such interconnection, and may include a "reasonable profit," which
terms are subject to interpretation by regulatory authorities. If the
incumbent local exchange carriers, particularly the Regional Bell Operating
Companies, charge alternative providers such as the Company unreasonably high
fees for interconnection to the local exchange carriers' networks,
significantly lower their rates for access and private line services or offer
significant volume and term discount pricing options to their customers, the
Company could be at a significant competitive disadvantage. See
"--Regulation."
Competition for local and access telecommunications services is based
principally on price, quality, network reliability, customer service and
service features. The Company believes that its management expertise allows it
to compete effectively with the incumbent local exchange carriers. The Company
generally offers its business customers local exchange services at prices that
are substantially similar to the established retail local exchange carrier
rates for basic business service, while generally providing enhanced calling
features and a higher level of customer service. Using the Company's
sophisticated proprietary software, each business customer subscribing to the
Company's integrated telecommunications services receives the lowest long
distance rate available each month from among the pricing plans of AT&T, MCI
and Sprint that generally are most popular with the Company's business
customers, and, in certain cases, rates specifically identified by a business
customer and agreed to by the Company. Residential customers receive flat-rate
long distance pricing. The Company's fiber optic networks will provide both
diverse access routing and redundant electronics, which design features are
not widely deployed by the local exchange carriers' networks.
Wireless Competition. The wireless telecommunications industry is
experiencing significant technological change, as evidenced by the increasing
pace of improvements in the capacity and quality of
20
digital technology, shorter cycles for new products and enhancements, and
changes in consumer preferences and expectations. The Company believes that
the market for wireless telecommunications services is likely to expand
significantly as equipment costs and service rates continue to decline,
equipment becomes more convenient and functional, and wireless services become
more diverse. The Company also believes that providers of wireless services
increasingly will offer, in addition to products that supplement a customer's
wireline communications (similar to cellular telephone services in use today),
wireline replacement products that may result in wireless services becoming
the customer's primary mode of communication. Accordingly, the Company expects
competition in the wireless telecommunications business to be dynamic and
intense as a result of the entrance of new competitors and the development of
new technologies, products and services. The Company anticipates that in the
future there could potentially be eight wireless competitors in each of its
proposed PCS markets: two existing cellular providers, five other PCS
providers and Nextel Communications Inc., an ESMR provider. Principal cellular
providers in the Company's proposed PCS markets include Ameritech Mobile
Communications, Inc., AT&T Wireless Services, Inc., Southwestern Bell Mobile
Systems, Inc., Western Wireless Corporation, CommNet Cellular Incorporated,
GTE Mobilnet Service Corporation, 360 Communications Company, Airtouch
Cellular, United States Cellular Corporation and BellSouth Corporation.
Principal PCS licensees in the Company's proposed PCS markets include AT&T
Wireless PCS, Inc., PRIMECO Personal Communications, L.P., WirelessCo, d/b/a
Sprint PCS, American Portable Telecommunications, Inc., d/b/a Aerial
Communications, Inc., Western PCS Corp., Cox Communications, Inc., DCR PCS,
Inc., d/b/a Pocket Communication Corp., Wireless PCS, Inc., d/b/a Airadigm
Communications, Inc., SprintCom, Inc., BRK Wireless Co. Inc., Western PCS BTA
I Corp., OPCSE-Galloway Consortium, Northcoast Operating Co. Inc., Minnesota
PCS Limited Partnership, Northeast Nebraska Telephone Company, Triad Cellular
Corp., Iowa L.P. 136, Redwood Wireless Corp., Polycell Communications Inc.,
CM-PCS Partners, and U S WEST.
Competition with these or other providers of wireless telecommunications
services may be intense. Many of the Company's potential wireless competitors
have substantially greater financial, technical, marketing, sales,
manufacturing and distribution resources than those of the Company and have
significantly greater experience than the Company in testing new or improved
wireless telecommunications products and services. Some competitors are
expected to market other services, such as cable television access, with their
wireless telecommunications service offerings. The Company does not offer
cable television access. In addition, several of the Company's potential
wireless competitors are operating or planning to operate, through joint
ventures and affiliation arrangements, wireless telecommunications systems
that encompass most of the United States. There can be no assurance that the
Company will be able to compete successfully in this environment or that new
technologies and products that are more commercially effective than the
Company's technologies and products will not be developed. See "--Wireless
Services."
Regulation
Overview. The Company's services are subject to federal, state and
local regulation. The FCC exercises jurisdiction over all facilities of, and
services offered by, telecommunications common carriers to the extent those
facilities are used to provide, originate or terminate interstate or
international communications. State regulatory commissions retain some
jurisdiction over the same facilities and services to the extent they are used
to originate or terminate intrastate common carrier communications. Local
governments may require the Company to obtain licenses, permits or franchises
regulating use of public rights-of-way necessary to install and operate its
networks. In addition, the licensing, construction, operation, sale and
interconnection arrangements of wireless telecommunications systems are
regulated to varying degrees by the FCC. The construction and operation of
wireless systems also may be subject to state and local regulation.
The Company, through its wholly owned subsidiary McLeodUSA
Telecommunications, holds various federal and state regulatory authorizations
and often joins other industry members in seeking regulatory reform at the
federal and state levels to open additional telecommunications markets to
competition.
21
The Company, through its wholly owned subsidiary McLeodUSA Network
Services, provides certain competitive access services as a private carrier on
a non-regulated basis. In general, a private carrier is one that provides
service to customers on an individually negotiated contractual basis, as
opposed to a common carrier that provides service to the public on the basis
of generally available rates, terms and conditions. The Company believes that
McLeodUSA Network Services' private carrier status is consistent with
applicable federal and state laws, as well as regulatory decisions
interpreting and implementing those laws as of the date of this Offering
Memorandum. Should such laws and/or regulatory interpretations change in the
future to reclassify McLeodUSA Network Services' regulatory status, the
Company believes that compliance with such reclassification would not have a
material adverse effect on the Company.
The Company, through its wholly owned subsidiary Ruffalo, Cody, is
subject to certain federal and state regulatory requirements, including, in
certain states, bonding requirements, due to its direct marketing,
telemarketing and fund-raising activities.
Federal Regulation. The Telecommunications Act became effective
February 8, 1996. The Telecommunications Act preempts state and local laws to
the extent that they prevent competitive entry into the provision of any
telecommunications service. Subject to this limitation, however, the state and
local governments retain most of their existing regulatory authority. The
Telecommunications Act imposes a variety of new duties on incumbent local
exchange carriers in order to promote competition in local exchange and access
services. Some smaller telephone companies may seek suspension or modification
of these duties, and some companies serving rural areas are exempt from these
duties. Some duties are also imposed on non-incumbent local exchange carriers,
such as the Company. The duties created by the Telecommunications Act include
the following:
Reciprocal Compensation Requires all local exchange carriers 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.
Resale Requires all local exchange carriers to permit
resale of their telecommunications services
without unreasonable restrictions or conditions.
In addition, incumbent local exchange carriers 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 incumbent local carrier in the
wholesale offering.
Interconnection Requires incumbent local exchange carriers to
permit their competitors to interconnect with
their facilities 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, physical collocation of
the requesting carrier's equipment in the
incumbent local exchange carrier's premises must
be offered, except where the incumbent local
exchange carrier can demonstrate space limitations
or other technical impediments to collocation.
Unbundled Access Requires incumbent local exchange carriers 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).
22
Number Portability Requires all local exchange carriers 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.
Dialing Parity Requires all local exchange carriers 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.
Access to Rights-of-Way Requires all local exchange carriers to permit
competing carriers access to poles, ducts,
conduits and rights-of-way at regulated prices.
Incumbent local exchange carriers are required to negotiate in good faith
with carriers requesting any or all of the above arrangements. Certain FCC
rules regarding negotiation and pricing of interconnection agreements have
been stayed by the U.S. Eighth Circuit Court of Appeals. However, carriers
still may negotiate agreements, and 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.
The Telecommunications Act also eliminates previous prohibitions on the
provision of interLATA long distance services by the Regional Bell Operating
Companies and the General Telephone Operating Companies. The Regional Bell
Operating Companies are now permitted to provide interLATA long distance
service outside those states in which they provide local exchange service
("out-of-region long distance service") upon receipt of any necessary state
and/or federal regulatory approvals that are otherwise applicable to the
provision of intrastate and/or interstate long distance service. Under the
Telecommunications Act, the Regional Bell Operating Companies will be allowed
to provide long distance service within the regions in which they also provide
local exchange service ("in-region service") upon specific approval of the FCC
and satisfaction of other conditions, including a checklist of interconnection
requirements. The General Telephone Operating Companies are permitted to enter
the long distance market without regard to limitations by region, although
regulatory approvals otherwise applicable to the provision of long distance
service will need to be obtained. The General Telephone Operating Companies
are also subject to the provisions of the Telecommunications Act that impose
interconnection and other requirements on local exchange carriers.
The Telecommunications Act imposes certain restrictions on the Regional
Bell Operating Companies in connection with the Regional Bell Operating
Companies' entry into long distance services. Among other things, the Regional
Bell Operating Companies must pursue such activities only through separate
subsidiaries with separate books and records, financing, management and
employees, and all affiliate transactions must be conducted on an arm's length
and nondiscriminatory basis. The Regional Bell Operating Companies are also
prohibited from jointly marketing local and long distance services, equipment
and certain information services unless competitors are permitted to offer
similar packages of local and long distance services in their market. Further,
the Regional Bell Operating Company must obtain in-region long distance
authority before jointly marketing local and long distance services in a
particular state. Additionally, AT&T and other major carriers serving more
than 5% of the nation's presubscribed long distance access lines are also
restricted, under certain conditions, from packaging their long distance
services and local services provided over Regional Bell Operating Company
facilities. These restrictions do not, however, apply to the Company because
it does not serve more than 5% of the nation's presubscribed access lines.
Prior to passage of the Telecommunications Act, the FCC had already
established different levels of regulations for dominant and non-dominant
carriers. For domestic common carrier telecommunications regulation, incumbent
local exchange carriers, including the Regional Bell Operating Companies, are,
as of the date hereof, considered dominant carriers for the provision of
interstate access and interexchange
23
services, while other interstate service providers, such as the Company, are
considered non-dominant carriers. The FCC has recently proposed that the
Regional Bell Operating Companies offering out-of-region interstate long
distance services be regulated as non-dominant carriers, as long as such
services are offered by an affiliate of the Regional Bell Operating Company
that complies with certain structural separation requirements. The FCC
regulates many of the rates, charges and services of dominant carriers to a
greater degree than non-dominant carriers.
As a non-dominant carrier, the Company may install and operate facilities
for the transmission of domestic interstate communications without prior FCC
authorization, although FCC authorization is required for the provision of
international telecommunications by non-dominant carriers. McLeodUSA
Telecommunications has obtained FCC authority to provide international
services. Services of non-dominant carriers are subject to relatively limited
regulation by the FCC. As of the date hereof, non-dominant carriers are
required to file tariffs listing the rates, terms and conditions of interstate
access and international services provided by the carrier. Periodic reports
concerning the carrier's interstate circuits and deployment of network
facilities also are required to be filed. The FCC generally does not exercise
direct oversight over cost justification and the level of charges for services
of non-dominant carriers, although it has the power to do so. The Company must
offer its interstate services on a nondiscriminatory basis, at just and
reasonable rates, and remains subject to FCC complaint procedures. Pursuant to
these FCC requirements, the Company's subsidiary, McLeodUSA
Telecommunications, has filed and maintains with the FCC a tariff for its
interstate and international services. All of the interstate and international
retail "basic" services (as defined by the FCC) provided by the Company
(through such subsidiary) and the rates charged for those services are
described therein.
On October 29, 1996, the FCC adopted an order in which it eliminated the
requirement that non-dominant interstate carriers such as the Company maintain
tariffs on file with the FCC for domestic interstate interexchange services.
The FCC's order was issued pursuant to authority granted to the FCC in the
Telecommunications Act to "forebear" from regulating any telecommunications
service provider if the FCC determines that the public interest will be
served. Following a nine-month transition period, relationships between
carriers and their customers will be set by contract. Long distance companies
are no longer required to file with the FCC tariffs for interstate
interexchange services and may immediately cease filing such tariffs. However,
several parties formally requested the FCC to reconsider its order, and MCI,
Sprint and The American Carriers Telephone Association have separately
appealed the FCC's order to the United States Court of Appeals for the
District of Columbia Circuit. On February 13, 1997, the United States Court of
Appeals for the District of Columbia Circuit stayed the FCC's order pending
judicial review of the appeals. If the appeals are unsuccessful and the FCC's
order becomes effective, the Company believes that the elimination of the
FCC's tariff requirement will permit the Company more rapidly to respond to
changes in the marketplace. In the absence of tariffs, however, the Company
will be required to obtain agreements with its customers regarding many of the
terms of its existing tariffs, and uncertainties regarding such new
contractual terms could increase the risks of claims against the Company from
its customers.
The FCC is as of the date hereof conducting a proceeding to implement the
provisions of the Telecommunications Act relating to the preservation and
advancement of universal telephone service. The Telecommunications Act sets
forth certain policy principles for universal telephone service, including
quality service, affordable rates, access to advanced services, access to
service in rural and high-cost areas, specific and predictable support
mechanisms, equitable and non-discriminatory contributions to support
mechanisms, and access to advanced telecommunications for schools, health care
providers and libraries. The Company expects the FCC's decision on universal
telephone service to reflect these principles. There can be no assurance that
the FCC's decision will not have a material adverse effect on the Company.
The FCC also imposes prior approval requirements on transfers of control
and assignments of operating authorizations. The FCC has the authority to
generally condition, modify, cancel, terminate or revoke operating authority
for failure to comply with federal laws and/or the rules, regulations and
policies of the FCC. Fines or other penalties also may be imposed for such
violations. There can be no assurance that the FCC or third parties will not
raise issues with regard to the Company's compliance with applicable laws and
regulations.
The FCC, through the Initial Interconnection Decisions, has ordered the
Regional Bell Operating Companies and all but one of the other local exchange
carriers having in excess of $100 million in gross annual revenue for
regulated services to provide expanded interconnection to local exchange
carrier central offices to any competitive access provider, interexchange
carrier or end user seeking such interconnection for the provision of
interstate access services. As a result, the Company is able to reach most
business customers in its metropolitan service areas and can expand its
potential customer base. The FCC has imposed mandatory virtual collocation
obligations on the local exchange carriers. Virtual collocation is a service
in which the local exchange carrier leases or purchases equipment designated
by the interconnector and exerts complete physical control over this
equipment, including central office installation, maintenance and repair. Some
local exchange carriers have voluntarily filed tariffs making "physical
collocation" available, enabling the interconnector to place its equipment in
the local exchange carriers central office space. As noted above, the
Telecommunications Act now requires most incumbent local exchange companies to
offer physical collocation.
24
Subsequent to the enactment of the Telecommunications Act, the FCC has
begun a series of expedited rulemaking proceedings to implement the
requirements of the Telecommunications Act concerning interconnection with
local exchange carrier facilities and other essential terms of the
relationships between competing local carriers. On August 8, 1996, the FCC
adopted the Interconnection Decision to implement the interconnection, resale
and number portability provisions of the Telecommunications Act. Certain
provisions of these rules have been appealed to various U.S. Courts of
Appeals. These appeals were consolidated into proceedings before the U.S.
Eighth Circuit Court of Appeals. Applications for a stay of the proposed rules
were rejected by the FCC. However, the U.S. Eighth Circuit Court of Appeals
has granted a temporary stay of certain provisions of the Interconnection
Decision, including the pricing rules and rules that would have permitted new
entrants to "pick and choose" among various provisions of existing
interconnection agreements, pending a decision on the merits. The FCC applied
to the U.S. Supreme Court to vacate the judicial stay, but the U.S. Supreme
Court, on November 12, 1996, refused to do so. All other provisions of the
Interconnection Decision remain in effect pending resolution of the appeal on
the merits.
In connection with the Initial Interconnection Decisions, the FCC granted
local exchange carriers additional flexibility in pricing their interstate
special and switched access services on a central office specific basis. Under
this pricing scheme, local exchange carriers may establish pricing zones based
on access traffic density and charge different prices for central offices in
each zone. Although no assurances are possible, the Company anticipates that
the FCC will grant local exchange carriers increasing pricing flexibility as
the number of interconnection agreements and competitors increases. In a
concurrent proceeding, the FCC enacted interim pricing rules that restructure
local exchange carrier switched transport rates in order to facilitate
competition for switched access.
In January 1997, U S WEST proposed to implement certain interconnection
surcharges in each of the states in its service region. On February 20, 1997,
the Company and several other parties filed a petition with the FCC objecting
to U S WEST's proposal. The petition was based on Section 252(d) of the
Telecommunications Act, which governs the pricing of interconnection and
network elements. The Company believes that U S WEST's proposal is an unlawful
attempt to recover costs associated with the upgrading of US WEST's network, in
violation of Section 252 of the Telecommunications Act. U S WEST filed an
opposition to the Company's petition with the FCC on March 3, 1997.
As of the date hereof, the Company does not offer PCS or cellular
services. On January 15, 1997, the FCC notified the Company that it was the
successful bidder for 26 "D" and "E" block frequency PCS licenses covering
areas of Iowa, Illinois, Minnesota, Nebraska and South Dakota. The Company
filed an application for such PCS licenses on January 30, 1997. Before the
Company can acquire the PCS licenses, the application is subject to review by
the FCC and challenge by third parties. In general, applications for FCC
radio licenses may be conditioned or denied, and may be revoked after grant,
if the FCC finds that an entity lacks the requisite "character" qualification
to be a licensee. In making that determination, the FCC considers whether an
applicant or licensee has been the subject of adverse findings in a judicial
or administrative proceeding involving, among other things, the possession or
sale of unlawful drugs, fraud, antitrust violations or unfair competition, and
has complied with the FCC's ownership, bidding and build-out rules.
All PCS licenses will be granted for a ten-year period, at the end of
which, absent prior revocation or a violation of the FCC's rules by the
licensee, they will be renewed. All PCS licensees must construct facilities
that offer coverage to one-third of the population of their service area
within five years of their initial license grants and to two-thirds of the
population within ten years. Licensees that fail to meet the coverage
requirements may be subject to forfeiture of the license.
The Communications Act of 1934, as amended (the "Communications Act"),
requires the FCC's prior approval of the assignment or transfer of control of
a PCS license. In addition, the FCC has established transfer disclosure
requirements that require licensees who transfer control of or assign a PCS
license within the first three years to file associated contracts for sale,
option agreements, management agreements or other documents disclosing the
total consideration that the applicant would receive in return for the
transfer or assignment of its license. Non-controlling interests in an entity
that holds a PCS license or PCS system generally may be bought or sold by U.S.
companies or individuals without prior FCC approval.
Under the Telecommunications Act, non-U.S. citizens or their
representatives, foreign governments or their representatives, or corporations
organized under the laws of a foreign country may not own, in the aggregate,
more than 20% of a company holding a common carrier radio license; or more
than 25% of the parent of a common carrier radio licensee if the FCC
determines that the public interest
25
would be served by prohibiting such ownership. If the Company succeeds in
acquiring PCS licenses, the Company will be required to comply with these
foreign ownership restrictions. In addition, the FCC has imposed reporting
requirements with respect to foreign affiliations between U.S. international
and foreign telecommunications carriers, as well as reports of certain
investments by other foreign entities. Depending on the particular foreign
affiliate and its "home" market, the FCC may limit the size of the foreign
affiliate's investment in the U.S. carrier or subject the U.S. carrier to
dominant carrier regulation on one or more international routes. The Company's
subsidiary, McLeodUSA Telecommunications, holds FCC authority to provide
international services, and therefore is also subject to the FCC's rules on
foreign affiliations.
Failure to comply with statutory requirements on foreign ownership of
companies holding radio licenses, or with the FCC's foreign affiliation
reporting requirements, may result in the FCC issuing an order to the entity
requiring divestiture of alien ownership to bring the entity into compliance
with the Communications Act and the FCC's rules. In addition, fines, a denial
of renewal or revocation of radio licenses are possible. The Company's Amended
and Restated Certificate of Incorporation (the "Restated Certificate") permits
the Board of Directors of the Company (the "Board") to redeem any of the
Company's capital stock from stockholders to the extent necessary to prevent
the loss or secure the reinstatement of any license, operating authority or
franchise from any governmental authority. As of the date hereof, the Company
has no knowledge of any alien ownership or affiliation with foreign
telecommunications carriers in violation of the Communications Act or the
FCC's rules.
Following the grant of a PCS license, existing licensees that operate
certain fixed microwave systems within the PCS license area retain the right
to continue to operate their systems until 2005. To secure a sufficient amount
of unencumbered spectrum to operate a PCS system efficiently, the Company may
need to relocate many of these incumbent licensees. In an effort to balance
the competing interests of existing microwave users and newly authorized PCS
licensees, the FCC has adopted a transition plan to relocate such microwave
operators to other spectrum blocks. This transition plan allows most microwave
users to operate in the PCS spectrum for a one-year voluntary negotiation
period and an additional one-year mandatory negotiation period. For public
safety entities dedicating a majority of their system communications for
police, fire or emergency medical services operations, the voluntary
negotiation period is three years. Parties unable to reach agreement within
these time periods may refer the matter to the FCC for resolution, but the
incumbent microwave user is permitted to continue its operations until final
FCC resolution of the matter. In connection with its proposed PCS system, the
Company estimates that it may be required to relocate approximately 50
microwave links operated by approximately 19 different microwave licensees.
Wireless systems are also subject to certain Federal Aviation
Administration regulations respecting the location, lighting and construction
of transmitter towers and antennas and may be subject to regulation under the
National Environmental Policy Act and the environmental regulations of the
FCC. Wireless providers also must satisfy a variety of FCC requirements
relating to technical and reporting matters. One such requirement is the
coordination of proposed frequency usage between adjacent systems. In
addition, the height and power of base station transmitting facilities and the
type of signals they emit must fall within specified parameters.
The Company, through its wholly owned subsidiary Ruffalo, Cody, is also
subject to rules governing telemarketing that have been promulgated by both
the FCC and the Federal Trade Commission (the "FTC"). The FCC and FTC
telemarketing rules prohibit telemarketers, such as Ruffalo, Cody, from
engaging in certain deceptive telemarketing practices and require that
telemarketers make certain disclosures. For example, these telemarketing
rules: prohibit the use of autodialers that employ prerecorded voice messages
without the prior express consent of the dialed party; proscribe the facsimile
transmission of unsolicited advertisements; require telemarketers to disclose
clear and conspicuous information concerning quality, cost and refunds to a
customer before a customer makes a purchase; require telemarketers to compile
lists of individuals who desire not to be contacted; limit telemarketers to
calling residences between the hours of 8:00 a.m. and 9:00 p.m.; require
telemarketers to explicitly identify the seller and state that the purpose of
the call is to sell goods; and prohibit product misrepresentations.
26
State Regulation. McLeodUSA Telecommunications, the Company's
subsidiary that provides intrastate common carrier services, is also subject
to various state laws and regulations. Most public utilities commissions
subject providers such as the Company to some form of certification
requirement, which requires providers to obtain authority from the state
public utilities commission prior to the initiation of service. In most
states, including Iowa and Illinois, the Company also is required to file
tariffs setting forth the terms, conditions and prices for services that are
classified as intrastate. The Company also is required to update or amend its
tariffs when it adjusts its rates or adds new products, and is subject to
various reporting and record-keeping requirements.
Many states also require prior approval for transfers of control of
certified carriers, corporate reorganizations, acquisitions of
telecommunications operations, assignment of carrier assets, carrier stock
offerings and incurrence by carriers of significant debt obligations.
Certificates of authority can generally be conditioned, modified, canceled,
terminated or revoked by state regulatory authorities for failure to comply
with state law and/or the rules, regulations and policies of state regulatory
authorities. Fines or other penalties also may be imposed for such violations.
There can be no assurance that state utilities commissions or third parties
will not raise issues with regard to the Company's compliance with applicable
laws or regulations.
The Company, through McLeodUSA Telecommunications, holds certificates to
offer local services through partitioning U S WEST switches in Iowa and
Ameritech switches in Illinois, has long distance authority in Iowa and
Illinois and has tariffs on file in these states, as necessary, governing the
provision of local and intrastate long distance services. In March 1995 and
April 1996, respectively, the Company received state regulatory approval in
Iowa and in Illinois to offer local switched services in Cedar Rapids, Iowa
and in Illinois cities other than Chicago. The Company intends to seek
regulatory approval to provide such services in other cities and towns in Iowa
and other states targeted by the Company when the economic terms of
interconnection with the incumbent local exchange carrier make the provision
of local switched services cost-effective. See "--Expansion of Certain
Facilities-based Services." In addition, the Company is authorized to provide
local exchange and long distance services through resale in Illinois, Iowa,
Minnesota, Wisconsin, Montana, South Dakota and North Dakota. As of the date
hereof, applications for authority to provide local services are pending in
Colorado, Wyoming and Idaho. The Company also is authorized to offer long
distance service in Alabama, Arizona, Arkansas, California, Colorado,
Delaware, Georgia, Idaho, Indiana, Kansas, Kentucky, Maine, Maryland,
Massachusetts, Mississippi, Michigan, Missouri, Montana, Nebraska, Nevada, New
Hampshire, New Jersey, Ohio, Oregon, Pennsylvania, Rhode Island, Texas, Utah,
Virginia, Washington and Wyoming. As of the date hereof, applications for
authority to provide long distance service are pending in several states,
including Connecticut, Florida, Louisiana, New Mexico, New York, North
Carolina, Oklahoma, Tennessee, Vermont and West Virginia. The Company has
applied for authority to provide long distance service in such states,
including states outside of its target markets, because it believes this
capability will enhance the Company's ability to attract business customers
that have offices outside of the Company's target markets. The Company may
also apply for authority to provide services in other states in the future.
While the Company expects and intends to obtain necessary operating authority
in each jurisdiction where it intends to operate, there can be no assurance
that each jurisdiction will grant the Company's request for authority.
Although the Telecommunications Act preempts the ability of states to
forbid local service competition some states where the legality of such
competition was previously uncertain have not yet completed regulatory or
statutory actions to comply with the Telecommunications Act. Furthermore, the
Telecommunications Act preserves the ability of states to impose reasonable
terms and conditions of service and other regulatory requirements. In the last
several years, Iowa, Illinois, Minnesota, Wisconsin, Wyoming and North Dakota
have enacted broad changes in those states' telecommunications laws that
authorize the entry of competitive local exchange carriers and provide for new
regulations to promote competition in local and other intrastate
telecommunications services. The Company believes that these state statutes
provide some protection to the Company against any discriminatory conduct by
the Regional Bell Operating Companies. The Iowa Utilities Board, for example,
has determined in three separate instances that the conduct of U S WEST
discriminated against the
27
Company in violation of Iowa law. U S WEST appealed two of these decisions by
the Iowa Utilities Board. On January 28, 1997, the Iowa District Court hearing
the appeals affirmed the decision of the Iowa Utilities Board in one of the
proceedings. U S WEST subsequently withdrew its appeal in the other matter.
The Company believes that, as the degree of intrastate competition
increases, the states will offer the local exchange carriers increasing
pricing flexibility. This flexibility may present the local exchange carriers
with an opportunity to subsidize services that compete with the Company's
services with revenues generated from non-competitive services, thereby
allowing incumbent local exchange carriers to offer competitive services at
prices below the cost of providing the service. The Company cannot predict the
extent to which this may occur or its impact on the Company's business.
The Communications Act preempts state or local regulation of the entry
of, or the rates charged by, any commercial or private radio service provider.
Notwithstanding such preemption, a state may petition the FCC for authority to
begin regulating or to continue regulating commercial radio services rates.
Petitioners must demonstrate that existing market conditions cannot protect
consumers from unreasonable and unjust rates or that the service is a
replacement for traditional wireline telephone service for a substantial
portion of the wireline service within the state. As of the date hereof, the
states in which the Company plans to provide PCS service have not sought to
regulate such matters.
States are not, however, prohibited from regulating other terms and
conditions of commercial mobile radio service, such as quality, billing
procedures and consumer protection standards. In addition, the siting and
construction of radio transmitter towers, antennas and equipment shelters are
often subject to state or local zoning, land use and other regulations. Under
the Telecommunications Act, states may not restrict cell siting or
modification based on the environmental effects of radio frequency emissions
if the emissions meet FCC standards.
The Company, through Ruffalo, Cody, engages in various direct marketing,
telemarketing and fund-raising activities. Most states have laws that govern
either direct marketing, telemarketing or fund-raising activities. In states
that regulate such activities, several types of restriction have been imposed,
either singly or in combination, including: (i) pre-commencement and post-
completion registration requirements; (ii) posting of professional bonds;
(iii) filing of operational contracts; (iv) imposing statutory waiting
periods; (v) requiring employee registration; and (vi) prohibiting control
over funds collected from such activities.
Local Government Authorizations. The Company is required to obtain
street use and construction permits and licenses and/or franchises to install
and expand its fiber optic networks using municipal rights-of-way. In some
municipalities where the Company has installed or anticipates constructing
networks, it will be required to pay license or franchise fees based on a
percentage of gross revenues or on a per linear foot basis. There can be no
assurance that, following the expiration of existing franchises, fees will
remain at their current levels. In many markets, the local exchange carriers
do not pay such franchise fees or pay fees that are substantially less than
those required to be paid by the Company. To the extent that competitors do
not pay the same level of fees as the Company, the Company could be at a
competitive disadvantage. Termination of the existing franchise or license
agreements prior to their expiration dates or a failure to renew the franchise
or license agreements and a requirement that the Company remove its facilities
or abandon its network in place could have a material adverse effect on the
Company.
Risk Factors
Limited Operating History; Operating Losses and Negative Cash Flow from
Operations. The Company began operations in 1992 and has only a limited
operating history upon which to base an evaluation of its performance. As a
result of operating expenses and development expenditures, the Company has
incurred significant operating and net losses to date. Net losses for 1994,
1995 and 1996 were approximately $11.4 million, $11.3 million and $22.3
million, respectively. At December 31, 1996, the Company had an accumulated
deficit of $47.8 million. Although its revenue has increased
28
substantially in each of the last three years, the Company also has
experienced significant increases in expenses associated with the development
and expansion of its fiber optic network and its customer base. The Company
expects to incur significant operating losses and to generate negative cash
flows from operating activities during the next several years, while it
develops its businesses, constructs, installs and expands its fiber optic
network and develops and constructs a PCS system. There can be no assurance
that the Company will achieve or sustain profitability or positive cash flows
from operating activities in the future. If the Company cannot achieve
operating profitability or positive cash flows from operating activities, it
may not be able to meet its debt service or working capital requirements,
which could have a material adverse effect on the Company. See
"--Risk Factors--Significant Capital Requirements," "Selected Financial Data"
and "Management's Discussion and Analysis of Financial Condition and Results
of Operations."
Significant Capital Requirements. Expansion of the Company's
operations, facilities, network and services will require significant capital
expenditures. As of December 31, 1996, the Company estimates that its
aggregate capital requirements for 1997, 1998 and 1999 will be approximately
$456 million. The Company's estimated capital requirements include the
estimated cost of (i) developing and constructing its fiber optic network,
(ii) market expansion activities, (iii) acquiring 26 PCS licenses for which
the Company was the successful bidder in the FCCs recent "D" and "E" block
frequency PCS license auction, (iv) developing, constructing and operating a
PCS system, and (v) constructing its new corporate headquarters and associated
buildings. These capital requirements are expected to be funded, in large
part, out of the net proceeds from the Company's March 1997 private offering
of the Notes (approximately $289.5 million), the net proceeds remaining from
the Company's public offerings of Class A Common Stock in June and November
1996 (approximately $224 million as of December 31, 1996), and lease payments
to the Company for portions of the Company's networks.
The Company may require additional capital in the future for business
activities related to those specified above and also for acquisitions, joint
ventures and strategic alliances, as well as to fund operating deficits and
net losses. These activities could require significant additional capital not
included in the foregoing estimated aggregate capital requirements of $456
million.
The Company's estimate of its future capital requirements is a "forward-
looking statement" within the meaning of the safe harbor provisions of the
Private Securities Litigation Reform Act of 1995. The Company's actual capital
requirements may differ materially as a result of regulatory, technological
and competitive developments (including new opportunities) in the Company's
industry.
The Company expects to meet its additional capital needs with the
proceeds from credit facilities and other borrowings, and additional debt and
equity issuances. The Company plans to obtain one or more lines of credit,
although, as of the date hereof, no such lines of credit have yet been
negotiated. There can be no assurance, however, that the Company will be
successful in producing sufficient cash flows or raising sufficient debt or
equity capital to meet its strategic objectives or that such funds, if
available at all, will be available on a timely basis or on terms that are
acceptable to the Company. Failure to generate or raise sufficient funds may
require the Company to delay or abandon some of its future expansion plans or
expenditures, which could have a material adverse effect on the Company. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations--Liquidity and Capital Resources."
Failure of U S WEST to Furnish Call Detail Records. The Company depends
on certain call detail records provided by U S WEST with respect to long
distance services, and Ameritech with respect to both local and long distance
services, in order to verify its customers' bills for these services. The
Company has in the past experienced certain omissions in the call detail
records it receives from U S WEST on a monthly basis. For example, during the
period from January 1995 through January 1996, U S WEST failed to furnish, on
average, monthly call detail records for 2.5% of the long distance calls
placed by the Company's customers in Iowa. Thus, the Company was unable to
verify with certainty that a given long distance call placed by a customer and
known by the Company to have been terminated by the Company's wholesale long
distance supplier was, in fact, placed by the customer. Absent such
29
verification, the Company does not bill its customer for the call. These call
detail omissions typically occur in connection with new customers of the
Company.
The Company does not believe this impediment to billing certain customers
for a small percentage of calls in a given month materially adversely affects
its relationships with or contractual obligations to its customers. The
failure to bill the customer does have a negative effect on the Company's
gross margins, because the Company incurs expenses for calls it does not bill.
During the years ended December 31, 1995 and December 31, 1996, the Company
estimates that it was unable to bill approximately $126,000 and $92,000,
respectively, in long distance calls due to this situation.
In January 1996, U S WEST advised the Company that it had instituted
certain new procedures, primarily involving data entry protocols, in an effort
to "capture" 100% of call detail records. Since implementing the protocol
changes, U S WEST has furnished the Company with approximately 99.4% of the
requisite call detail records for February through December 1996. There can be
no assurance, however, that U S WEST will not continue to experience
difficulties in furnishing complete call detail records to the Company, that
the percentage of call detail records not provided to the Company will not
increase, or that the resulting negative effect on gross margins will not have
a material adverse effect on the Company.
PCS System Implementation Risks. The Company's proposed investment in
the ownership, development, construction and operation of a PCS system
involves a high degree of risk and substantial expenditures. There can be no
assurance that the Company will succeed in developing a PCS system or that,
after expending substantial amounts to develop such a system, the Company will
achieve or sustain profitability or positive cash flows from PCS operations.
The ownership, development, construction and operation of a PCS system could
have a material adverse effect on the Company.
In the absence of FCC mandated technology protocols, the Company will be
required to choose from among several competing and potentially incompatible
digital protocol technologies in order to build and operate a PCS system. The
selection of a particular digital protocol technology could adversely affect
the ability of the Company to successfully offer PCS service. See "--Wireless
Services."
The Company does not own or operate any facilities for providing wireless
telecommunication services to the public. The successful implementation of a
PCS system will require the Company to, among other things, lease or acquire
sites for base stations, construct the base stations, install the necessary
equipment and conduct system testing. Each stage of implementing PCS service
involves various risks and contingencies, many of which are not in the
Company's control. In the event the Company encounters delays or other
problems, the Company's plans for providing PCS services could be adversely
affected.
The Company's success in the implementation and operation of a PCS system
also is subject to other factors beyond the Company's control. These factors
include, without limitation, (i) changes in general and local economic
conditions, (ii) availability of equipment necessary to operate the PCS
system, (iii) changes in communications service rates charged by others, (iv)
changes in the supply and demand for PCS and the commercial viability of PCS
systems as a result of competing with wireline and wireless operators in the
same geographic area, (v) demographic changes that might negatively affect the
potential market for PCS, (vi) changes in the federal and state regulatory
scheme affecting the operation of PCS systems (including the enactment of new
statutes and the promulgation of changes in the interpretation or enforcement
of existing or new rules and regulations) and (vii) changes in PCS or
competing wireless technologies that have the potential of rendering obsolete
the technology and equipment that the Company intends to use to construct its
PCS system. In addition, the extent of the potential demand for PCS cannot be
estimated with any degree of certainty and may be less than the Company
anticipates. See "--Wireless Services" and "--Risk Factors--Rapid
Technological Changes." There can be no assurance that one or more of these
factors will not have a material adverse effect on the Company's ownership,
development, construction or operation of a PCS system.
30
The Company will be required to abide by various FCC rules governing PCS
license holders, such as rules limiting the percentage of the Company's
capital stock that may be directly owned or voted by non-U.S. citizens, by a
foreign government or by a foreign corporation to 20%, and limiting indirect
foreign ownership to 25%, absent waiver by the FCC. See "--Regulation."
Furthermore, certain of the FCC rules require all PCS licensees to meet
certain buildout and population coverage requirements. Failure to comply with
such requirements could result in the imposition of fines on the Company by
the FCC or cause revocation or forfeiture of any PCS licenses the Company
acquires, even after the Company has expended substantial amounts to develop a
PCS system.
The ownership, development, construction and operation of a PCS system is
expected to impose significant demands on the Company's management,
operational and financial resources. There can be no assurance that the
Company will be able to successfully manage the implementation and operation
of a PCS system. Any failure to effectively manage the implementation and
operation of any future PCS system (including deploying adequate systems,
procedures and controls in a timely manner) could have a material adverse
effect on the Company.
Dependence on Key Personnel. The Company's business is dependent upon a
small number of key executive officers, particularly Clark E. McLeod, the
Company's Chairman and Chief Executive Officer, and Stephen C. Gray, the
Company's President and Chief Operating Officer. As of the date hereof, the
Company does not have any term employment agreements with these or any other
employees. However, the Company has entered into employment, confidentiality
and non-competition agreements with Messrs. McLeod and Gray and certain other
key employees of the Company providing for employment by the Company for an
indefinite period, subject to termination by either party (with or without
cause) on 30 days' prior written notice, and an agreement not to compete with
the Company for a period of one or two years, depending on the employee,
following termination for cause or voluntary termination of employment. The
Company maintains "key man" insurance on Mr. McLeod, in the amount of $2
million, and on Mr. Gray, in the amount of $1 million.
There can be no assurance that the employment, confidentiality and non-
competition agreements will improve the Company's ability to retain its key
managers or employees or that the Company can attract or retain other skilled
management personnel in the future. The loss of the services of key personnel,
or the inability to attract additional qualified personnel, could have a
material adverse effect on the Company.
Contract with the State of Iowa. The Company's telecommunications
network maintenance services revenue is derived almost exclusively from the
State of Iowa under the Iowa Communications Network Maintenance Contract,
which expires in 2004. Revenues from the Company's services performed for the
State of Iowa under the Iowa Communications Network Maintenance Contract and
related contracts totaled $3.4 million, $4.9 million and $5.9 million in 1994,
1995 and 1996, respectively, or 42%, 17% and 7%, of the Company's total
revenues in 1994, 1995 and 1996, respectively.
The State of Iowa has the right to terminate the Iowa Communications
Network Maintenance Contract in the event of a lack of funding as well as for
material breach by the Company. As of the date hereof, the Company does not
believe that there are grounds for terminating the Iowa Communications Network
Maintenance Contract or that the State of Iowa intends to do so. However,
termination of the Iowa Communications Network Maintenance Contract by the
State of Iowa could have a material adverse effect on the Company.
Uncertainties of Expansion. The Company is engaged in the expansion and
development of its network and services. The expansion and development of its
network and services will depend on, among other things, its ability to
partition the incumbent local exchange company's central office switch, enter
markets, design fiber optic network routes, install facilities, relocate
microwave licensees and obtain rights-of-way, building access, antenna sites
and any required government authorizations and/or permits, all in a timely
manner, at reasonable costs and on satisfactory terms and conditions.
Implementation of the Company's current and future expansion plans will also
depend on factors such as: (i) the availability of financing and regulatory
approvals; (ii) the number of potential customers in a target market; (iii)
the
31
existence of strategic alliances or relationships; (iv) technological,
regulatory or other developments in the Company's business; (v) changes in the
competitive climate in which the Company operates; and (vi) the emergence of
future opportunities. There can be no assurance that the Company will be able
to expand its existing network or services. Furthermore, the Company's ability
to manage its expansion effectively also will require it to continue to
implement and improve its operating, financial and accounting systems and to
expand, train and manage its employees. The inability to manage its planned
expansion effectively could have a material adverse effect on the Company.
Finally, if the Company's challenges to the U S WEST Centrex Action (as
defined below) fail and no favorable settlement agreement is reached, there
could be a material adverse effect on the Company's planned expansions and
business prospects. See "Legal Proceedings."
Risks Associated With Acquisitions. As part of its business strategy,
the Company acquired Ruffalo, Cody and McLeodUSA Publishing during 1996 and
will continue to evaluate additional strategic acquisitions and alliances
principally relating to its current operations. Such transactions commonly
involve certain risks including, among others: the difficulty of assimilating
the acquired operations and personnel; the potential disruption of the
Company's ongoing business; the possible inability of management to maximize
the financial and strategic position of the Company through the successful
incorporation of acquired assets and rights into the Company's service
offerings and the maintenance of uniform standards, controls, procedures and
policies; the risks of entering markets in which the Company has little or no
direct prior experience; and the potential impairment of relationships with
employees or customers as a result of changes in management. There can be no
assurance that the Company will be successful in overcoming these risks or any
other problems encountered in connection with the acquisitions of Ruffalo,
Cody and McLeodUSA Publishing or future transactions. In addition, any such
transactions could materially adversely affect the Company's operating results
due to dilutive issuances of equity securities, the incurrence of additional
debt and the amortization of expenses related to goodwill and other intangible
assets, if any. See "--Recent Transactions."
Need to Obtain and Maintain Permits and Rights-of-Way. In order to
develop and construct its network, the Company must obtain local franchises
and other licenses and permits, as well as rights to utilize underground
conduit and aerial pole space and other rights-of-way and easements from
entities such as local exchange carriers and other utilities, railroads,
interexchange carriers, state highway authorities, local governments and
transit authorities. The Company has entered into long-term agreements with
its two principal electric utility stockholders, IES and MidAmerican,
pursuant to which the Company generally has access to the electric utilities'
rights-of-way, poles and towers, primarily located in Iowa, for so long as the
utilities maintain their franchises to provide electrical services in a given
locality. There can be no assurance that IES, MidAmerican or the Company will
be able to maintain existing franchises, permits and rights-of-way or that the
Company will be able to obtain and maintain the other franchises, permits and
rights-of-way needed to implement its business plan on acceptable terms.
Although the Company believes that its existing arrangements will not be
canceled and will be renewed as needed in the near future, if any of the
existing franchises, license agreements or rights-of-way were terminated or
not renewed and the Company were forced to remove its facilities, such
cancellation or non-renewal of certain of such arrangements could have a
material adverse effect on the Company. See "--Network Facilities" and "--
Regulation."
Rapid Technological Changes. The telecommunications industry is subject
to rapid and significant changes in technology. While the Company believes
that for the foreseeable future these changes will neither materially
adversely affect the continued use of its fiber optic telecommunications
network nor materially hinder the Company's ability to acquire necessary
technologies, the effect of technological changes on the business of the
Company cannot be predicted. There can be no assurance that technological
developments in telecommunications will not have a material adverse effect on
the Company.
Variability of Operating Results. As a result of the significant
expenses associated with the construction and expansion of its network and
services, including, without limitation, the acquisition of PCS licenses and
the development, construction and operation of a PCS system, the Company
anticipates that its operating results could vary significantly from period to
period. Such variability could
32
have a material adverse effect on the Company. See "Management's Discussion
and Analysis of Financial Condition and Results of Operations."
Control of the Company. As of March 19, 1997, IES, MidAmerican, Allsop
Venture Partners III, L.P. and Clark and Mary McLeod owned, directly or
indirectly, in the aggregate approximately 41% of the outstanding Class A
Common Stock and all of the Class B Common Stock, which represented
approximately 50% of the combined voting power of the Common Stock. The Class
B Common Stock is convertible into Class A Common Stock at any time at the
option of the holders of Class B Common Stock. If all of the Class B Common
Stock were converted into Class A Common Stock, IES, MidAmerican, Allsop and
Mr. and Mrs. McLeod would hold approximately 59% of the Class A Common Stock
and voting power of the Company. Accordingly, such stockholders collectively
are able to control the management policy of the Company and all fundamental
corporate actions, including mergers, substantial acquisitions and
dispositions, and election of the Board. IES, MidAmerican and Mr. and Mrs.
McLeod also have entered into a voting agreement with respect to the election
of directors. The Restated Certificate contains provisions that may make it
more difficult to effect a hostile takeover of the Company or to remove
members of the Board.
Volatility of Stock Price. Since the Class A Common Stock has been
publicly traded, the market price of the Class A Common Stock has fluctuated
over a wide range and may continue to do so in the future. See "Market for
Registrant's Common Equity and Related Stockholder Matters--Price Range of
Class A Common Stock." In the future, the market price of the Class A Common
Stock could be subject to significant fluctuations in response to various
factors and events, including, among other things: the depth and liquidity of
the trading market of the Class A Common Stock; quarterly variations in the
Company's actual or anticipated operating results or growth rates; changes in
estimates by analysts; market conditions in the industry; announcements by
competitors; regulatory and judicial actions; and general economic conditions.
In addition, the stock market has from time to time experienced significant
price and volume fluctuations, which have particularly affected the market
prices of the stocks of high growth companies, and which may be unrelated to
the operating performance of particular companies. As a result of the
foregoing, there can be no assurance that the price of the Class A Common
Stock will not continue to fluctuate or will not decline.
Dependence on Regional Bell Operating Companies; U S WEST Centrex Action.
See "Legal Proceedings--Dependence on Regional Bell Operating Companies; U S
WEST Centrex Action."
Refusal of U S WEST to Improve its Processing of Service Orders. See
"Legal Proceedings--Refusal of U S WEST to Improve its Processing of Service
Orders."
Competition. See "--Competition."
Regulation. See "--Regulation."
Employees
As of December 31, 1996, the Company employed a total of 1,713 full-time
employees and 364 part-time employees. The Company believes that its future
success will depend on its continued ability to attract and retain highly
skilled and qualified employees. The Company believes that its relations with
its employees are good.
33
Executive Officers of the Company
The following is a list of the executive officers of the Company,
together with biographical summaries of their experience. The ages of the
persons set forth below are as of December 31, 1996.
Name Age Position(s) with Company
---- --- ------------------------
Clark E. McLeod.............. 50 Chairman, Chief Executive Officer and Director
Stephen C. Gray.............. 38 President, Chief Operating Officer and Director
Blake O. Fisher, Jr.......... 52 Chief Financial Officer, Executive Vice President,
Corporate Administration, Treasurer and Director
Kirk E. Kaalberg............. 37 Executive Vice President, Network Services
Stephen K. Brandenburg....... 44 Executive Vice President and Chief Information Officer
David M. Boatner............. 48 Executive Vice President, Business Services
Albert P. Ruffalo............ 50 Executive Vice President, Consumer Services
Arthur L. Christoffersen..... 50 Executive Vice President, Publishing Services
Casey D. Mahon............... 45 Senior Vice President, General Counsel and Secretary
Clark E. McLeod. Mr. McLeod founded the Company and has served as
Chairman, Chief Executive Officer and a director of the Company since its
inception in June 1991. His previous business venture, Teleconnect, an Iowa-
based long distance telecommunications company, was founded in January 1980.
Mr. McLeod served as Chairman and Chief Executive Officer of Teleconnect from
January 1980 to December 1988, and from December 1988 to August 1990, he
served as President of Telecom*USA, the successor to Teleconnect following its
merger with SouthernNet, Inc. in December 1988. By 1990, Telecom*USA had
become America's fourth largest long distance telecommunications company with
nearly 6,000 employees. MCI purchased Telecom*USA in August 1990 for $1.25
billion.
Stephen C. Gray. Mr. Gray has been Chief Operating Officer of the
Company since September 1992, President since October 1994 and a director
since April 1993. Prior to joining the Company, Mr. Gray served from August
1990 to September 1992 as Vice President of Business Services at MCI, where he
was responsible for MCI's local access strategy and for marketing and sales
support of the Business Markets division. From February 1988 to August 1990,
he served as Senior Vice President of National Accounts and Carrier Services
for Telecom*USA, where his responsibilities included sales, marketing, key
contract negotiations and strategic acquisitions and combinations. Prior to
joining Telecom*USA, from September 1986 to February 1988, Mr. Gray held a
variety of management positions with Williams Telecommunications Company, a
long distance telephone company. From August 1983 to September 1986, Mr. Gray
held a variety of management positions with Clay Desta Communications, Inc., a
long distance company.
Blake O. Fisher, Jr. Mr. Fisher has served as a director of the Company
since October 1996, as Executive Vice President, Corporate Administration
since September 1996 and as Chief Financial Officer and Treasurer since
February 1996. Mr. Fisher also served as one of IES' nominees on the Board
from April 1993 to February 1996. He served as Executive Vice President and
Chief Financial Officer of IES, a diversified electric utility holding
company, from January 1991 to February 1996. Mr. Fisher also served as
President of IES Utilities Inc. from February 1995 to February 1996. Prior to
joining IES, Mr. Fisher held a variety of management positions with Consumers
Power Company, an electric utility, including Vice President of Finance and
Treasurer.
Kirk E. Kaalberg. Mr. Kaalberg has served since September 1996 as the
Company's Executive Vice President, Network Services where he is responsible
for the maintenance of the Iowa Communications Network and the design and
development of the Company's network and switching platforms. From March 1994
to September 1996, Mr. Kaalberg served as Senior Vice President, Network
Design and Development and from January 1992 to February 1994, he served as
Vice President of the Company. From August 1990 to January 1992, Mr. Kaalberg
served as a senior manager of MCI, where he managed a 175-person conference
calling, financial and operations group. From August 1987 to
34
August 1990, Mr. Kaalberg was an employee of Teleconnect and its successor,
Telecom*USA, where he was responsible for business planning and management
information systems project prioritization. From 1983 to 1987, he held a
variety of product management positions with Banks of Iowa, Computer Services,
Inc., a computer services company, and Source Data Systems, a software
company.
Stephen K. Brandenburg. Mr. Brandenburg has served since September 1996
as Executive Vice President and Chief Information Officer of the Company,
where he is responsible for the design and deployment of the Company's
internal computing systems and operations. From June 1995 to September 1996,
he served as Senior Vice President, Intelligent Technologies and Systems of
the Company. Prior to joining the Company, Mr. Brandenburg served from August
1990 to June 1995 as Vice President, Revenue Management Systems at MCI, where
he was responsible for MCI's 1,400 person business markets traffic/call
processing, order/entry, billing and calling card operations. From 1987 to
August 1990, he served as Senior Vice President of Information Systems at
Teleconnect and its successor, Telecom*USA. Prior to joining Teleconnect, Mr.
Brandenburg held a variety of information systems positions with academic
medical centers, including the Mayo Medical Clinic and the University of
Wisconsin.
David M. Boatner. Mr. Boatner has served since September 1996 as
Executive Vice President, Business Services of the Company. From February 1996
to September 1996, he served as the Company's Senior Vice President, Sales and
Marketing. Prior to joining the Company, Mr. Boatner served from January 1995
to February 1996 as Regional Vice President of Sales of WorldCom, a long
distance telecommunications company, where he was responsible for sales in the
central, western and southwest regions of the United States. From May 1989 to
January 1995, Mr. Boatner served as Vice President for Commercial Sales of
WilTel, Inc., a long distance telecommunications company which was acquired by
WorldCom in January 1995. Prior to joining WilTel, Inc., Mr. Boatner held a
variety of positions at AT&T and its Bell operating subsidiaries.
Albert P. Ruffalo. Mr. Ruffalo has served as the Company's Executive
Vice President, Consumer Services since September 1996. Since August 1991 Mr.
Ruffalo has served as President and Chief Executive Officer of Ruffalo, Cody,
which was acquired by the Company on July 15, 1996. From September 1990 to
July 1991, Mr. Ruffalo served as President of MCI Direct, Inc., an indirect
wholly owned subsidiary of MCI. From 1983 to August 1990, Mr. Ruffalo held
various executive positions at Teleconnect and Telecom*USA Data Base Marketing
Company, an indirect wholly owned subsidiary of Telecom*USA, Teleconnect's
successor. From 1980 to 1983, Mr. Ruffalo was Marketing Manager of National
Oats Corporation, a grain distribution firm.
Arthur L. Christoffersen. Mr. Christoffersen has served as the
Company's Executive Vice President, Publishing Services since September 20,
1996, the date the Company acquired McLeodUSA Publishing. Mr. Christoffersen
has served as Chairman, President and Chief Executive Officer of McLeodUSA
Publishing since November 1990, the date Mr. Christoffersen and other
investors acquired McLeodUSA Publishing from MCI. From December 1987 to August
1990, Mr. Christoffersen served as Executive Vice President and Chief
Financial Officer of Teleconnect and its successor, Telecom*USA. From 1975 to
1987, Mr. Christoffersen held a variety of management positions, including
Executive Vice President, of Life Investors, Inc., a diversified financial
services company.
Casey D. Mahon. Ms. Mahon is responsible for the legal and regulatory
affairs of the Company, which she joined in June 1993 as General Counsel. Ms.
Mahon has served as Senior Vice President of the Company since February 1996
and as the Company's Secretary since July 1993. Prior to joining the Company,
she was engaged in the private practice of law, with emphasis on
telecommunications, regulatory and corporate law. From August 1990 to December
1990, she served as Vice President of Corporate Affairs at MCI, where she
assisted in transitional matters relating to MCI's purchase of Telecom*USA.
From March 1986 to August 1990, Ms. Mahon served as Senior Vice President,
General Counsel and Secretary of Teleconnect and its successor, Telecom*USA.
From 1977 to 1986, Ms. Mahon served in various legal, financial and faculty
positions at the University of Iowa.
35
Item 2. Properties.
The Company leases offices and space in a number of locations, primarily
for sales offices and network equipment installations. The Company's
headquarters is housed in 55,000 square feet of office space in Cedar Rapids,
Iowa, under a lease expiring in March 2001. In August 1996, the Company
purchased approximately 194 acres of farm land in southern Cedar Rapids, Iowa
on which the Company is constructing a one-story, 160,000 square foot building
to serve as the Company's new headquarters and plans to construct an
additional office building as well as other buildings that will house the
Company's telephone switching, computer and maintenance equipment. The total
cost of the construction of the Company's new corporate headquarters and
associated buildings is estimated to be approximately $27.5 million. The new
headquarters is scheduled for occupancy by mid-1997. In addition, the Company
owns 88 acres of undeveloped farm and forest land in southern Cedar Rapids,
Iowa.
Item 3. Legal Proceedings.
The Company is not aware of any material litigation against the Company.
The Company is involved in numerous regulatory proceedings before various
public utilities commissions, particularly the Iowa Utilities Board, as well
as before the FCC.
Dependence on Regional Bell Operating Companies; U S WEST Centrex Action.
The Company is dependent on the Regional Bell Operating Companies for
provision of its local and certain of its long distance services. As of the
date hereof, U S WEST and Ameritech are the Company's sole suppliers of access
to local central office switches. The Company uses such access to partition
the local switch and provide local service to its customers.
The Company purchases access in the form of a product generally known as
"Centrex." Without such access, the Company could not, as of the date hereof,
provide bundled local and long distance services, although it could provide
stand-alone long distance service. Since the Company believes its ability to
offer bundled local and long distance services is critical to its current
sales efforts, any successful effort by U S WEST or Ameritech to deny or
substantially limit the Company's access to partitioned switches would have a
material adverse effect on the Company.
On February 5, 1996, U S WEST filed tariffs and other notices announcing
its intention to limit future Centrex access to its switches by Centrex
customers (including the Company) throughout U S WEST's fourteen-state service
region, effective February 5, 1996 (the "U S WEST Centrex Action"). Although U
S WEST stated that it would "grandfather" existing Centrex agreements with the
Company and permit the Company to continue to use U S WEST's central office
switches through April 29, 2005, it also indicated that it would not permit
the Company to expand to new cities and would severely limit the number of new
lines it would permit the Company to partition onto U S WEST's portion of the
switches in cities served by the Company.
The Company has challenged, or is challenging, the U S WEST Centrex
Action before the public utilities commissions in certain of the states served
by U S WEST where the Company is doing business or plans to do business. The
Company based such challenges on various state and federal laws, regulations
and regulatory policies, including Sections 251(b)(1) and 251(c)(4)(B) of the
Telecommunications Act, which the Company believes impose upon the Regional
Bell Operating Companies the duty not to prohibit, and not to impose
unreasonable or discriminatory conditions or limitations on, the resale of
their telecommunications services, and Section 251(c)(4)(A) of the
Telecommunications Act, which the Company believes obligates the Regional Bell
Operating Companies to offer for resale at wholesale rates any telephone
communications services that are provided at retail to subscribers who are not
telecommunications carriers. Additional statutes cited in the Company's
challenges include provisions of the laws of Iowa, Minnesota, Nebraska, South
Dakota, North Dakota, Idaho and Colorado, which the Company believes prohibit
restrictions on the resale of local exchange services, functions or
capabilities; prohibit local exchange carriers from refusing access by other
carriers to essential facilities on the same terms and conditions as the local
exchange carrier provides to itself;
36
and prohibit the provision of carrier services pursuant to rates, terms and
conditions that are unreasonably discriminatory.
In Iowa, the Company filed a complaint with the Iowa Utilities Board
against U S WEST's actions and was granted interim relief on an ex parte basis
that allowed the Company to continue to expand to new cities and expand the
number of new lines partitioned onto U S WEST's switches. Subsequent to the
grant of interim relief, the Company on March 18, 1996 entered into a
settlement agreement with U S WEST that permits the Company to continue to
expand, without restrictions, the number of new lines it serves in Iowa
through March 18, 2001. In addition, the settlement agreement provides that
the Company may expand to seven new markets (central offices) in Iowa per year
through March 18, 2001. As a result of the settlement agreement, the Company
withdrew its complaint before the Iowa Utilities Board. Because MCI, AT&T and
others also challenged U S WEST's action, the Iowa Utilities Board continued
to review the U S WEST Centrex Action and on June 14, 1996 issued an order
rejecting U S WEST's filing. The order of the Iowa Utilities Board was
appealed by U S WEST and affirmed by the Iowa District Court for Polk County
on February 21, 1997.
In Minnesota, U S WEST's initial filing was rejected on procedural
grounds by the Public Utilities Commission. On April 30, 1996, U S WEST
refiled its proposed limitations on Centrex service in Minnesota, proposing to
"grandfather" the service to existing customers as of July 9, 1996. The
Company opposed this filing in a letter to the Minnesota Public Utilities
Commission on May 20, 1996. On May 31, 1996, the Minnesota Public Utilities
Commission issued an order suspending the new U S WEST filing and scheduling a
contested-case proceeding to consider it. On December 23, 1996, an
administrative law judge ruled that U S WEST must continue to offer Centrex
service in Minnesota. U S WEST filed exceptions to this ruling. The Minnesota
Public Utilities Commission denied U S WEST's exceptions on February 20, 1997.
U S WEST has filed a petition for rehearing with the Minnesota Public
Utilities Commission. As of the date hereof, the Minnesota Public Utilities
Commission had not yet ruled on the petition for a rehearing.
In South Dakota, the Public Utilities Commission rejected the U S WEST
Centrex Action on August 22, 1996. U S WEST appealed the unfavorable decision
of the Public Utilities Commission in South Dakota state court. On December 2,
1996, the South Dakota state court hearing the appeal affirmed the decision of
the Public Utilities Commission.
In North Dakota, on November 6, 1996, the Public Service Commission
concluded that the U S WEST Centrex Action is unlawful and ordered U S WEST to
reinstate Centrex service in North Dakota. U S WEST appealed the unfavorable
decision by the Public Service Commission in North Dakota state court. On
January 24, 1997, the North Dakota state court hearing the appeal affirmed the
decision of the Public Service Commission.
In Nebraska, on November 25, 1996, the Public Service Commission rejected
complaints objecting to the U S WEST Centrex Action. In Idaho, on November 14,
1996, the Public Utilities Commission rejected complaints by AT&T and MCI
objecting to the U S WEST Centrex Action. The Company subsequently filed its
own complaint with the Idaho Public Utilities Commission, which as of the date
hereof had not yet been ruled on by the Idaho Public Utilities Commission.
Other telecommunication firms also have challenged the U S WEST Centrex
Action in each of the other states where U S WEST engages in local telephone
service and public utilities commissions in several of those states have
rejected the U S WEST Centrex Action. In Oregon, U S WEST's filing was
rejected by the Public Utilities Commission on March 7, 1996. In Colorado, on
September 3, 1996, an administrative law judge issued a recommendation that
the U S WEST Centrex Action be rejected. On December 20, 1996, the Colorado
Public Utilities Commission rejected U S WEST's exceptions to the
recommendation. In Wyoming, U S WEST's filing was rejected by the Public
Service Commission on September 6, 1996. On March 21, 1997, the Wyoming Public
Service Commission rejected U S WEST's petition for a rehearing of the matter.
On October 29, 1996, the Arizona Corporation Commission rejected the U S WEST
Centrex Action. In New Mexico, the Public Service Commission has not allowed
U S WEST's filing to become effective. In Utah, on September 25, 1996, the
Public Service Commission
37
rejected the U S WEST Centrex Action and ordered U S WEST to continue the
availability of Centrex service for resale. In Montana, on March 6, 1997, the
Public Service Commission approved the U S WEST Centrex Action.
The Company anticipates that U S WEST will continue to appeal unfavorable
decisions by public utilities commissions with respect to the U S WEST Centrex
Action.
In addition to the U S WEST Centrex Action, U S WEST has taken other
measures that may impede the Company's ability to use Centrex service to
provide its competitive local exchange services. In Colorado, U S WEST filed
new tariffs in July 1996 that, as interpreted by U S WEST, would prohibit the
Company from consolidating telephone lines of separate customers into leased
common blocks in U S WEST's central office switches, thereby significantly
increasing the cost of serving customers in Colorado through resale of Centrex
services. The Company filed a complaint with the Colorado Public Utilities
Commission on February 12, 1997 alleging that U S WEST's tariffs, as
interpreted by U S WEST, unlawfully create a barrier to the Company's ability
to compete in Colorado. The Company's complaint is scheduled to be heard by
the Colorado Public Utilities Commission on April 7, 1997.
There can be no assurance that the Company will ultimately succeed in its
legal challenges to the U S WEST Centrex Action or other actions by U S WEST
that have the effect of preventing or deterring the Company from using Centrex
service, or that these actions by U S WEST, or similar actions by other
Regional Bell Operating Companies, will not have a material adverse effect on
the Company. In any jurisdiction where U S WEST prevails, the Company's
ability to offer integrated telecommunications services would be impaired,
which could have a material adverse effect on the Company. See "Business--
Competition."
If the U S WEST Centrex Action or other actions by U S WEST have the
effect of preventing or deterring the Company from using Centrex service in
any jurisdiction and the Company is consequently not able to obtain Centrex
access on acceptable economic terms or at all in a state where the Company is
doing business or plans to do business, the Company intends to evaluate other
U S WEST services that could potentially be purchased and resold in such
jurisdiction to allow the Company to provide some form of integrated local and
long distance services until the Company can obtain access to unbundled
elements pursuant to interconnection agreements. There can be no assurance
that the Company would be able to identify, purchase and resell any such U S
WEST service or ultimately obtain access to such unbundled elements.
The Company also anticipates that U S WEST will seek various legislative
initiatives in states within the Company's target market area in an effort to
reduce state regulatory oversight over its rates and operations. There can be
no assurance that U S WEST will not succeed in such efforts or that any such
state legislative initiatives, if adopted, will not have a material adverse
effect on the Company.
Refusal of U S WEST to Improve its Processing of Service Orders. As a
result of its use of the Centrex product, the Company depends upon U S WEST to
process service orders placed by the Company to transfer new customers to the
Company's local service. U S WEST has imposed a limit of processing one new
local service order of the Company per hour for each U S WEST central office.
Furthermore, according to the Company's records, U S WEST commits an error on
one of every three lines ordered by the Company, thereby further delaying the
transition of new customers to the Company's local service. The Company has
repeatedly requested that U S WEST increase its local service order processing
rate and improve the accuracy of such processing, which U S WEST refused to
do.
On July 12, 1996, the Company filed a complaint with the Iowa Utilities
Board against U S WEST in connection with such actions. At a hearing held to
consider the complaint, U S WEST acknowledged that it had not dedicated
resources to improve its processing of the Company's service orders to switch
new customers to the Company's local service because of its desire to limit
Centrex service. In an order issued on October 10, 1996, the Iowa Utilities
Board determined that U S WEST's limitation on the processing of the Company's
service orders constituted an unlawful discriminatory practice under Iowa law.
On October 21, 1996, in accordance with the Iowa Utilities Board's order, the
Company and
38
U S WEST jointly filed supplemental evidence regarding a potential
modification of order processing practices that would increase U S WEST's rate
of processing service orders. However, since implementing the new process, U S
WEST has not significantly increased its overall order processing rate. On
December 23, 1996, the Company filed a report with the Iowa Utilities Board
requesting further direction. On February 14, 1997, the Iowa Utilities Board
clarified that U S WEST must eliminate numerical limitations on the Company's
residential and business orders. There can be no assurance, however, that the
decision of or any further action by the Iowa Utilities Board will adequately
resolve the service order problems or that such problems will not impair the
Company's ability to expand or to attract new customers, which could have a
material adverse effect on the Company.
Item 4. Submission of Matters to a Vote of Security Holders.
None.
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder
Matters.
Price Range of Class A Common Stock
The Company completed its initial public offering of Class A Common Stock
in June 1996, at a price per share of Class A Common Stock of $20.00. The
Class A Common Stock has been quoted on The Nasdaq National Market under the
symbol "MCLD" since June 11, 1996. Prior to June 11, 1996, no established
public trading market for the Class A Common Stock existed. The following
table sets forth for the periods indicated the high and low sales price per
share of the Class A Common Stock as reported by The Nasdaq National Market.
1996 High Low
---- ------- -------
Second Quarter (from June 11, 1996).... $26.75 $22.25
Third Quarter.......................... $39.50 $23.50
Fourth Quarter......................... $34.50 $25.00
On March 19, 1997, the last reported sale price of the Class A Common
Stock on The Nasdaq National Market was $18.875 per share. On March 19, 1997,
there were 508 holders of record of the Class A Common Stock and two holders
of record of the Class B Common Stock.
Dividend Policy
The Company has never declared or paid any cash dividends on its capital
stock and does not anticipate paying dividends in the foreseeable future. The
Company will effectively be prohibited from paying cash dividends for the
foreseeable future pursuant to restrictions contained in the indenture
relating to the Notes (the "Indenture"). Future dividends, if any, will be at
the discretion of the Board and will depend upon, among other things, the
Company's operations, capital requirements and surplus, general financial
condition, contractual restrictions in financing agreements (including the
Indenture) and such other factors as the Board may deem relevant. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations--Liquidity and Capital Resources."
Recent Sales of Unregistered Securities
During 1996, the Company offered and sold the following equity securities
that were not registered under the Securities Act of 1933, as amended (the
"Securities Act"):
(1) In February 1996, the Company issued 23,438 shares of Class A Common
Stock to Blake O. Fisher, Jr. upon the exercise of stock options granted to
Mr. Fisher pursuant to the Company's Directors Stock Option Plan. The price
per share was $.99, for an aggregate consideration of $23,125.
39
(2) On July 15, 1996, the Company acquired Ruffalo, Cody in a cash and
stock transaction valued at up to a maximum of approximately $19.9 million,
based on the average closing sales price of the Class A Common Stock on The
Nasdaq National Market at the time of the transaction. On July 15, 1996, the
Company paid approximately $4.8 million in cash and issued 361,420 shares of
Class A Common Stock to the shareholders of Ruffalo, Cody, and granted options
to purchase 158,009 shares of Class A Common Stock to the holders of options
to purchase shares of Ruffalo, Cody common stock. An additional $50,782 in
cash and 113,387 shares of Class A Common Stock were placed into escrow to be
delivered to certain of the shareholders of Ruffalo, Cody over a period of 18
months, contingent upon the fulfillment of certain conditions relating to
Ruffalo, Cody's ongoing revenues from a material agreement with a major long
distance carrier to provide telemarketing services. The major long distance
carrier terminated this agreement, effective December 31, 1996. A total of
$50,782 and 37,107 shares of Class A Common Stock were distributed pursuant to
the escrow agreement in January 1997 and the Company expects one additional
distribution of 19,070 shares of Class A Common Stock to occur in April 1997.
See "Executive Compensation" for information regarding the grant of
options to purchase shares of Class A Common Stock to certain employees
pursuant to the Company's 1996 Employee Stock Option Plan as partial
consideration for the execution of employment, confidentiality and non-
competition agreements.
Each issuance of securities described above was made in reliance upon the
exemption from registration provided by Section 4(2) of the Securities Act or
Regulation D promulgated thereunder for transactions by an issuer not
involving any public offering. The recipients of securities in each such
transaction represented their intention to acquire the securities for
investment only and not with a view to or for distribution in connection with
such transactions. All recipients had adequate access to information about the
Company through their relationship with the Company or through information
about the Company made available to them.
40
Item 6. Selected Financial Data.
The following table sets forth selected consolidated financial data and
should be read in conjunction with and is qualified by reference to
"Management's Discussion and Analysis of Financial Condition and Results of
Operations," the Consolidated Financial Statements of the Company, the notes
thereto and the other financial data contained elsewhere in this Form 10-K.
(In thousands except per share data)
Year Ended December 31,
-------------------------------------------------------------
1996(1)(2) 1995(1)(3) 1994 1993 1992
------------- ------------- ---------- --------- --------
Operations Statement Data:
Revenue........................................... $ 81,323 $ 28,998 $ 8,014 $ 1,550 $ 250
-------- -------- -------- ------- -------
Operating expenses:
Cost of service............................... 52,624 19,667 6,212 1,528 262
Selling, general and administrative........... 46,044 18,054 12,373 2,390 219
Depreciation and amortization................. 8,485 1,835 772 235 6
Other......................................... 2,380 -- -- -- --
-------- -------- -------- ------- -------
Total operating expenses...................... 109,533 39,556 19,357 4,153 487
-------- -------- -------- ------- -------
Operating loss.................................... (28,210) (10,558) (11,343) (2,603) (237)
Interest income (expense), net.................... 5,369 (771) (73) 163 --
Other non-operating expenses...................... 495 -- -- -- --
Income taxes...................................... -- -- -- -- --
-------- -------- -------- ------- -------
Net loss.......................................... $(22,346) $(11,329) $(11,416) $(2,440) $ (237)
======== ======== ======== ======= =======
Loss per common and common equivalent share....... $ (.52) $ (.31) $ (.31) $ (.08) $ (.02)
======== ======== ======== ======= =======
Weighted average common and common equivalent
shares outstanding............................ 43,019 37,055 36,370 29,655 14,925
======== ======== ======== ======= =======
December 31,
-----------------------------------------------------------------------------
As Adjusted
1996(4) 1996(1)(5) 1995(1)(6) 1994 1993 1992
-------- ---------- ---------- ---- ---- ----
(unaudited)
Balance Sheet Data:
Current assets...................... $513,851 $224,401 $ 8,507 $ 4,862 $ 7,077 $ 544
Working capital (deficit)........... $475,418 $185,968 $ (1,208) $ 1,659 $ 5,962 $ (440)
Property and equipment, net......... $ 92,123 $ 92,123 $ 16,119 $ 4,716 $ 1,958 $ 135
Total assets........................ $752,994 $452,994 $ 28,986 $ 10,687 $ 9,051 $ 694
Long-term debt...................... $302,573 $ 2,573 $ 3,600 $ 3,500 -- --
Stockholders' equity (deficit)...... $403,429 $403,429 $ 14,958 $ 3,291 $ 7,936 $ (290)
Year Ended December 31,
------------------------------------------------------------
1996(1)(2) 1995(1)(3) 1994 1993 1992
---------- ---------- ---- ---- ----
Other Financial Data:
Capital expenditures, including
business acquisitions........................ $173,782 $ 14,697 $ 3,393 $ 2,052 $ 138
EBITDA(7)........................................ $(17,345) $ (8,723) $(10,571) $(2,368) $ (231)
- -----------------------------------
(1) The acquisitions of MWR, Ruffalo, Cody and McLeodUSA Publishing in April
1995, July 1996 and September 1996, respectively, affect the comparability
of the historical data presented to the historical data for prior periods
shown.
(2) Includes operations of Ruffalo, Cody from July 16, 1996 to December 31, 1996
and operations of McLeodUSA Publishing from September 21, 1996 to December
31, 1996.
(3) Includes operations of MWR from April 29, 1995 to December 31, 1995.
(4) Adjusted to reflect the application of proceeds of $289.5 million (net of
discount and commissions and other offering expenses in an aggregate amount
of $10.5 million) from the Company's March 1997 private offering of the
Notes.
(5) Includes Ruffalo, Cody and McLeodUSA Publishing, which were acquired by the
Company on July 15, 1996 and September 20, 1996, respectively.
(6) Includes MWR, which was acquired by the Company on April 28, 1995.
(7) EBITDA consists of operating loss before depreciation, amortization and
other nonrecurring operating expenses. The Company has included EBITDA data
because it is a measure commonly used in the industry. EBITDA is not a
measure of financial performance under generally accepted accounting
principles and should not be considered an alternative to net income as a
measure of performance or to cash flows as a measure of liquidity.
41
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations.
The following discussion and analysis should be read in conjunction
with the Company's Consolidated Financial Statements and the notes thereto and
the other financial data appearing elsewhere in this Form 10-K.
Overview
The Company has historically derived its telecommunications revenue
from (i) the sale of local and long distance telecommunications services to
end users, (ii) telecommunications network maintenance services and (iii)
special access and private line services. The Company also derives revenue
from ancillary services as a result of its acquisitions of Ruffalo, Cody,
McLeodUSA Publishing and Digital Communications in July 1996, September 1996
and January 1997, respectively. The Company began deriving revenue from direct
marketing and telemarketing services on July 15, 1996, the date the Company
acquired Ruffalo, Cody. The Company began deriving revenue from the sale of
advertising space in telephone directories published by McLeodUSA Publishing
on September 20, 1996, the date the Company acquired McLeodUSA Publishing. The
Company began deriving revenue from the sale, installation and service of
business telephone systems on January 30, 1997, the date the Company acquired
Digital Communications. See "Business--Recent Transactions" and "--Liquidity
and Capital Resources." The table set forth below summarizes the Company's
percentage of revenues from these sources:
Year Ended
December 31,
-------------------
1996 1995 1994
----- ----- -----
Local and long distance
telecommunications services ............ 51% 74% 58%
Telecommunications network maintenance
services ............................... 7 17 42
Special access and private line services. 13 9 --
Ancillary services ...................... 29 -- --
---- ---- ----
100% 100% 100%
==== ==== ====
The Company began offering "bundled" local and long distance services to
business customers in January 1994. At the end of 1995, the Company began
providing, on a test basis, long distance services to residential customers.
In June 1996, the Company began marketing and providing to residential
customers in Cedar Rapids, Iowa and Iowa City, Iowa an integrated package of
telecommunications services, marketed under the name PrimeLine(R), that
includes local and long distance service, voice mail, paging, Internet access
and travel card services. The Company expanded its PrimeLine(R) service to
Cedar Falls, Iowa and Waterloo, Iowa in January 1997 and Des Moines, Iowa in
February 1997. The Company plans to continue its efforts to market and provide
local, long distance and other telecommunications services to business
customers and plans to accelerate its efforts to market its PrimeLine(R)
service to residential customers. The Company believes its efforts to market
its integrated telecommunications services will be enhanced by its July 1996
acquisition of Ruffalo, Cody, which specializes in direct marketing and
telemarketing services, including telecommunications sales, and its September
1996 acquisition of McLeodUSA Publishing, which publishes and distributes
"white page" and "yellow page" telephone directories in fifteen states in the
midwestern and Rocky Mountain regions of the United States, including most of
the Company's target markets.
Because its revenue from network maintenance is derived almost
exclusively from the Iowa Communications Network Maintenance Contract and such
revenue is expected to increase more slowly than the Company's other types of
revenue, the Company expects that revenue derived from network maintenance
services will continue to constitute a decreasing percentage of the Company's
revenue in the future. Special access and private line services as a
percentage of the Company's total revenue increased in 1995 due to the revenue
generated by MWR, which was acquired in April 1995. Excluding the ancillary
revenues the Company began deriving following the acquisitions of Ruffalo,
Cody and
42
McLeodUSA Publishing, the percentage of total revenues from the Company's
three historical sources would have been 72%, 10% and 18%, respectively, for
the year ended December 31, 1996.
The Company's principal operating expenses consist of cost of service;
selling, general and administrative expenses ("SG&A"); and depreciation and
amortization. Cost of service primarily includes local services purchased from
two Regional Bell Operating Companies, costs to terminate the long distance
calls of the Company's customers through an interexchange carrier, costs
associated with maintaining the Iowa Communications Network and costs
associated with operating the Company's network. Cost of service also includes
the costs of printing and distributing the telephone directories published by
McLeodUSA Publishing. SG&A consists of selling and marketing, customer service
and corporate administrative expenses. Depreciation and amortization include
depreciation of the Company's telecommunications network and equipment;
amortization of goodwill related to the Company's acquisitions, including its
acquisitions of MWR, Ruffalo, Cody and McLeodUSA Publishing; amortization
expense related to the excess of estimated fair market value in aggregate of
certain options over the aggregate exercise price of such options granted to
certain officers, other employees and directors; and amortization of one-time
installation costs associated with transferring customers' local line service
from the Regional Bell Operating Companies to the Company's telemanagement
service.
As the Company expands into new markets, both cost of service and SG&A
will increase. The Company expects to incur SG&A expenses prior to achieving
significant revenues in new markets. Significant levels of marketing activity
may be necessary in new markets in order for the Company to build a customer
base large enough to generate sufficient revenue to offset such marketing
expenses. In addition, SG&A may increase as a percentage of total revenue in
the short term after the Company enters a new market, because many of the
fixed costs of providing service in new markets are incurred before
significant revenue can be expected from those markets.
In January and February 1996, the Company granted options to purchase an
aggregate of 965,166 and 688,502 shares of Class A Common Stock, respectively,
at an exercise price of $2.67 per share, to certain directors, officers and
other employees. The estimated fair market value of these options, in the
aggregate, at the date of grant was later determined to exceed the aggregate
exercise price by approximately $9.2 million. This amount will be amortized on
a monthly basis over the four-year vesting period of the options.
The Company has experienced operating losses since its inception as a
result of efforts to build its customer base, develop and construct its
network infrastructure, build its internal staffing, develop its systems and
expand into new markets. The Company expects to continue to focus on
increasing its customer base and geographic coverage. Accordingly, the Company
expects that its cost of service, SG&A and capital expenditures will continue
to increase significantly, all of which may have a negative impact on
operating results. The Company expects to incur significant operating losses
and to generate negative cash flows from operating and construction activities
during the next several years while it develops its business, installs and
expands its fiber optic network and develops and constructs its proposed PCS
system. In addition, the Company may be forced to change its pricing policies
to respond to a changing competitive environment, and there can be no
assurance that the Company will be able to maintain its operating margin. See
"Business--Competition" and "Business--Regulation." There can be no assurance
that growth in the Company's revenue or customer base will continue or that
the Company will be able to achieve or sustain profitability or positive cash
flows.
The Company has generated net operating losses since its inception and,
accordingly, has incurred no income tax expense. The Company has reduced the
net deferred tax assets generated by these losses by a valuation allowance
which offsets the net deferred tax asset due to the uncertainty of realizing
the benefit of the tax loss carryforwards. The Company will reduce the
valuation allowance when, based on the weight of available evidence, it is
more likely than not that some portion or all of the deferred tax assets will
be realized.
43
Year Ended 1996 Compared with Year Ended 1995
Revenue increased from $29 million for the year ended December 31, 1995
to $81.3 million for the year ended December 31, 1996, representing an
increase of $52.3 million or 180%. Revenue from the sale of local and long
distance telecommunications services accounted for $19.9 million of this
increase. Total local and long-distance customers increased 103% from 8,776 at
December 31, 1995 to 17,872 at December 31, 1996. Local lines under the
Company's management increased 83% from 35,795 at December 31, 1995 to 65,367
at December 31, 1996. Average lines per customer decreased from 4.31 at
December 31, 1995 to 3.95 at December 31, 1996, due to the increase in
residential customers. Average monthly revenue per line decreased from $62.68
for the month ended December 31, 1995 to $59.90 for the month ended December
31, 1996, also due to the increase in residential customers.
Included in the year ended December 31, 1996 revenue was $8.6 million of
revenue from Ruffalo Cody, which was acquired on July 15, 1996, and $15.1
million in revenue from McLeodUSA Publishing, which was acquired on September
20, 1996. Excluding these acquisitions, 1996 revenue would have been $57.6
million.
Cost of service increased from $19.7 million for the year ended December
31, 1995 to $52.6 million for the year ended December 31, 1996, an increase of
$32.9 million or 168%. This increase in cost of service was due primarily to
the growth in the Company's local and long distance telecommunications
services and to the acquisitions of Ruffalo, Cody and McLeodUSA Publishing,
which contributed $4.5 million and $6.7 million, respectively, to the
increase. Cost of service as a percentage of revenue decreased from 68% to
65%, primarily as a result of the effect of these acquisitions. The cost of
providing local and long-distance services as a percentage of local and long
distance telecommunications revenue increased from 68% for the year ended
December 31, 1995 to 70% for the year ended December 31, 1996, primarily as a
result of an increased number of higher volume, price-sensitive customers and
increased local line costs associated with expansion into new markets.
SG&A increased from $18.1 million for the year ended December 31, 1995 to
$46 million for the year ended December 31, 1996, an increase of $27.9 million
or 155%. The acquisitions of Ruffalo Cody and McLeodUSA Publishing contributed
$3.3 million and $7.3 million, respectively, to the increase. Increased costs
of $17.3 million related to expansion of selling, customer support and
administration activities to support the Company's growth also contributed to
this increase.
Depreciation and amortization expenses increased from $1.8 million for
the year ended December 31, 1995 to $8.5 million for the year ended December
31, 1996, an increase of $6.7 million or 362%. This increase consisted of $2.1
million related to the acquisitions of Ruffalo, Cody and McLeodUSA Publishing;
amortization expense of $2 million related to the excess of estimated
aggregate fair market value of certain options over the aggregate exercise
price of such options granted to certain officers, other employees, and
directors; and $2.6 million due primarily to the growth of the Company's
network in 1996.
Other operating expense in 1996 represented the realization of a purchase
accounting adjustment related to the capitalization of costs associated with
directories in progress at the time the Company acquired McLeodUSA Publishing.
The Company had net interest income of $5.4 million for the year ended
December 31, 1996 compared to net interest expense of $771,000 for the year
ended December 31, 1995 as a result of earnings on investments made with a
portion of the proceeds of the Company's public offerings of Class A Common
Stock during 1996 and decreased interest expense on reduced borrowings as a
result of the Company's payment of all amounts outstanding under a bank credit
facility maintained by the Company from May 1994 until June 1996 (the "Credit
Facility") with a portion of the net proceeds from the Company's initial
public offering of Class A Common Stock. The Company also had other non-
operating income of $495,000 for the year ended December 31, 1996.
44
Net loss increased from $11.3 million for the year ended December 31,
1995 to $22.3 million for the year ended December 31, 1996, an increase of $11
million. This increase resulted primarily from the expansion of the local and
long distance businesses, amortization and other operating expenses related to
the acquisitions of Ruffalo, Cody and McLeodUSA Publishing and amortization
expense related to stock options granted to certain officers, other employees
and directors. The development of the Company's business and the construction
and expansion of its network require significant expenditures, a substantial
portion of which is incurred before the realization of revenues.
Operating loss before depreciation, amortization and other nonrecurring
operating expenses ("EBITDA") decreased from a negative $8.7 million for the
year ended December 31, 1995 to a negative $17.3 million for the year ended
December 31, 1996, a decrease of $8.6 million. The change reflected the
increase in the operating loss incurred in 1996 due primarily to the expansion
of the Company's local, long distance and other telecommunications services
and the factors described above.
Year Ended 1995 Compared with Year Ended 1994
Revenue increased from $8 million in 1994 to $29 million in 1995,
representing an increase of $21 million or 262%. Revenue from the increase in
the sale of local and long distance telecommunications services accounted for
$16.9 million of this increase. Total local and long distance customers served
increased 69% from 5,137 at December 31, 1994 to 8,700 at December 31, 1995.
Local lines under the Company's management increased 109% from 17,112 at
December 31, 1994 to 35,795 at December 31, 1995. Average lines per customer
increased from 3.33 at December 31, 1994 to 4.31 at December 31, 1995. Average
monthly revenue per line increased from $58.30 for the month ended December
31, 1994 to $62.68 for the month ended December 31, 1995.
Revenue from telecommunications network maintenance services was $4.9
million in 1995. The Company acquired MWR, a competitive access provider that
offers most of the Company's special access and private line services, in
April 1995 in an acquisition accounted for as a purchase. MWR represented $1.6
million of the Company's revenue in 1995.
Cost of service increased from $6.2 million in 1994 to $19.7 million in
1995, an increase of $13.5 million or 217%. This increase in cost of service
resulted primarily from costs for providing local and long distance services.
Cost of service as a percentage of revenue decreased from 78% in 1994 to 68%
in 1995, principally as a result of certain economies of scale.
SG&A increased from $12.4 million in 1994 to $18.1 million in 1995, an
increase of $5.7 million or 46%. This increase was due to increased
compensation resulting from selling and customer support activities of $2.8
million, additional administrative personnel expense of $1.6 million and
associated costs of $1.3 million required to handle the growth experienced
primarily in local and long distance revenues.
Depreciation and amortization expenses increased from $772,000 in 1994 to
$1.8 million in 1995, an increase of $1 million or 138%. This increase
consisted of depreciation of $362,000 related to the additional fiber optic
network purchased and built during 1995; $304,000 of depreciation related to
capital costs associated with the growth of the Company; $266,000 resulting
from the amortization of one-time installation costs primarily associated with
transferring customers' local line service from the Regional Bell Operating
Companies to the Company's telemanagement service; and amortization of
goodwill of $117,000 related to the Company's acquisition of MWR in 1995.
Net interest expense increased from $73,000 in 1994 to $771,000 in 1995.
This net increase resulted from an increase in interest expense of $692,000
due to the need for additional secured debt in 1995 to fund the Company's
growth and operating losses and a decrease in interest income of $6,000
resulting from reduced investment of funds due to the use of funds needed to
satisfy working capital needs.
45
The Company's net loss decreased from $11.4 million in 1994 to $11.3
million in 1995, a decrease of $87,000. This decrease resulted from the
ability of the Company to generate additional service income while reducing
customer acquisition and support costs as a percentage of service income.
EBITDA improved from a negative $10.6 million in 1994 to a negative $8.7
million in 1995, an improvement of $1.9 million. The improvement reflected the
decrease in the net loss and the increase in depreciation and amortization in
1995 resulting from the capital expenditures necessary to support the
Company's revenue growth.
Year Ended 1994 Compared with Year Ended 1993
Telecommunications revenue increased from $1.6 million in 1993 to $8
million in 1994, representing an increase of $6.4 million or 417%. This
increase reflected an increase in revenue from the Iowa Communications Network
Maintenance Contract of $1.9 million as well as the Company's commencement of
local and long distance service. The increased revenue from the Iowa
Communications Network Maintenance Contract resulted from the ability to
charge full maintenance costs in 1994 versus reduced charges in 1993 because
of a warranty period on the network.
Cost of service increased from $1.5 million in 1993 to $6.2 million in
1994, an increase of $4.7 million or 307%. This increase in cost of service
resulted primarily from costs for providing local and long distance services.
SG&A increased from $2.4 million in 1993 to $12.4 million in 1994, an
increase of $10 million or 418%. This increase was due to increased
compensation resulting from selling and customer support activities of $5.5
million, additional administrative personnel of $1.8 million and associated
costs of $2.7 million resulting from the start-up of local and long distance
services.
Depreciation and amortization expenses increased from $235,000 in 1993 to
$772,000 in 1994, an increase of $537,000 or 228%. This increase was primarily
due to depreciation on the increased capital expenditures required to enter
the local and long distance businesses and the amortization of one time
installation costs associated with transferring customers' local line service
from the Regional Bell Operating Companies to the Company's telemanagement
service.
Interest income in 1993 was $163,000 compared to net interest expense of
$73,000 in 1994. The decrease resulted from an increase in interest expense of
$218,000 due to the need for additional secured debt in 1994 to fund the
Company's growth and operating losses and a decrease in interest income of
$18,000 resulting from reduced investment of funds due to the use of funds
needed to satisfy the Company's working capital needs.
The Company's net loss increased from $2.4 million in 1993 to $11.4
million in 1994, an increase of $9 million. This increase was primarily due to
the Company's entry into the local and long distance businesses.
EBITDA decreased from a negative $2.4 million in 1993 to a negative $10.6
million in 1994, a decrease of $8.2 million. The decrease reflected the
increased losses incurred in 1994 related to the Company's entry into the
local and long distance businesses.
Liquidity and Capital Resources
Since the inception of the Company in June 1991, the Company's total
assets have grown to $453 million (approximately $753 million as adjusted to
reflect the application of the net proceeds from the Company's March 1997
private offering of the Notes) at December 31, 1996. At December 31, 1996,
$92.1 million of the total assets consisted of property and equipment, net of
depreciation. The growth of the Company has been funded through private sales
of equity securities yielding proceeds of $41 million, drawings under the
Credit Facility, net proceeds of approximately $396.2 million from public
offerings of Class A Common Stock, and net proceeds of approximately $289.5
million from the Company's March
46
1997 private offering of the Notes. At December 31, 1996, the Company's
current assets of $224.4 million exceeded its current liabilities of $38.4
million, providing working capital of $186 million, which represents an
improvement of $187.2 million compared to December 31, 1995 primarily
attributable to the Company's completion of its public offerings of Class A
Common Stock in 1996. At December 31, 1995, the Company's current liabilities
of $9.7 million exceeded current assets of $8.5 million, resulting in a
working capital deficit of $1.2 million. This working capital deficit resulted
from the growth experienced by the Company, the increase in working capital
components and the substantial investment in property and equipment.
The net cash used in operating activities totaled $11.8 million for the
year ended December 31, 1996 and $9.5 million for the year ended December 31,
1995. During the year ended December 31, 1996, cash for operating activities
was used primarily to fund the Company's net loss of $22.3 million for such
period. The Company also required cash to fund the growth in trade receivables
of $9.3 million offset by a decrease in other current assets of $675,000. The
increase in accounts receivable was a result of the growth in local and long
distance telecommunications services and special access and private line
services. This use of cash was partially offset by an increase in accounts
payable and accrued expenses of $3.2 million due to the costs associated with
the increase in telecommunications revenue, an increase in deferred revenue of
$9.5 million resulting primarily from amounts received in advance in
connection with the completion of construction of network segments under long-
term leases of fiber optic telecommunication networks and an increase in
depreciation and amortization expense. During the year ended December 31,
1995, cash for operating activities was used primarily to fund the Company's
net loss of $11.3 million for such period. The Company also required cash to
fund the growth in trade receivables of $3.6 million and deferred line
installation costs of $800,000 as a result of the growth in local and long
distance telecommunications services and entry into special access and private
line services. The use of cash during the year ended December 31, 1995 was
partially offset by an increase in accounts payable and accrued expenses of
$4.1 million due to the costs associated with the increase in
telecommunications revenue and an increase in depreciation and amortization
expense.
The Company's investing activities used cash of $283.1 million during the
year ended December 31, 1996 and $5.5 million during the year ended December
31, 1995. The significant use of cash for investing activities for the year
ended December 31, 1996 consisted of the purchase of available-for-sale
securities with certain of the net proceeds from the Company's public
offerings of Class A Common Stock, the purchase of Ruffalo, Cody and McLeodUSA
Publishing, and the Company's continued development and expansion of its fiber
optic telecommunications network.
During 1994, the Company started building its telemanagement business by
offering local and long distance services to business customers through the
purchase of Centrex services from two Regional Bell Operating Companies and
interexchange carrier services for termination of long distance calls. The
equipment required for the growth of the telemanagement business, the
Company's development and construction of its fiber optic telecommunications
network and other capital expenditures resulted in purchases of equipment,
fiber optic cable and other property and equipment totaling $70.3 million and
$5.3 million during the years ended December 31, 1996 and 1995, respectively.
Cash received from net financing activities was $391.4 million during the
year ended December 31, 1996, primarily as a result of the Company's public
offerings of Class A Common Stock in June and November 1996. The Company paid
off and canceled the Credit Facility in June 1996 with a portion of the net
proceeds from its initial public offering of Class A Common Stock. Cash
received from financing activities during 1995 was $15 million and was
primarily obtained through the issuance of Class A Common Stock for an
aggregate purchase price of $14 million in a private placement transaction. In
addition, in April 1995 the Company issued Class B Common Stock valued at $8.3
million to acquire MWR.
On March 4, 1997, the Company received net proceeds of approximately
$289.5 million from a private offering of the Notes. The Notes will accrete to
an aggregate principal amount of $500 million by March 1, 2002. Interest will
not accrue on the Notes prior to March 1, 2002. Thereafter, interest will
accrue at a rate of 10 1/2% per annum and will be payable semi-annually on
March 1 and September 1 of
47
each year, commencing September 1, 2002. The Notes will be redeemable, at the
option of the Company, in whole or in part, at any time on or after March 1,
2002, at 105.25% of their principal amount at maturity, plus accrued and
unpaid interest, declining to 100% of their principal amount at maturity, plus
accrued and unpaid interest, on or after March 1, 2005. In the event of
certain equity investments in the Company by certain strategic investors on or
before March 1, 2000, the Company may, at its option, use all or a portion of
the net proceeds therefrom to redeem up to a maximum of 331/3% of the original
principal amount of the Notes at a redemption price of 110.5% of the accreted
value thereof. In addition, in the event of a change of control of the
Company, each holder of Notes will have the right to require the Company to
repurchase all or any part of such holder's Notes at a repurchase price equal
to 101% of the accreted value thereof prior to March 1, 2002, or 101% of the
principal amount thereof plus accrued and unpaid interest, if any, on or after
March 1, 2002.
The Notes are senior unsecured obligations of the Company ranking pari
passu in right of payment with all other existing and future senior unsecured
obligations of the Company and rank senior to all other existing and future
subordinated debt of the Company. The Notes are effectively subordinated to
all existing and future secured indebtedness of the Company and its
subsidiaries to the extent of the value of the assets securing such
indebtedness. The Notes also are effectively subordinated to all existing and
future third-party indebtedness and other liabilities of the Company's
subsidiaries.
The Indenture imposes operating and financial restrictions on the Company
and its subsidiaries. These restrictions affect, and in certain cases
significantly limit or prohibit, among other things, the ability of the
Company and its subsidiaries to incur additional indebtedness, pay dividends
or make distributions in respect of the Company's or such subsidiaries'
capital stock, make other restricted payments, enter into sale and leaseback
transactions, create liens upon assets, enter into transactions with
affiliates or related persons, sell assets, or consolidate, merge or sell all
or substantially all of their assets. There can be no assurance that such
covenants will not adversely affect the Company's ability to finance its
future operations or capital needs or to engage in other business activities
that may be in the interest of the Company.
On July 15, 1996, the Company acquired Ruffalo, Cody in a cash and stock
transaction valued at up to a maximum of approximately $19.9 million, based on
the average closing sales price of the Class A Common Stock on The Nasdaq
National Market at the time of the transaction. On July 15, 1996, the Company
paid approximately $4.8 million in cash and issued 361,420 shares of Class A
Common Stock to the shareholders of Ruffalo, Cody, and granted options to
purchase 158,009 shares of Class A Common Stock to the holders of options to
purchase shares of Ruffalo, Cody common stock. An additional $50,782 in cash
and 113,387 shares of Class A Common Stock were placed into escrow to be
delivered to certain of the shareholders of Ruffalo, Cody over a period of 18
months, contingent upon the fulfillment of certain conditions relating to
Ruffalo, Cody's ongoing revenues from a material agreement with a major long
distance carrier to provide telemarketing services. The major long distance
carrier terminated this agreement, effective December 31, 1996. A total of
$50,782 and 37,107 shares of Class A Common Stock were distributed pursuant to
the escrow agreement in January 1997 and the Company expects one additional
distribution of 19,070 shares of Class A Common Stock to occur in April 1997.
See "Business--Recent Transactions." The Company recorded the Ruffalo, Cody
acquisition as a purchase for accounting purposes.
On September 20, 1996, the Company acquired McLeodUSA Publishing for
approximately $74.1 million in cash and an additional amount estimated as of
the date hereof to be approximately $1.6 million to be paid to certain
employees of McLeodUSA Publishing as part of an incentive plan. At the time of
the acquisition, McLeodUSA Publishing had outstanding debt of approximately
$6.6 million. The Company recorded the McLeodUSA Publishing acquisition as a
purchase for accounting purposes.
On January 30, 1997, the Company acquired Digital Communications in a
stock transaction valued at approximately $2.3 million, based on the average
closing sales price of the Class A Common Stock on The Nasdaq National Market
at the time of the transaction. On January 30, 1997, the Company issued 84,430
shares of Class A Common Stock to the shareholders of Digital Communications.
The Company recorded the Digital Communications acquisition as a purchase for
accounting purposes.
48
The Company used a portion of the net proceeds from the Company's initial
public offering of Class A Common Stock to fund the McLeodUSA Publishing
acquisition and the cash portion of the Ruffalo, Cody acquisition.
At December 31, 1996, the Company had no actual contractual capital
commitments for costs associated with the construction of fiber optic
networks.
On January 15, 1997, the FCC notified the Company that it was the
successful bidder for 26 "D" and "E" block frequency PCS licenses in 24
markets covering areas of Iowa, Illinois, Minnesota, Nebraska and South
Dakota. The Company bid an aggregate of approximately $32.8 million for these
PCS licenses, which the Company will be required to pay to the FCC following
grant of the licenses, anticipated to occur during the second or third quarter
of 1997. The Company will be required to make significant additional
expenditures to develop, construct and operate a PCS system.
As of December 31, 1996, the Company estimates that its aggregate capital
requirements for 1997, 1998 and 1999 will be approximately $456 million. The
Company's estimated capital requirements include the estimated cost of (i)
developing and constructing its fiber optic network, (ii) market expansion
activities, (iii) acquiring 26 PCS licenses for which the Company was the
successful bidder in the FCC's recent "D" and "E" block frequency PCS license
auction, (iv) developing, constructing and operating a PCS system, and (v)
constructing its new corporate headquarters and associated buildings. These
capital requirements are expected to be funded, in large part, out of the net
proceeds from the Company's March 1997 private offering of the Notes
(approximately $289.5 million), the net proceeds remaining from the Company's
public offerings of Class A Common Stock in June and November 1996
(approximately $224 million as of December 31, 1996), and lease payments to
the Company for portions of the Company's networks.
The Company may require additional capital in the future for business
activities related to those specified above and also for acquisitions, joint
ventures and strategic alliances, as well as to fund operating deficits and
net losses. These activities could require significant additional capital not
included in the foregoing estimated aggregate capital requirements of $456
million.
The Company's estimate of its future capital requirements is a "forward-
looking statement" within the meaning of the safe harbor provisions of the
Private Securities Litigation Reform Act of 1995. The Company's actual capital
requirements may differ materially as a result of regulatory, technological
and competitive developments (including new opportunities) in the Company's
industry.
The Company expects to meet its additional capital needs with the
proceeds from credit facilities and other borrowings, and additional debt and
equity issuances. The Company plans to obtain one or more lines of credit,
although, as of the date hereof, no such lines of credit have yet been
negotiated. There can be no assurance, however, that the Company will be
successful in producing sufficient cash flows or raising sufficient debt or
equity capital to meet its strategic objectives or that such funds, if
available at all, will be available on a timely basis or on terms that are
acceptable to the Company. See "Business--Risk Factors--Significant Capital
Requirements."
Inflation
The Company does not believe that inflation has had a significant impact
on the Company's consolidated operations.
Item 8. Financial Statements and Supplementary Data.
The Consolidated Financial Statements of the Company, including the
Company's Consolidated Balance Sheets as of December 31, 1996 and 1995,
Consolidated Statements of Operations for the years ended December 31, 1996,
1995 and 1994, Consolidated Statements of Stockholders' Equity for the years
ended December 31, 1996, 1995 and 1994, Consolidated Statements of Cash Flows
for the years ended December 31, 1996, 1995 and 1994, and Notes to
Consolidated Financial Statements,
49
together with a report thereon of McGladrey & Pullen, LLP, dated January 31,
1997 (except for the first paragraph of Note 13, as to which the date is March
4, 1997), are attached hereto as pages F-1 through F-20.
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure.
On March 27, 1997, the Company engaged the accounting firm of Arthur
Andersen LLP as the Company's principal independent accountants, to replace
McGladrey & Pullen, LLP, the Company's former independent accountants,
effective with such engagement. The decision to change independent accountants
was made following a review of competitive proposals submitted by Arthur
Andersen LLP and two other major public accounting firms, and was recommended
by the Audit Committee of the Board of Directors and approved by the Board.
McGladrey & Pullen, LLP did not resign and did not decline to stand for re-
election.
During the two most recent fiscal years ended December 31, 1996 and 1995,
and the interim period subsequent to December 31, 1996, there have been no
disagreements with McGladrey & Pullen, LLP on any matter of accounting
principles or practices, financial statement disclosure, or auditing scope or
procedure which would have caused McGladrey & Pullen, LLP to make reference in
their report to such disagreements if not resolved to their satisfaction.
McGladrey & Pullen, LLP's reports on the financial statements of the
Company for the fiscal years ended December 31, 1996 and 1995 have contained
no adverse opinion or disclaimer of opinion and were not qualified or modified
as to uncertainty, audit scope or accounting principles.
The Company has provided McGladrey & Pullen, LLP with a copy of this
disclosure and requested that McGladrey & Pullen, LLP furnish it with a letter
addressed to the Securities and Exchange Commission (the "Commission") stating
whether it agrees with the above statements. (A copy of the McGladrey &
Pullen, LLP letter addressed to the Commission is filed as Exhibit 16.1 to
this Form 10-K).
PART III
Item 10. Directors and Executive Officers of the Registrant.
Reference is made to the information set forth under the captions
"Election of Directors--Information as to Nominees and Other Directors" and
"Executive Compensation and Other Information--Section 16(a) Beneficial
Ownership Reporting Compliance" appearing in the Company's definitive Proxy
Statement for the Annual Meeting of Stockholders to be held on May 29, 1997
(the "Proxy Statement"), to be filed within 120 days after the end of the
Company's fiscal year, which information is incorporated herein by reference.
Information required by this item with respect to executive officers is
provided in Item 1 of this Form 10-K. See "Business--Executive Officers of the
Company."
Item 11. Executive Compensation.
Reference is made to the information set forth under the captions
"Election of Directors--Directors' Compensation" and "Executive Compensation
and Other Information" appearing in the Proxy Statement to be filed within 120
days after the end of the Company's fiscal year, which information is
incorporated herein by reference.
Item 12. Security Ownership of Certain Beneficial Owners and Management.
Reference is made to the information set forth under the caption "Stock
Owned by Management" and "Principal Holders of Voting Securities" appearing in
the Proxy Statement to be filed within 120 days after the end of the Company's
fiscal year, which information is incorporated herein by reference.
50
Item 13. Certain Relationships and Related Transactions.
Reference is made to the information set forth under the caption
"Executive Compensation and Other Information--Certain Transactions" appearing
in the Proxy Statement to be filed within 120 days after the end of the
Company's fiscal year, which information is incorporated herein by reference.
PART IV
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K.
(a)(1) The following Consolidated Financial Statements of the Company and
independent auditor's report are included in Item 8 of this Form 10-K.
Independent Auditor's Report.
Consolidated Balance Sheets as of December 31, 1996 and 1995.
Consolidated Statements of Operations for the years ended December
31, 1996, 1995, and 1994.
Consolidated Statements of Stockholders' Equity for the years ended
December 31, 1996, 1995 and 1994.
Consolidated Statements of Cash Flows for the years ended December
31, 1996, 1995 and 1994.
Notes to Consolidated Financial Statements.
(a)(2) The following financial statement schedule is filed as part of
this report and is attached hereto as pages S-1 and S-2.
Independent Auditor's Report on the Financial Statement Schedules.
Schedule II -- Valuation and Qualifying Accounts.
All other schedules for which provision is made in the applicable
accounting regulations of the Commission either have been included in the
Consolidated Financial Statements of the Company or the notes thereto, are not
required under the related instructions or are inapplicable, and therefore
have been omitted.
(a)(3) The following exhibits are either provided with this Form 10-K or
are incorporated herein by reference:
Exhibit
Number Exhibit Description
------ -------------------
2.1 Agreement and Plan of Reorganization dated April 28, 1995
among Midwest Capital Group Inc., MWR Telecom, Inc. and
McLeod, Inc. (Filed as Exhibit 2.1 to Registration
Statement on Form S-1, File No. 333-3112 ("Initial Form
S-1"), and incorporated herein by reference).
2.2 Agreement and Plan of Reorganization dated as of July 12,
1996 among Ruffalo, Cody & Associates, Inc., certain
shareholders of Ruffalo, Cody & Associates, Inc. and
McLeod, Inc. (Filed as Exhibit 2 to Current Report on
Form 8-K, File No. 0-20763, filed with the Commission on
July 29, 1996 and incorporated herein by reference).
51
Exhibit
Number Exhibit Description
------ -------------------
2.3 Agreement and Plan of Reorganization dated as of August
15, 1996 among Telecom USA Publishing Group, Inc. and
McLeod, Inc. (Filed as Exhibit 2 to Current Report on
Form 8-K, File No. 0-20763, filed with the Commission on
August 26, 1996 and incorporated herein by reference).
2.4 Agreement and Plan of Reorganization dated as of January
27, 1997 among McLeod, Inc., Digital Communications of
Iowa, Inc., Clark E. McLeod and Mary E. McLeod. (Filed as
Exhibit 2 to Current Report on Form 8-K, File No. 0-
20763, filed with the Commission on February 24, 1997 and
incorporated herein by reference).
3.1 Amended and Restated Certificate of Incorporation of
McLeod, Inc. (Filed as Exhibit 3.1 to Initial Form S-1
and incorporated herein by reference).
3.2 Amended and Restated Bylaws of McLeod, Inc. (Filed as
Exhibit 3.2 to Registration Statement on Form S-1, File
No. 333-13885 ("November Form S-1"), and incorporated
herein by reference).
4.1 Form of Class A Common Stock Certificate of McLeod, Inc.
(Filed as Exhibit 4.1 to Initial Form S-1 and
incorporated herein by reference).
4.2 Indenture dated March 4, 1997 between McLeod, Inc. and
United States Trust Company of New York, as Trustee,
relating to the 10 1/2% Senior Discount Notes Due 2007 of
McLeod, Inc.
4.3 Initial Global 10 1/2% Senior Discount Note Due March 1,
2007 of McLeod, Inc., dated March 4, 1997.
4.4 Form of Certificated 10 1/2% Senior Discount Note Due
March 1, 2007 of McLeod, Inc.
4.5 Registration Agreement dated March 4, 1997 among McLeod,
Inc., Salomon Brothers Inc and Morgan Stanley & Co.
Incorporated.
4.6 Investor Agreement dated as of April 1, 1996 among
McLeod, Inc., IES Investments Inc., Midwest Capital Group
Inc., MWR Investments Inc., Clark and Mary McLeod, and
certain other stockholders. (Filed as Exhibit 4.8 to
Initial Form S-1 and incorporated herein by reference).
4.7 Amendment No. 1 to Investor Agreement dated as of October
23, 1996 by and among McLeod, Inc., IES Investments Inc.,
Midwest Capital Group Inc., MWR Investments Inc., Clark
E. McLeod and Mary E. McLeod. (Filed as Exhibit 4.3 to
November Form S-1 and incorporated herein by reference).
10.1 Credit Agreement dated as of May 16, 1994 among McLeod,
Inc., McLeod Network Services, Inc., McLeod
Telemanagement, Inc., McLeod Telecommunications, Inc. and
The First National Bank of Chicago. (Filed as Exhibit
10.1 to Initial Form S-1 and incorporated herein by
reference).
10.2 First Amendment to Credit Agreement dated as of June 17,
1994 among McLeod, Inc., McLeod Network Services, Inc.,
McLeod Telemanagement, Inc., McLeod Telecommunications,
Inc. and The First National Bank of Chicago. (Filed as
Exhibit 10.2 to Initial Form S-1 and incorporated herein
by reference).
10.3 Second Amendment to Credit Agreement dated as of December
1, 1994 among McLeod, Inc., McLeod Network Services,
Inc., McLeod Telemanagement, Inc., McLeod
Telecommunications, Inc. and The First National Bank of
Chicago. (Filed as Exhibit 10.3 to Initial Form S-1 and
incorporated herein by reference).
52
Exhibit
Number Exhibit Description
------ -------------------
10.4 Third Amendment to Credit Agreement dated as of May 31,
1995 among McLeod, Inc., McLeod Network Services, Inc.,
McLeod Telemanagement, Inc., McLeod Telecommunications,
Inc., MWR Telecom, Inc. and The First National Bank of
Chicago. (Filed as Exhibit 10.4 to Initial Form S-1 and
incorporated herein by reference).
10.5 Fourth Amendment to Credit Agreement dated as of July 28,
1995 among McLeod, Inc., McLeod Network Services, Inc.,
McLeod Telemanagement, Inc., McLeod Telecommunications,
Inc., MWR Telecom, Inc. and The First National Bank of
Chicago. (Filed as Exhibit 10.5 to Initial Form S-1 and
incorporated herein by reference).
10.6 Fifth Amendment to Credit Agreement dated as of October
18, 1995 among McLeod, Inc., McLeod Network Services,
Inc., McLeod Telemanagement, Inc., McLeod
Telecommunications, Inc., MWR Telecom, Inc. and The First
National Bank of Chicago. (Filed as Exhibit 10.6 to
Initial Form S-1 and incorporated herein by reference).
10.7 Sixth Amendment to Credit Agreement dated as of March 29,
1996 among McLeod, Inc., McLeod Network Services, Inc.,
McLeod Telecommunications, Inc., MWR Telecom, Inc. and
The First National Bank of Chicago. (Filed as Exhibit
10.7 to Initial Form S-1 and incorporated herein by
reference).
10.8 Security Agreement dated as of May 16, 1994 among McLeod,
Inc., McLeod Network Services, Inc., McLeod
Telemanagement, Inc., McLeod Telecommunications, Inc. and
The First National Bank of Chicago. (Filed as Exhibit
10.8 to Initial Form S-1 and incorporated herein by
reference).
10.9 First Amendment to Security Agreement dated as of
December 1, 1994 among McLeod, Inc., McLeod Network
Services, Inc., McLeod Telemanagement, Inc., McLeod
Telecommunications, Inc. and The First National Bank of
Chicago. (Filed as Exhibit 10.9 to Initial Form S-1 and
incorporated herein by reference).
10.10 Support Agreement dated as of December 1, 1994 among IES
Diversified Inc., McLeod, Inc., McLeod Network Services,
Inc., McLeod Telemanagement, Inc., McLeod
Telecommunications, Inc. and The First National Bank of
Chicago. (Filed as Exhibit 10.10 to Initial Form S-1 and
incorporated herein by reference).
10.11 Agreement Regarding Support Agreement dated December 1994
between McLeod, Inc. and IES Diversified Inc. (Filed as
Exhibit 10.11 to Initial Form S-1 and incorporated herein
by reference).
10.12 Agreement Regarding Guarantee dated May 16, 1994 between
McLeod, Inc. and IES Diversified Inc. (Filed as Exhibit
10.12 to Initial Form S-1 and incorporated herein by
reference).
10.13 Joinder to and Assumption of Credit Agreement dated as of
April 28, 1995 between McLeod Merging Co. and The First
National Bank of Chicago. (Filed as Exhibit 10.13 to
Initial Form S-1 and incorporated herein by reference).
10.14 Joinder to and Assumption of Security Agreement dated as
of April 28, 1995 between McLeod Merging Co. and The
First National Bank of Chicago. (Filed as Exhibit 10.14
to Initial Form S-1 and incorporated herein by
reference).
10.15 Letter from The First National Bank of Chicago to James
L. Cram dated April 28, 1995 regarding extension of the
termination date under the Credit Agreement. (Filed as
Exhibit 10.15 to Initial Form S-1 and incorporated herein
by reference).
53
Exhibit
Number Exhibit Description
- ------ -------------------
10.16 Credit Agreement dated as of March 29, 1996 among McLeod, Inc., McLeod
Network Services, Inc., McLeod Telemanagement, Inc., McLeod
Telecommunications, Inc. MWR Telecom, Inc. and The First National Bank
of Chicago. (Filed as Exhibit 10.16 to Initial Form S-1 and
incorporated herein by reference).
10.17 Agreement for Construction Related Services dated as of October 17,
1995 between City Signal Fiber Services, Inc. and McLeod Network
Services, Inc. (Filed as Exhibit 10.17 to Initial Form S-1 and
incorporated herein by reference).
10.18 Construction Services Agreement dated March 27, 1996 between City
Signal Fiber Services, Inc. and McLeod Network Services, Inc. (Filed
as Exhibit 10.18 to Initial Form S-1 and incorporated herein by
reference).
10.19 Fiber Optic Use Agreement dated as of February 14, 1996 between McLeod
Network Services, Inc. and Galaxy Telecom, L.P. (Filed as Exhibit
10.19 to Initial Form S-1 and incorporated herein by reference).
10.20 Agreement dated as of July 11, 1994 between McLeod Network Services,
Inc. and KLK Construction. (Filed as Exhibit 10.20 to Initial Form S-1
and incorporated herein by reference).
10.21 Lease Agreement dated September 5, 1995 between State of Iowa and MWR
Telecom, Inc. (Filed as Exhibit 10.21 to Initial Form S-1 and
incorporated herein by reference).
10.22 Lease Agreement dated September 5, 1995 between State of Iowa and
McLeod Network Services, Inc. (Filed as Exhibit 10.22 to Initial Form
S-1 and incorporated herein by reference).
10.23 Contract dated September 5, 1995 between Iowa Telecommunications and
Technology Commission and MWR Telecom, Inc. (Filed as Exhibit 10.23 to
Initial Form S-1 and incorporated herein by reference).
10.24 Contract dated June 27, 1995 between Iowa National Guard and McLeod
Network Services, Inc. (Filed as Exhibit 10.24 to Initial Form S-1 and
incorporated herein by reference).
10.25 Addendum Number One to Contract dated September 5, 1995 between Iowa
National Guard and McLeod Network Services, Inc. (Filed as Exhibit
10.25 to Initial Form S-1 and incorporated herein by reference).
10.26 U S WEST Centrex Plus Service Rate Stability Plan dated October 15,
1993 between McLeod Telemanagement, Inc. and U S WEST Communications,
Inc. (Filed as Exhibit 10.26 to Initial Form S-1 and incorporated
herein by reference).
10.27 U S WEST Centrex Plus Service Rate Stability Plan dated July 17, 1993
between McLeod Telemanagement, Inc. and U S WEST Communications, Inc.
(Filed as Exhibit 10.27 to Initial Form S-1 and incorporated herein by
reference).
10.28 Ameritech Centrex Service Confirmation of Service Orders dated various
dates in 1994, 1995 and 1996 between McLeod Telemanagement, Inc. and
Ameritech Information Industry Services. (Filed as Exhibit 10.28 to
Initial Form S-1 and incorporated herein by reference).
54
Exhibit
Number Exhibit Description
- ------ -------------------
10.29 Lease Agreement dated as of December 28, 1993 between 2060 Partnership
and McLeod Telemanagement, Inc., as amended by Amendments First to
Ninth dated as of July 3, 1994, March 25,1994, June 22, 1994, August
12, 1994, September 12, 1994, September 20, 1994, November 16, 1994,
September 20, 1995 and January 6, 1996, respectively. (Filed as
Exhibit 10.29 to Initial Form S-1 and incorporated herein by
reference).
10.30 Lease Agreement dated as of May 24, 1995 between 2060 Partnership and
McLeod Telemanagement, Inc. (Filed as Exhibit 10.30 to Initial
Form S-1 and incorporated herein by reference).
10.31 Lease Agreement dated October 31, 1995 between I.R.F.B. Joint Venture
and McLeod Telemanagement, Inc. (Filed as Exhibit 10.31 to Initial
Form S-1 and incorporated herein by reference).
10.32 First Amendment to Lease Agreement dated as of November 20, 1995
between I.R.F.B. Joint Venture and McLeod Telemanagement, Inc. (Filed
as Exhibit 10.32 to Initial Form S-1 and incorporated herein by
reference).
10.33 Uniform Purchase Agreement dated July 22, 1993 between McLeod, Inc.
and Hill's Maple Crest Farms Partnership. (Filed as Exhibit 10.33 to
Initial Form S-1 and incorporated herein by reference).
10.34 Master Right-of-Way Agreement dated July 27, 1994 between McLeod
Network Services, Inc. and IES Industries Inc. (Filed as Exhibit 10.34
to Initial Form S-1 and incorporated herein by reference).
10.35 Master Right-of-Way and Tower Use Agreement dated February 13, 1996
between IES Industries Inc. and McLeod, Inc. (Filed as Exhibit 10.35
to Initial Form S-1 and incorporated herein by reference).
10.36 Master Pole, Duct and Tower Use Agreement dated February 20, 1996
between MidAmerican Energy Company and McLeod, Inc. (Iowa and South
Dakota). (Filed as Exhibit 10.36 to Initial Form S-1 and incorporated
herein by reference).
10.37 Master Pole, Duct and Tower Use Agreement dated February 20, 1996
between MidAmerican Energy Company and McLeod, Inc. (Illinois). (Filed
as Exhibit 10.37 to Initial Form S-1 and incorporated herein by
reference).
10.38 Settlement Agreement dated March 18, 1996 between U S WEST
Communications, Inc. and McLeod Telemanagement, Inc. (Filed as Exhibit
10.38 to Initial Form S-1 and incorporated herein by reference).
10.39 Agreement dated August 4, 1995 between Vadacom, Inc. and McLeod
Telemanagement, Inc. (Filed as Exhibit 10.39 to Initial Form S-1 and
incorporated herein by reference).
10.40 McLeod Telecommunications, Inc. 1992 Incentive Stock Option Plan.
(Filed as Exhibit 10.40 to Initial Form S-1 and incorporated herein by
reference).
10.41 McLeod, Inc. 1993 Incentive Stock Option Plan. (Filed as Exhibit 10.41
to Initial Form S-1 and incorporated herein by reference).
10.42 McLeod, Inc. 1995 Incentive Stock Option Plan. (Filed as Exhibit 10.42
to Initial Form S-1 and incorporated herein by reference).
10.43 McLeod Telecommunications, Inc. Director Stock Option Plan. (Filed as
Exhibit 10.43 to Initial Form S-1 and incorporated herein by
reference).
55
Exhibit
Number Exhibit Description
------ -------------------
10.44 Promissory Note dated July 18, 1995 between Kirk E. Kaalberg and
McLeod, Inc. (Filed as Exhibit 10.44 to Initial Form S-1 and
incorporated herein by reference).
10.45 Promissory Note dated March 29, 1996 between Stephen K. Brandenburg
and McLeod, Inc. (Filed as Exhibit 10.45 to Initial Form S-1 and
incorporated herein by reference).
10.46 Agreement dated April 28, 1995 among McLeod, Inc., McLeod
Telecommunications, Inc., McLeod Telemanagement, Inc., McLeod Network
Services, Inc. and Clark E. McLeod. (Filed as Exhibit 10.46 to Initial
Form S-1 and incorporated herein by reference).
+10.47 Telecommunications Services Agreement dated March 14, 1994 between
WiITeI, Inc. and McLeod Telemanagement, Inc., as amended. (Filed as
Exhibit 10.47 to Initial Form S-1 and incorporated herein by
reference).
10.48 Amendment to Contract Addendum A to Contract No. 2102 dated March 31,
1993 between the Iowa Department of General Services and McLeod
Telecommunications, Inc. (Filed as Exhibit 10.48 to Initial Form S-1
and incorporated herein by reference).
10.49 Construction Services Agreement dated June 30, 1995 between MFS
Network Technologies, Inc. and MWR Telecom, Inc. (Filed as Exhibit
10.49 to Initial Form S-1 and incorporated herein by reference).
10.50 First Amendment to Agreement Regarding Support Agreement dated May 14,
1996 among McLeod, Inc., IES Diversified Inc. and IES Investments Inc.
(Filed as Exhibit 10.50 to Initial Form S-1 and incorporated herein by
reference).
10.51 First Amendment to Agreement Regarding Guarantee dated May 14, 1996
among McLeod, Inc., IES Diversified Inc. and IES Investments Inc.
(Filed as Exhibit 10.51 to Initial Form S-1 and incorporated herein by
reference).
10.52 Amended and Restated Directors Stock Option Plan of McLeod, Inc.
(Filed as Exhibit 10.52 to Initial Form S-1 and incorporated herein by
reference).
10.53 Forms of Employment, Confidentiality and Non-Competition Agreement
between McLeod, Inc. and certain employees of McLeod, Inc. (Filed as
Exhibit 10.53 to Initial Form S-1 and incorporated herein by
reference).
10.54 Form of Change-of-Control Agreement between McLeod, Inc. and certain
employees of McLeod, Inc. (Filed as Exhibit 10.54 to Initial Form S-1
and incorporated herein by reference).
10.55 McLeod, Inc. 1996 Employee Stock Option Plan, as amended. (Filed as
Exhibit 10.55 to November Form S-1 and incorporated herein by
reference).
10.56 McLeod, Inc. Employee Stock Purchase Plan, as amended.
10.57 Form of Indemnity Agreement between McLeod, Inc. and certain officers
and directors of McLeod, Inc. (Filed as Exhibit 10.57 to Initial Form
S-1 and incorporated herein by reference).
10.58 License Agreement dated April 24, 1996 between PageMart, Inc. and MWR
Telecom, Inc. (Filed as Exhibit 10.58 to Initial Form S-1 and
incorporated herein by reference).
10.59 Assignment of Purchase Agreement dated August 15, 1996 between Ryan
Properties, Inc. and McLeod, Inc. (Filed as Exhibit 10.59 to November
Form S-1 and incorporated herein by reference).
56
Exhibit
Number Exhibit Description
- ------ -------------------
10.60 Assignment of Purchase Agreement dated August 14, 1996 between Ryan
Properties, Inc. and McLeod, Inc. (Filed as Exhibit 10.60 to November
Form S-1 and incorporated herein by reference).
10.61 Asset Purchase Agreement dated September 4, 1996 between Total
Communication Services, Inc. and McLeod Telemanagement, Inc. (Filed as
Exhibit 10.61 to November Form S-1 and incorporated herein by
reference).
10.62 First Amendment to Asset Purchase Agreement dated September 30, 1996
between Total Communication Services, Inc. and McLeod Telemanagement,
Inc. (Filed as Exhibit 10.62 to November Form S-1 and incorporated
herein by reference).
10.63 McLeod, Inc. Incentive Plan. (Filed as Exhibit 10.63 to November Form
S-1 and incorporated herein by reference).
10.64 Amended and Restated Credit Agreement dated as of May 5, 1996 among
Telecom*USA Publishing Group, Inc., Telecom*USA Publishing Company and
Telecom*USA Neighborhood Directories, Inc. and Norwest Bank Iowa,
National Association. (Filed as Exhibit 10.64 to November Form S-1 and
incorporated herein by reference).
10.65 First Amendment to Amended and Restated Credit Agreement dated as of
January 31, 1996 by and between Telecom*USA Publishing Group, Inc.,
Telecom*USA Publishing Company and Telecom*USA Neighborhood
Directories, Inc. and Norwest Bank Iowa, National Association. (Filed
as Exhibit 10.65 to November Form S-1 and incorporated herein by
reference).
10.66 Lease Agreement dated as of September 26, 1994 between Ryan
Properties, Inc. and Ruffalo, Cody & Associates, Inc. (Filed as
Exhibit 10.66 to November Form S-1 and incorporated herein by
reference).
10.67 First Lease Amendment dated as of April 12, 1995 between Ryan
Properties, Inc. and Ruffalo, Cody & Associates, Inc. (Filed as
Exhibit 10.67 to November Form S-1 and incorporated herein by
reference).
10.68 Lease Agreement dated as of July 18, 1995 between 2060 Partnership,
L.P. and Telecom*USA Publishing Company. (Filed as Exhibit 10.68 to
November Form S-1 and incorporated herein by reference).
10.69 Lease Agreement dated April 26, 1995 by and between A.M. Henderson and
Telecom*USA Publishing Company. (Filed as Exhibit 10.69 to November
Form S-1 and incorporated herein by reference).
10.70 License Agreement dated as of April 19, 1994, between Ameritech
Information Industry Services and Telecom*USA Publishing Company.
(Filed as Exhibit 10.70 to November Form S-1 and incorporated herein
by reference).
10.71 License Agreement dated September 13, 1993 between U S WEST
Communications, Inc. and Telecom*USA Publishing Company. (Filed as
Exhibit 10.71 to November Form S-1 and incorporated herein by
reference).
10.72 Form of McLeod, Inc. Directors Stock Option Plan Option Agreement.
(Filed as Exhibit 10.72 to November Form S-1 and incorporated herein
by reference).
10.73 Forms of McLeod, Inc. 1996 Employee Stock Option Plan Incentive Stock
Option Agreement. (Filed as Exhibit 10.73 to November Form S-1 and
incorporated herein by reference).
57
Exhibit
Number Exhibit Description
- ------ -------------------
10.74 Forms of McLeod, Inc. 1996 Employee Stock Option Plan Non-Incentive
Stock Option Agreement. (Filed as Exhibit 10.74 to November Form S-1
and incorporated herein by reference).
10.75 Option Agreement dated April 27, 1995 between Fronteer Directory
Company, Inc. and Telecom*USA Publishing Company. (Filed as Exhibit
10.75 to November Form S-1 and incorporated herein by reference).
10.76 Promissory Note dated May 5, 1995 between Telecom*USA Publishing
Company and Fronteer Directory Company, Inc. (Filed as Exhibit 10.76
to November Form S-1 and incorporated herein by reference).
10.77 Security Agreement dated May 5, 1995 between Telecom*USA Publishing
Company and Fronteer Directory Company, Inc. (Filed as Exhibit 10.77
to November Form S-1 and incorporated herein by reference).
10.78 Design/Build Construction Contract dated September 17, 1996 between
Ryan Construction Company of Minnesota, Inc. and McLeod, Inc. (Filed
as Exhibit 10.78 to November Form S-1 and incorporated herein by
reference).
10.79 Guaranty Agreement dated as of October 17, 1996 by McLeod, Inc. in
favor of Kirkwood Community College. (Filed as Exhibit 10.79 to
November Form S-1 and incorporated herein by reference).
10.80 Industrial New Jobs Training Agreement dated as of October 31, 1996
between Kirkwood Community College and McLeod Telemanagement, Inc.
(Filed as Exhibit 10.80 to November Form S-1 and incorporated herein
by reference).
10.81 Industrial New Jobs Training Agreement dated as of October 31, 1996
between Kirkwood Community College and McLeod Telecommunications, Inc.
(Filed as Exhibit 10.81 to November Form S-1 and incorporated herein
by reference).
10.82 Industrial New Jobs Training Agreement dated as of October 31, 1996
between Kirkwood Community College and McLeod Network Services, Inc.
(Filed as Exhibit 10.82 to November Form S-1 and incorporated herein
by reference).
10.83 Industrial New Jobs Training Agreement dated as of October 31, 1996
between Kirkwood Community College and McLeod, Inc. (Filed as Exhibit
10.83 to November Form S-1 and incorporated herein by reference).
10.84 Change Order No. 1 to the Construction Services Agreement dated
November 22, 1995 by and between MWR TeIecom, Inc. and MFS Network
Technologies, Inc. (Filed as Exhibit 10.84 to November Form S-1 and
incorporated herein by reference).
10.85 Change Order No. 2 to the Construction Services Agreement dated August
14, 1996 between MWR Telecom, Inc. and MFS Network Technologies, Inc.
(Filed as Exhibit 10.85 to November Form S-1 and incorporated herein
by reference).
10.86 Change Order No. 3 to the Construction Services Agreement dated
October 31, 1996 between MWR Telecom, Inc. and MFS Network
Technologies, Inc. (Filed as Exhibit 10.86 to November Form S-1 and
incorporated herein by reference).
10.87 Independent Contractor Sales Agreement dated May, 1995 between Sprint
Communications Company L.P. and Ruffalo, Cody & Associates, Inc.
(Filed as Exhibit 10.87 to November Form S-1 and incorporated herein
by reference).
10.88 Second Amendment to Asset Purchase Agreement dated October 31, 1996
between Total Communication Services, Inc. and McLeod Telemanagement,
Inc. (Filed as Exhibit 10.88 to November Form S-1 and incorporated
herein by reference)
58
Exhibit
Number Exhibit Description
------ -------------------
10.89 Escrow Agreement dated July 15, 1996 among McLeod, Inc., certain
shareholders of Ruffalo, Cody & Associates, Inc., Albert P. Ruffalo
and Norwest Bank N.A. (Filed as Exhibit 10.89 to November Form S-1
and incorporated herein by reference).
10.90 Sale and Purchase Agreement dated January 27, 1997 among McLeodUSA
Publishing Company, Fronteer Financial Holdings, Ltd., Classified
Directories, Inc., Larry A. Scott, James Greff, Randall L. Gowin and
Edwin Dressler and certain directors, officers and shareholders of
Fronteer Financial Holdings, Ltd.
10.91 Sale and Purchase Agreement dated February 27, 1997 among McLeodUSA
Publishing Company, Indiana Directories, Inc., John Morgan, Hank
Meijer, Jack Hendricks, Brad Nelson and Talking Directories, Inc.
10.92 Amendment to Sale and Purchase Agreement dated February 28, 1997
between McLeodUSA Publishing Company and Indiana Directories, Inc.
10.93 Ameritech Centrex Service Confirmation of Service Orders dated
August 21, 1996 between McLeod Telemanagement, Inc. and Ameritech
Information Industry Services.
*10.94 Amended and Restated Program Enrollment Terms dated November 1, 1996
between WorldCom Network Services, Inc. d/b/a WilTel and McLeod
Telemanagement, Inc.
11.1 Statement regarding Computation of Per Share Earnings.
16.1 Letter regarding Change in Certifying Accountant.
21.1 Subsidiaries of McLeod, Inc.
23.1 Consent of McGladrey & Pullen, LLP.
27.1 Financial Data Schedule.
99.1 Purchase Agreement dated as of August 15, 1996 between Iowa Land and
Building Company and Ryan Properties, Inc. (Filed as Exhibit 99.1 to
November Form S-1 and incorporated herein by reference).
99.2 Purchase Agreement dated as of June 28, 1996 between Donald E.
Zvacek, Dennis E. Zvacek and Robert J. Zvacek and Ryan Properties,
Inc. (Filed as Exhibit 99.2 to November Form S-1 and incorporated
herein by reference).
- ---------------
+ Confidential treatment has been granted. The copy filed as an exhibit
omits the information subject to the confidential treatment request.
* To be filed by amendment.
(b) Reports on Form 8-K.
On October 7, 1996, the Company filed a Current Report on Form 8-K to
report the acquisition on September 20, 1996 of McLeodUSA Publishing for
approximately $74.1 million in cash and an additional amount estimated as of the
date hereof to be approximately $1.6 million to be paid to certain employees of
McLeodUSA Publishing as part of an incentive plan. The Form 8-K was amended on
October 11, 1996 to include the relevant financial statements of McLeodUSA
Publishing and pro forma financial information for the Company.
59
(c) Exhibits.
The Company hereby files as part of this Form 10-K the Exhibits listed in
the Index to Exhibits.
(d) Financial Statement Schedules.
The following financial statement schedule is filed herewith:
Schedule II -- Valuation and Qualifying Accounts
Schedules not listed above have been omitted because they are
inapplicable or the information required to be set forth therein is provided in
the Consolidated Financial Statements of the Company or notes thereto.
60
GLOSSARY
Access--Telecommunications services that permit long distance carriers to
use local exchange facilities to originate and/or terminate long distance
service.
Access to Rights-of-Way--Access to poles, ducts, conduits and other
rights-of-way.
CAP (competitive access provider)--A company that provides its customers
with an alternative to the local exchange company for local transport of
private line and special access telecommunications services.
Central offices--The switching centers or central switching facilities of
the local exchange companies.
Collocation--The ability of a CAP such as the Company to connect its
network to the LECs central offices. Physical collocation occurs when a CAP
places its network connection equipment inside the local exchange company's
central offices. Virtual collocation is an alternative to physical collocation
pursuant to which the local exchange company permits a CAP to connect its
network to the local exchange company's central offices on comparable terms,
even through the CAP's network connection equipment is not physically located
inside the central offices.
Dedicated--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 customer's designation.
Digital--A method of storing, processing and transmitting information
through the use of distinct electronic or optical pulses that represent the
binary digits 0 and 1. Digital transmission and switching technologies employ
a sequence of these pulses to represent information as opposed to the
continuously variable analog signal. The precise digital numbers minimize
distortion (such as graininess or snow in the case of video transmission, or
static or other background distortion in the case of audio transmission).
FCC--Federal Communications Commission.
Interconnection--Interconnection of facilities between or among local
exchange carriers, including potential physical collocation of one carrier's
equipment in the other carrier's premises to facilitate such interconnection.
Initial Interconnection Decisions--Rulings by the FCC announced in
September 1992 and August 1993, which require the Regional Bell Operating
Companies and most other large local exchange carriers to provide
interconnection in local exchange company central offices to any CAP, long
distance carrier or end user seeking such interconnection for the provision of
interstate special access and switched access transport services.
Interconnection Decision--The August 1996 order issued by the FCC
implementing the interconnection provisions of the Telecommunications Act.
Portions of this order have been temporarily stayed by the U.S. Eighth Circuit
Court of Appeals.
InterLATA--Telecommunications services originating in a LATA and
terminating outside of that LATA.
IntraLATA--Telecommunications services originating and terminating in the
same LATA.
61
LATA (local access and transport area)--A geographic area composed of
contiguous local exchanges, usually but not always within a single state. The
State of Iowa contains all or part of five LATAs; the State of Illinois
contains all or part of 17 LATAs. There are approximately 200 LATAs in the
United States.
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.
LEC (local exchange carrier)--A company providing local telephone
services.
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.
Number portability--The ability of an end user to change local exchange
carriers while retaining the same telephone number.
POPs (points of presence)--Locations where a long distance carrier has
installed transmission equipment in a service area that serves as, or relays
calls to, a network switching center of that long distance carrier.
Private line--A dedicated telecommunications connection between end user
locations.
Public switched 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.
Public utilities commission--A state regulatory body, established in most
states, which regulates utilities, including telephone companies providing
intrastate services.
Reciprocal compensation--The same compensation of a new competitive local
exchange carrier for termination of a local call by the local exchange carrier
on its network, as the new competitor 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
local exchange carrier) of such services to other providers or carriers on a
wholesale or a retail basis.
Route mile--The number of miles of the telecommunications path in which
fiber optic cables are installed.
Self-healing ring--A self-healing ring is a network design in which the
network backbone consists of a continuous ring connecting a central hub
facility with one or more network nodes (such as customer premises). Traffic
is routed between the hub and each of the nodes simultaneously in both a
clockwise and a counterclockwise direction. In the event of a cable cut or
component failure along one of these paths, traffic will continue to flow
along the alternate path so no traffic is lost. In the event of a catastrophic
node failure, other nodes will be unaffected because traffic will continue to
flow along whichever path (primary or alternate) does not pass through the
affected node. The switch from the primary to the alternate path will be
imperceptible to most users.
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.
62
Switch--A device that opens or closes circuits or selects the paths or
circuits to be used for transmission of information. Switching is a process of
interconnecting circuits to form a transmission path between users.
Switched access transport services--Transportation of switched traffic
along dedicated lines between the local exchange company central offices and
long distance carrier POPs.
Switched traffic--Telecommunications traffic along the public switched
network. This traffic is generally switched at the local exchange company's
central offices.
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.
63
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.
McLEOD, INC.
By /s/ Clark E. McLeod
-----------------------
Clark E. McLeod
Chairman and Chief Executive Officer
March 27, 1997
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 indicated and on the dates indicated.
Signature Title Date
--------- ----- ----
/s/ Clark E. McLeod Chairman, Chief Executive Officer March 27, 1997
- --------------------------- and Director (Principal Executive
Clark E. McLeod Officer)
/s/ Stephen C. Gray President, Chief Operating March 27, 1997
- --------------------------- Officer and Director
Stephen C. Gray
/s/ Blake O. Fisher, Jr. Chief Financial Officer, March 27, 1997
- --------------------------- Executive Vice President,
Blake O. Fisher, Jr. Corporate Administration,
Treasurer and Director (Principal
Financial Officer)
/s/ Joseph H. Ceryanec Vice President, Finance, March 27, 1997
- --------------------------- Corporate Controller and
Joseph H. Ceryanec Principal Accounting Officer
(Principal Accounting Officer)
/s/ Russell E. Christiansen Director March 27, 1997
- ---------------------------
Russell E. Christiansen
/s/ Thomas M. Collins Director March 27, 1997
- ---------------------------
Thomas M. Collins
/s/ Paul D. Rhines Director March 27, 1997
- ---------------------------
Paul D. Rhines
/s/ Lee Liu Director March 27, 1997
- ---------------------------
Lee Liu
64
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page
----
McLEOD, INC. AND SUBSIDIARIES
Independent Auditor's Report........................................... F-2
Consolidated Balance Sheets as of December 31, 1996 and 1995........... F-3
Consolidated Statements of Operations for the years ended
December 31, 1996, 1995 and 1994..................................... F-4
Consolidated Statements of Stockholders' Equity for the years ended
December 31, 1996, 1995 and 1994..................................... F-5
Consolidated Statements of Cash Flows for the years ended
December 31, 1996, 1995 and 1994..................................... F-6
Notes to Consolidated Financial Statements............................. F-7
F-1
INDEPENDENT AUDITOR'S REPORT
To the Board of Directors
McLeod, Inc.
Cedar Rapids, Iowa
We have audited the accompanying consolidated balance sheets of McLeod,
Inc. and subsidiaries as of December 31, 1996 and 1995, and the related
consolidated statements of operations, stockholders' equity, and cash flows
for each of the three years in the period ended December 31, 1996. 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 consolidated financial statements referred to above
present fairly, in all material respects, the financial position of McLeod,
Inc. and subsidiaries as of December 31, 1996 and 1995, and the results of
their operations and their cash flows for each of the three years in the
period ended December 31, 1996 in conformity with generally accepted
accounting principles.
McGladrey & Pullen, LLP
Cedar Rapids, Iowa
January 31, 1997,
except for the first paragraph
of Note 13 as to which the
date is March 4, 1997
F-2
MCLEOD, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
December 31, 1996 and 1995
(In thousands, except shares)
ASSETS (Note 4) 1996 1995
---- ----
Current Assets
Cash and cash equivalents (Note 3)............................................................. $ 96,480 $ --
Investment in available-for-sale securities (Note 3)........................................... 80,518 --
Trade receivables, net (Note 2)................................................................ 27,560 6,689
Inventory...................................................................................... 1,600 1,598
Deferred expenses.............................................................................. 12,156 --
Prepaid expenses and other..................................................................... 6,087 220
--------- ---------
Total current assets...................................................................... 224,401 8,507
--------- ---------
Property and Equipment
Land........................................................................................... 2,246 311
Telecommunication networks..................................................................... 32,041 8,056
Furniture, fixtures and equipment.............................................................. 22,302 5,742
Networks in progress (Note 5).................................................................. 35,481 4,155
Building in progress (Note 5).................................................................. 6,103 --
--------- ---------
98,173 18,264
Less accumulated depreciation.................................................................. 6,050 2,145
--------- ---------
92,123 16,119
--------- ---------
Investments, Intangibles and Other Assets
Investment in available-for-sale securities (Note 3)........................................... 47,474 --
Goodwill, net.................................................................................. 57,012 2,525
Customer lists, net............................................................................ 17,095 --
Noncompete agreements, net..................................................................... 6,737 --
Deferred line installation costs, net.......................................................... 2,083 1,424
Other (Note 13)................................................................................ 6,069 411
--------- ---------
136,470 4,360
--------- ---------
$ 452,994 $ 28,986
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities
Current maturities of long-term debt (Note 4).................................................. $ 793 $ --
Accounts payable............................................................................... 15,807 5,832
Checks issued not yet presented for payment.................................................... -- 919
Accrued payroll and payroll related expenses................................................... 7,259 1,955
Other accrued liabilities...................................................................... 3,095 857
Deferred revenue, current portion.............................................................. 1,793 134
Customer deposits.............................................................................. 9,686 18
--------- ---------
Total current liabilities................................................................. 38,433 9,715
--------- ---------
Long-Term Debt, less current maturities (Note 4)................................................... 2,573 3,600
--------- ---------
Deferred Revenue, less current portion............................................................. 8,559 713
--------- ---------
Commitments (Notes 5 and 13)
Stockholders' Equity (Notes 4, 7, 8, 9 and 13)
Capital stock:
Preferred, Class A, $5.50 par value; authorized 1,150,000 shares; none issued............. -- --
Preferred, $.01 par value; authorized 2,000,000 shares; none issued; terms
determined upon issuance............................................................... -- --
Common, Class A, $.01 par value; authorized 75,000,000 shares; issued and
outstanding 1996 36,172,817 shares; 1995 16,387,081 shares............................. 362 164
Common, Class B, convertible, $.01 par value; authorized 22,000,000 shares;
issued and outstanding 1996 and 1995 15,625,929 shares................................. 156 156
Additional paid-in capital..................................................................... 450,736 40,117
Accumulated deficit............................................................................ (47,825) (25,479)
--------- ---------
403,429 14,958
--------- ---------
$ 452,994 $ 28,986
========= =========
See Notes to Consolidated Financial Statements.
F-3
MCLEOD, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
Years Ended December 31, 1996, 1995 and 1994
(In thousands, except per share data)
1996 1995 1994
---------- ---------- ----------
Revenue (Note 2).............................................. $ 81,323 $ 28,998 $ 8,014
-------- -------- --------
Operating expenses:
Cost of service............................................ 52,624 19,667 6,212
Selling, general and administrative........................ 46,044 18,054 12,373
Depreciation and amortization.............................. 8,485 1,835 772
Other...................................................... 2,380 -- --
-------- -------- --------
Total operating expenses............................... 109,533 39,556 19,357
-------- -------- --------
Operating loss......................................... (28,210) (10,558) (11,343)
-------- -------- --------
Nonoperating income (expense):
Interest income............................................ 6,034 139 145
Interest (expense)......................................... (665) (910) (218)
Other income............................................... 495 -- --
-------- -------- --------
Total nonoperating income (expense).................... 5,864 (771) (73)
-------- -------- --------
Loss before income taxes............................... (22,346) (11,329) (11,416)
Income taxes (Note 6)......................................... -- -- --
-------- -------- --------
Net loss............................................... $(22,346) $(11,329) $(11,416)
======== ======== ========
Loss per common and common equivalent share (Note 8).......... $(0.52) $(0.31) $(0.31)
======== ======== ========
Weighted average common and common equivalent shares
outstanding (Note 8)......................................... 43,019 37,055 36,370
======== ======== ========
See Notes to Consolidated Financial Statements.
F-4
MCLEOD, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (NOTES 8, 9 AND 13)
Years Ended December 31, 1996, 1995 and 1994
(In thousands, except shares)
Capital Stock
---------------------------
Common Additional Treasury
---------------- Paid-In Accumulated ---------
Preferred Class A Class B Capital Deficit Stock Total
--------- ------- ------- ---------- ------------ --------- ----------
Balance, December 31, 1993.................... $ -- $120 $ 56 $ 10,494 $ (2,734) $ -- $ 7,936
Net loss.................................... -- -- -- -- (11,416) -- (11,416)
Issuance of 2,484,720 shares of Class
A common stock............................. -- 25 -- 3,604 -- -- 3,629
Issuance of 2,045,457 shares of Class
B common stock............................. -- -- 20 2,980 -- -- 3,000
Purchase of 22,500 shares of common
stock for the treasury .................... -- -- -- -- -- (33) (33)
Amortization of fair value of stock
options issued to nonemployees -- -- -- 175 -- -- 175
(Note 4)................................. --------- ---- ---- -------- -------- -------- --------
Balance, December 31, 1994.................... -- 145 76 17,253 (14,150) (33) 3,291
Net loss.................................... -- -- -- -- (11,329) -- (11,329)
Issuance of 1,908,600 shares of Class
A common stock............................. -- 19 -- 4,278 -- -- 4,297
Issuance of 4,279,414 shares of Class
B common stock............................. -- -- 43 9,652 -- -- 9,695
Issuance of 3,676,058 shares of Class
B common stock in connection with the
acquisition of MWR Telecom Inc.
(Note 11)................................ -- -- 37 8,296 -- -- 8,333
Reissuance of 22,500 shares of
treasury stock............................. -- -- -- 6 -- 33 39
Amortization of fair value of stock
options issued to nonemployees
(Note 4)................................... -- -- -- 632 -- -- 632
--------- ---- ---- -------- -------- -------- --------
Balance, December 31, 1995.................... -- 164 156 40,117 (25,479) -- 14,958
Net loss.................................... -- -- -- -- (22,346) -- (22,346)
Issuance of 19,424,316 shares of
Class A common stock....................... -- 194 -- 396,020 -- -- 396,214
Issuance of 361,420 shares of Class A
common stock in connection with the
acquisition of Ruffalo, Cody &
Associates, Inc. (Note 11).............. -- 4 -- 8,941 -- -- 8,945
Options to purchase 158,009 shares of
Class A common stock granted in
connection with the acquisition of
Ruffalo, Cody & Associates, Inc.,
less cash to be received upon
exercise of options (Note 11)........... -- -- -- 3,301 -- -- 3,301
Amortization of fair value of stock
options issued to nonemployees
(Note 4)................................... -- -- -- 341 -- -- 341
Amortization of compensation expense
related to stock options (Note 7)........ -- -- -- 2,016 -- -- 2,016
--------- ---- ---- -------- -------- -------- --------
Balance, December 31, 1996.................... $ -- $362 $156 $450,736 $(47,825) $ -- $403,429
========= ==== ==== ======== ======== ======== ========
See Notes to Consolidated Financial Statements.
F-5
MCLEOD, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31, 1996, 1995 and 1994
(In thousands)
1996 1995 1994
---------- ---------- ----------
Cash Flows from Operating Activities
Net loss............................................................................. $ (22,346) $ (11,329) $ (11,416)
Adjustments to reconcile net loss to net cash (used in) operating activities:
Depreciation.................................................................... 3,944 1,299 633
Amortization.................................................................... 4,882 1,168 314
Changes in assets and liabilities, net of effects of purchase business
acquisitions (Note 11):
(Increase) in trade receivables............................................. (9,317) (3,575) (2,272)
(Increase) in inventory..................................................... (2) (269) (185)
Decrease in deferred expenses............................................... 1,966 -- --
(Increase) in deferred line installation costs.............................. (1,289) (806) (1,136)
Increase in accounts payable and accrued expenses........................... 3,192 4,084 1,994
Increase in deferred revenue................................................ 9,505 9 716
Increase in customer deposits............................................... 1,366 11 6
Other, net.................................................................. (3,703) (70) (16)
--------- --------- ---------
Net cash (used in) operating activities................................... (11,802) (9,478) (11,362)
--------- --------- ---------
Cash Flows from Investing Activities
Purchase of property and equipment................................................... (70,290) (5,272) (3,363)
Available-for-sale securities:
Purchases.......................................................................... (207,681) -- --
Sales.............................................................................. 17,577 -- --
Maturities......................................................................... 62,389 -- --
Business acquisitions (Note 11)...................................................... (80,081) -- --
Deposits on PCS licenses (Note 13)................................................... (4,800) -- --
Other................................................................................ (222) (266) (79)
--------- --------- ---------
Net cash (used in) investing activities................................... (283,108) (5,538) (3,442)
--------- --------- ---------
Cash Flows from Financing Activities
Increase (decrease) in checks issued not yet presented for payment................... (919) 885 34
Proceeds from line of credit agreements.............................................. 55,925 42,200 8,400
Payments on line of credit agreements................................................ (59,825) (42,100) (4,900)
Proceeds from long-term debt......................................................... 2,060 -- --
Payments on long-term debt........................................................... (2,065) -- --
Net proceeds from issuance of common stock........................................... 396,214 13,992 6,629
Reissuance (purchase) of treasury stock.............................................. -- 39 (33)
--------- --------- ---------
Net cash provided by financing activities................................. 391,390 15,016 10,130
--------- --------- ---------
Net increase (decrease) in cash and cash equivalents...................... 96,480 -- (4,674)
Cash and cash equivalents:
Beginning............................................................................ -- -- 4,674
--------- --------- ---------
Ending............................................................................... $ 96,480 $ -- $ --
========= ========= =========
Supplemental Disclosure of Cash Flow Information
Cash payment for interest, net of interest capitalized 1996 $204; 1995 $62;
and 1994 none...................................................................... $ 300 $ 261 $ 35
========= ========= =========
Supplemental Schedule of Noncash Investing and Financing Activities
Accounts payable incurred for property and equipment................................. $ 5,989 $ 1,234 $ 141
========= ========= =========
Purchase business acquisitions (Note 11)
See Notes to Consolidated Financial Statements.
F-6
MCLEOD, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1. Nature of Business and Significant Accounting Policies
Nature of business: The Company is a diversified telecommunications
company that provides a broad range of products and services to business and
residential customers and government agencies in the Midwest, primarily in
Iowa and Illinois. The Company's services primarily include local and long-
distance telecommunications services, competitive access services, including
special access and private line services, and maintenance and installation
services on fiber optic telecommunications networks. The Company also provides
telemarketing services to businesses and nonprofit entities throughout the
United States and publishes telephone directories in a fifteen-state area
primarily in the midwestern United States. The Company's business is highly
competitive and is subject to various federal, state and local regulations.
Accounting estimates: The preparation of financial statements in
conformity with generally accepted accounting principles requires management
to make estimates and assumptions that affect the reported amount of assets
and liabilities 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.
A summary of the Company's significant accounting policies is as follows:
Principles of consolidation: The accompanying financial statements include
those of the Company and its subsidiaries, all of which are wholly-owned. All
significant intercompany items and transactions have been eliminated in
consolidation.
Cash and cash equivalents: For purposes of reporting cash flows, the
Company considers all highly liquid debt instruments purchased with a maturity
of three months or less to be cash equivalents.
Investments: Management determines the appropriate classification of the
securities at the time they are acquired and evaluates the appropriateness of
such classifications at each balance sheet date. The Company has classified
its securities as available-for-sale. Available-for-sale securities are stated
at fair value, and unrealized holding gains and losses, net of the related
deferred tax effect, are reported as a component of stockholders' equity.
Realized gains and losses are determined on the basis of the specific
securities sold.
Trade receivables: In accordance with the industry practice for the
publication of telephone directories, trade receivables include certain
unbilled revenue from installment contracts. It is anticipated that a
substantial portion of all such amounts at December 31, 1996 will be collected
within one year (see Note 2).
Inventory: Inventory is carried principally at the lower of average cost
or market and consists primarily of new and reusable parts to maintain fiber
optic networks. Inventories of approximately $1.6 million used to support a
maintenance agreement are amortized on a straight-line basis over the 10-year
life of the agreement (see Note 2).
F-7
Note 1. Nature of Business and Significant Accounting Policies--(Continued)
Property and equipment: Property and equipment is stated at cost.
Construction costs, including interest, are capitalized during the
installation of fiber optic telecommunications networks. Depreciation is
computed by the straight-line method over the following estimated useful
lives:
Years
-----
Telecommunications networks........ 5-15
Furniture, fixtures and equipment.. 2-10
The Company's telecommunications networks are subject to technological
risks and rapid market changes due to new products and services and changing
customer demand. These changes may result in changes in the estimated economic
lives of these assets.
Goodwill and customer lists: Goodwill and customer lists resulting from
the Company's acquisitions are being amortized over a range of 5 to 25 years
using the straight-line method and are periodically reviewed for impairment
based upon an assessment of future operations to ensure that they are
appropriately valued. Accumulated amortization on goodwill totaled $1,049,000
and $117,000, and accumulated amortization on customer lists totaled $432,000
and none at December 31, 1996 and 1995, respectively.
Noncompete agreements: Noncompete agreements primarily relate to
directories previously acquired by Telecom*USA Publishing Group, Inc. (now
known as McLeodUSA Publishing Company (McLeodUSA Publishing)) and are being
amortized by the straight-line method over various periods. Accumulated
amortization on noncompete agreements totaled $250,000 and none at December
31, 1996 and 1995, respectively.
Deferred line installation costs: Deferred line installation costs include
costs incurred in the establishment of local access lines for customers and
are being amortized on the straight-line method over the life of the average
customer contract. The contracts' terms do not exceed 60 months. Accumulated
amortization on deferred line installation costs totaled $1,148,000 and
$518,000 at December 31, 1996 and 1995, respectively.
Income tax matters: The Company recognizes deferred tax assets and
liabilities for the expected future tax consequences of events that have been
included in the financial statements or tax returns. Under this method,
deferred tax assets and liabilities are determined based on the difference
between the financial statement and tax bases of assets and liabilities using
enacted tax rates in effect for the year in which the differences are expected
to reverse. Net deferred tax assets are reduced by a valuation allowance when
appropriate. Deferred tax assets and liabilities are adjusted for the effects
of changes in tax laws and rates on the date of enactment.
Deferred revenue: Amounts received in advance under long-term leases of
fiber optic telecommunications networks are recognized as revenue on a
straight-line basis over the life of the leases.
Revenue recognition: Revenues for local and long-distance services are
recognized when subscribers use telecommunications services. The revenue from
long-term leases of fiber optic telecommunications networks is recognized over
the term of the lease. Base annual revenue for telecommunications contract
maintenance is recognized on a straight-line basis over the term of the
contract. Additional services provided under these contracts are recognized as
the services are performed.
F-8
Note 1. Nature of Business and Significant Accounting Policies--(Continued)
Fees from telemarketing contracts are recognized as revenue in the period
the services are performed.
Revenues from directories are recorded upon publication.
Customer deposits consist of cash received from customers at the time a
sales contract is signed. They are recorded as revenue when the related
directory is published or when the related service is performed.
Cost of service and deferred expenses: Cost of service includes local and
long-distance services purchased primarily from two Regional Bell Operating
Companies and one interexchange carrier and the cost of operating the
Company's fiber optic telecommunications networks. The agreement with the
interexchange carrier requires minimum monthly purchase and minutes-of-usage
commitments. Cost of service also includes direct costs associated with
telemarketing services and the production costs associated with the
publication of directories.
Deferred expenses consist of production and selling costs on unpublished
directory advertising orders. They are expensed when the related directory is
published and the related revenue of the directory is recognized.
Stock options issued to employees: In fiscal year 1996, the Company
adopted the provisions of SFAS No. 123, Accounting for Stock-Based
Compensation, which establishes a fair value based method for the financial
reporting of its stock-based employee compensation plans. However, as allowed
by the new standard, the Company has elected to continue to measure
compensation using the intrinsic value based method as prescribed by
Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to
Employees. Under this method, compensation is measured as the difference
between the market value of the stock on the grant date, less the amount
required to be paid for the stock. The difference, if any, is charged to
expense over the periods of service.
The estimated market value used for the stock options granted was
determined on a periodic basis by the Company's Board of Directors prior to
the Company's initial public offering on June 10, 1996 (see Note 8).
Subsequent to the Company's initial public offering, the market value used for
stock options granted is based upon the closing price of the Class A common
stock on the day before the grant date.
Stock options issued to nonemployees: The Company uses the Black-Scholes
model to determine the fair value of the stock options issued to nonemployees
at the date of grant. This amount is amortized to expense over the vesting
period of the options.
Loss per common and common equivalent share: Loss per common and common
equivalent share has been computed using the number of shares of common stock
and common stock equivalents outstanding after giving effect to the
recapitalization (see Note 8). Pursuant to Securities and Exchange Commission
Staff Accounting Bulletin No. 83, stock issued and stock options granted with
exercise prices below the initial public offering price during the twelve-
month period preceding the date of the initial filing of the Registration
Statement filed in connection with the Company's initial public offering have
been included in the calculation as if they were outstanding for all periods
through June 30, 1996, the end of the quarter in which the initial public
offering was declared effective.
Fair value of financial instruments: The fair value of the Company's
investment in available-for-sale securities is disclosed in Note 3. The
carrying amount of long-term debt approximates fair value because these
obligations bear interest at current rates.
F-9
Note 1. Nature of Business and Significant Accounting Policies--(Continued)
Reclassifications: Certain items in the 1995 consolidated financial
statements have been reclassified, with no effect on net loss or accumulated
deficit, to be consistent with the classification in the 1996 consolidated
financial statements.
Note 2. Trade Receivables and Major Customer
The composition of trade receivables, net is as follows:
December 31,
-------------------
1996 1995
--------- --------
(In thousands)
Trade receivables:
Billed............................................. $22,846 $6,908
Unbilled........................................... 8,613 --
------- ------
31,459 6,908
Less allowance for doubtful accounts............... (3,899) (219)
and discounts..................................... ------- ------
$27,560 $6,689
======= ======
During 1992, the Company obtained an assignment of a contract covering the
maintenance and operations responsibilities for the State of Iowa Fiber Optic
Communications Network through October 2004. The annual fee for performing
this maintenance is adjusted annually by the change in the Consumer Price
Index and for additions to the network. The revenue from this and related
contracts amounted to approximately $5,936,000, $4,937,000 and $3,407,000 for
1996, 1995 and 1994, respectively. The Company also had additional revenues
from the State of Iowa for various fiber optic network construction projects,
which totaled $3,788,000 and $403,000 in 1996 and 1995, respectively. Trade
receivables include approximately $4,860,000 and $2,143,000 from this customer
at December 31, 1996 and 1995, respectively.
Note 3. Investments
At December 31, 1996, the Company held $147,439,000, $54,759,000 and
$7,850,000 in corporate debt securities, United States Government and
governmental agency securities and mortgage-backed securities, respectively.
The Company has classified these securities as available-for-sale, and at
December 31, 1996, their amortized cost approximates fair value. The
available-for-sale securities have been classified as cash and cash
equivalents, investment in available-for-sale securities--current and
investment in available-for-sale securities--long-term, with $82,056,000,
$80,518,000 and $47,474,000, respectively, being recorded in each
classification at December 31, 1996.
The contractual maturities of the available-for-sale securities at December
31, 1996 are as follows (In thousands):
Due within one year..................................... $161,205
Due after one year through three........................ 40,731
years
Due after three years................................... 262
Mortgage-backed securities.............................. 7,850
--------
$210,048
========
Expected maturities will differ from contractual maturities because the
issuers of certain debt securities do have the right to call or prepay their
obligations without any penalties. The amount classified as current assets on
the accompanying balance sheets represent the expected maturities of the debt
securities during the next year.
F-10
Note 4. Pledged Assets and Long-term Debt
Long-term debt consisted of the following at December 31, 1996 and 1995:
1996 1995
---- ----
(In thousands)
Borrowings on line of credit agreements (A) and (B) .............................. $ -- $3,600
Note payable, due January 1, 1997, including interest at 6.625%
Collateralized by a second lien on publishing rights to purchased
directories.................................................................... 500 --
Note payable, due in various annual installments, including interest at
8.25%, through 2006. Collateralized by publishing rights to
purchased directories........................................................... 1,008 --
Contracts payable, to finance company, due in various monthly
payments, including interest at 8.50% to 8.625%, through
November 1998, collateralized by equipment with a depreciated
cost of approximately $298,000.................................................. 248 --
Incentive compensation agreements, due in various estimated
amounts plus interest at 6% through January 2001 (See Note 11).................. 1,610 --
------ ------
3,366 3,600
Less current maturities............................................................ 793 --
------ ------
$2,573 $3,600
====== ======
(A) At December 31, 1995, the Company had a line of credit agreement with The
First National Bank of Chicago under which it could borrow up to
$20,000,000 from any of three facilities as specified in the agreement. In
March 1996, the agreement was amended to increase the allowable maximum
borrowings to $32,000,000. The agreement required interest payments and
facility fees to be paid at various rates. Class B common stock options
were granted to a stockholder which guaranteed any borrowings under two of
the facilities. The Company used the Black-Scholes model to determine the
value of the options, which was approximately $3,400,000, at the date of
issuance. This value was being amortized over the vesting period of the
options. A portion of the proceeds from the Company's initial public
offering on June 10, 1996 (see Note 8) was used to pay off all existing
indebtedness under these credit facilities, which were subsequently
cancelled. Upon cancellation, the vesting on Class B common stock options
was terminated which also terminated the amortization of the fair value of
the options. At December 31, 1996, a total of 1,300,688 Class B common
stock options are vested.
Due to the inclusion of the amortization of the fair value of these
options in interest expense, the effective average interest rate on the
borrowings under these credit facilities was approximately 15%, 27% and
47% for the years ended December 31, 1996, 1995 and 1994, respectively.
(B) At December 31, 1996, a subsidiary of the Company has a line of credit
agreement with a bank, which expires May 2, 1997. The subsidiary may
borrow up to 80% of its eligible trade receivables up to a maximum of
$2,500,000. Borrowings under this agreement are collateralized by
substantially all of the subsidiary's assets and bear interest at the
bank's prime rate (the current effective rate is 8.25%).
F-11
Note 4. Pledged Assets and Long-term Debt--(Continued)
Principal payments required on the long-term debt at December 31, 1996 are
as follows (in thousands):
1997............................................... $ 793
1998............................................... 1,090
1999............................................... 515
2000............................................... 378
2001............................................... 114
Later years........................................ 476
------
$3,366
======
Note 5. Leases and Commitments
Leases: The Company leases its facilities under noncancelable agreements
which expire at various times through March 2001. These agreements require
various monthly rentals plus the payment of applicable property taxes,
maintenance and insurance. The Company also leases vehicles and equipment under
agreements which expire at various times through December 2001 and require
various monthly rentals.
The total minimum rental commitment at December 31, 1996 under the leases
mentioned above is as follows (In thousands):
1997................................................ $ 4,935
1998................................................ 4,133
1999................................................ 3,386
2000................................................ 2,702
2001................................................ 1,619
Thereafter.......................................... 6,510
-------
$23,285
=======
The total rental expense included in the consolidated statements of
operations for 1996, 1995 and 1994 is approximately $3,640,000, $1,558,000 and
$622,000, respectively, which also includes short-term rentals for office
facilities.
Network construction: During 1995, the Company was awarded contracts from
the State of Iowa to build 265 fiber optic telecommunications network segments
throughout the State of Iowa. Upon completion of each segment, the Company will
receive approximately $115,000 for a seven-year lease for certain capacity on
that segment. The Company will recognize this revenue of approximately
$30,475,000 on a straight-line basis over the term of the lease based on the
relationship of individual segment costs to total projected costs. For the years
ended December 31, 1996 and 1995, revenue of $445,000 and none, respectively,
had been recognized under these contracts.
F-12
Note 5. Leases and Commitments--(Continued)
The Company estimates that minimum future construction costs required to
fulfill its obligations under the 1995 contract with the State of Iowa would
be approximately $24,986,000. The Company, however, expects that its actual
construction costs will be higher with respect to such network segments,
because the Company is adding more fiber and route miles than is contractually
required with respect to such construction, in order to optimize the design of
its network. The Company anticipates that the costs to complete this project
will be incurred as follows (In thousands):
1997........................................... $13,413
1998........................................... 9,701
1999........................................... 1,872
-------
$24,986
=======
Buildings: In August 1996, the Company purchased approximately 194 acres
of land on which the Company is constructing its headquarters and associated
buildings. Of the land purchased, approximately 75 acres was purchased from a
subsidiary of a stockholder for approximately $692,000. At December 31, 1996,
the total remaining commitments on the building in progress, including
fixtures, is approximately $14.7 million.
Note 6. Income Tax Matters
Net deferred taxes consist of the following components as of December 31,
1996 and 1995:
1996 1995
---- ----
(In thousands)
Deferred tax assets:
Net operating loss carryforwards.................... $19,419 $ 9,681
Accruals and reserves not currently deductible...... 4,033 529
Deferred revenues................................... 285 301
Other............................................... 571 17
------- -------
24,308 10,528
Less valuation allowance............................ 16,211 8,418
------- -------
8,097 2,110
------- -------
Deferred tax liabilities:
Deferred line installation cost..................... 833 570
Property and equipment.............................. 2,202 1,540
Customer list....................................... 3,698 --
Deferred expenses................................... 1,035 --
Other............................................... 329 --
------- -------
8,097 2,110
------- -------
$ -- $ --
======== =======
A valuation allowance has been recognized to offset the related net
deferred tax assets due to the uncertainty of realizing the benefit of the
loss carryforwards. The Company has available net operating loss carryforwards
totaling approximately $48.5 million which expire in various amounts in the
years 2008 to 2011.
F-13
Note 6. Income Tax Matters--(Continued)
The income tax provision differs from the amount of income tax determined
by applying the U. S. Federal income tax rate to pretax income for 1996, 1995
and 1994 due to the following:
1996 1995 1994
---- ---- ----
(In thousands)
Computed "expected" tax (benefit) $(7,821) $(3,965) $(3,996)
Increase (decrease) in income taxes
resulting from:
Change in valuation allowance 7,793 3,007 4,622
Deferred tax rate differential
on temporary differences 1,661 919 (594)
Tax deductions due to
exercises of incentive stock options (2,028) -- --
Other 395 39 (32)
------- ------- -------
$ -- $ -- $ --
======== ======== ========
Note 7. Stock-based Compensation Plans
At December 31, 1996, the Company has various stock-based compensation
plans which are described below. Grants under the Company's stock option plans
are accounted for in accordance with Accounting Principles Board (APB) Opinion
No. 25 and related Interpretations. The Company issued 965,166 and 688,502
stock options in January and February 1996. The estimated fair market value of
these options at the date of grant was later determined to exceed the
exercise price by $4,170,000 and $5,020,000, respectively. As a result, the
Company is amortizing approximately $9,190,000 over the vesting period of
these options. Compensation cost of $2,016,000 has been charged to income for
the year ended December 31, 1996 using the intrinsic value based method as
prescribed by APB No. 25. Had compensation cost for all of the stock-based
compensation plans been determined based on the grant date fair values of
awards granted during 1996 and 1995, as prescribed by SFAS No. 123, reported
net loss and loss per common and common equivalent share would have been as
follows (in thousands, except per share data):
December 31,
----------------------
1996 1995
---------- ----------
Pro forma net loss $(24,776) $(11,646)
Pro forma loss per common and common (0.58) (0.31)
equivalent share
1992, 1993 and 1995 Incentive Stock Option Plans: The Company has reserved
5,410,588 shares of Class A common stock for issuance to employees under the
1992, 1993 and 1995 Incentive Stock Option Plans. Options outstanding under
these plans were granted at prices equal to the estimated fair market value on
the dates of grant as determined by the Company's Board of Directors. Under
the 1992 and 1993 plans, all options granted become exercisable at a rate of
25% per year, on a cumulative basis, and expire seven years after the date of
grant. Under the 1995 plan, all options, except for options granted to the
Company's chairman and chief executive officer, become exercisable at a rate
of 25% per year, on a cumulative basis, beginning five years from the date of
grant. The options granted to the Company's chairman and chief executive
officer vest at a rate of 20% per year on a cumulative basis. All options
granted under the 1995 plan expire ten years after the date of grant. These
plans have been superseded by the 1996 Employee Stock Option Plan, and no
future grants of options will be made under these plans.
F-14
Note 7. Stock-based Compensation Plans--(Continued)
1996 Employee Stock Option Plan: The Company has reserved 4,458,236 shares
of Class A common stock for issuance to employees under the 1996 Employee
Stock Option Plan, which supersedes the 1992, 1993 and 1995 Incentive Stock
Option Plans. The exercise price for options granted under this plan is the
fair market value of the Company's Class A common stock on the day before the
grant date (or 110% of the fair market value if the grantee beneficially owns
more than 10% of the outstanding Class A common stock). The options granted
expire ten years after the grant date (or five years after the grant date if
the grantee beneficially owns more than 10% of the outstanding Class A common
stock), and vest over periods determined by the Compensation Committee;
however, no more than $100,000 worth of stock covered by the options may
become exercisable in any calendar year by an individual employee. The 1996
Plan will terminate in March 2006, unless terminated earlier by the Board of
Directors.
Directors' Stock Option Plan: The Company has reserved 550,000 shares of
Class A common stock for issuance under the Directors' Plan to directors who
are not officers or employees of the Company. The Director's Plan was adopted
and approved by the stockholders in 1993 and amended and restated on March 28,
1996 to be a ''formula'' plan providing for an automatic grant of options to
eligible directors. Each eligible director who commences service on the Board
of Directors after the amendment and restatement of the plan will be granted
an initial option to purchase 10,000 shares of Class A common stock. An
additional option to purchase 5,000 shares of Class A common stock will be
granted after each of the next two annual meetings to each eligible director
who remains for the two-year period. Options granted under the Directors' Plan
vest at a rate of 25% per year, on a cumulative basis and expire seven years
after the date of grant (ten years after the date of grant for options granted
under the amended and restated plan). However, upon a change in control of the
Company as defined in the Directors' Plan, all options will become fully
exercisable. The Company has the right to repurchase any Class A common stock
issued pursuant to the exercise of an option granted under this plan that is
offered for sale to an individual who is not an employee or director of the
Company. The Directors' Plan will terminate in March 2006, unless terminated
earlier by the Board of Directors.
Employee Stock Purchase Plan: Under the stock purchase plan, employees may
purchase up to an aggregate of 1,000,000 shares of Class A common stock
through payroll deductions. Employees of the Company who have been employed
more than six months and who are regularly scheduled to work more than 20
hours per week are eligible to participate in the plan, provided that they own
less than five percent of the total combined voting power of all classes of
stock of the Company. The purchase price for each share will be determined by
the Compensation Committee, but may not be less than 90% of the closing price
of the Class A common stock on the first or last trading day of the payroll
deduction period, whichever is lower. No employee may purchase in any calendar
year Class A common stock having an aggregate fair value in excess of $25,000.
Upon termination of employment, an employee other than a participating
employee who is subject to Section 16(b) under the Securities Exchange Act of
1934, as amended, will be refunded all monies in his or her account and the
employee's option to purchase shares will terminate. The plan will terminate
in March 2006, unless terminated earlier by the Board of Directors. The
Company has implemented this plan effective February 1, 1997.
The fair value of each grant under the Company's stock option plans is
estimated at the grant date using the Black-Scholes option-pricing model with
the following weighted-average assumptions for grants in 1996 and 1995,
respectively: risk-free interest rates of 6.08% and 6.30%; price volatility of
40% and expected lives of 4 years for both years and no expected dividends.
F-15
Note 7. Stock-based Compensation Plans--(Continued)
A summary of the status of the Company's stock option plans as of and for
the years ended December 31, 1996, 1995 and 1994 is as follows (In thousands,
except price data):
Weighted-
Average
Exercise
Shares Price
------- ---------
Outstanding at January 1, 1994..................... 2,569 $0.60
Granted.......................................... 786 1.55
Forfeited........................................ (233) 0.95
-----
Outstanding at December 31, 1994................... 3,122 0.82
Granted.......................................... 2,006 2.18
Exercised........................................ (11) 0.29
Forfeited........................................ (248) 1.75
-----
Outstanding at December 31, 1995................... 4,869 1.33
Granted.......................................... 3,502 13.14
Exercised........................................ (491) 1.30
Forfeited........................................ (336) 7.64
-----
Outstanding at December 31, 1996................... 7,544 6.54
=====
Number Of Options
---------------------
1996 1995 1994
----- ---- ----
Exercisable, end of year.................. 2,324 1,581 1,035
===== ===== =====
Weighted-average fair value per
option of options granted 5.74 0.86
during the year ===== =====
Other pertinent information related to the options outstanding at December
31, 1996 is as follows (In thousands except life and price data):
Options Outstanding Options Exercisable
------------------------------------------------ -------------------
Weighted-
Average Weighted- Weighted-
Remaining Average Average
Range Of Number Contractual Exercise Number Exercise
Exercise Prices Outstanding Life Price Exercisable Price
------------------ ----------- ----------- --------- ----------- -------------------
$0.27 to $1.47........................ 2,517 3.42 $ .71 1,969 $0.61
$1.73 to $2.93........................ 3,351 6.05 2.39 333 2.10
$4.29 to $9.30........................ 56 7.19 6.49 22 4.37
$20.00 to $28.50...................... 1,620 9.57 24.21 -- --
----- -----
7,544 5.94 6.54 2,324 0.85
===== =====
In addition, the Company has reserved 1,300,688 shares of Class B common
stock for issuance to a stockholder which had guaranteed certain debt
agreements which were repaid with proceeds from the Company's initial public
offering and cancelled. All of these options have vested at December 31, 1996.
F-16
Note 8. Capital Stock Information and Investor Agreement
Public offerings: On June 10, 1996, the Company undertook an initial
public offering of Class A common stock which yielded net proceeds of
approximately $258 million. On November 20, 1996, the Company completed an
additional public offering of Class A common stock which yielded net proceeds
of approximately $138 million in additional capital.
Recapitalization: In March 1996, the Company's Board of Directors
authorized a restatement of its Articles of Incorporation, increasing the
authorized Class A common stock from 15,000,000 shares of $.01 par value stock
to 75,000,000 shares of $.01 par value stock and increasing the authorized
Class B common stock from 15,000,000 shares of $.01 par value stock to
22,000,000 shares of $.01 par value stock. All Class B common stock has rights
identical to Class A common stock other than their voting rights, which are
equal to .40 vote per share. Each share of Class B common stock is convertible
into one share of Class A common stock at the option of the holder. The
restated Articles of Incorporation also authorizes the Board of Directors to
issue up to 2,000,000 shares of $.01 par value preferred stock. The terms of
the preferred stock are determined at the time of issuance. The Board of
Directors also declared a 3.75 to 1 stock split for both the Class A and Class
B common stock which was effected in the form of a stock dividend. All
references to share and per share amounts give retroactive effect to this
stock split and recapitalization.
Additionally, the Company has authorized but not issued 1,150,000 shares of
$5.50 par value redeemable Class A preferred stock. If issued, holders of the
Class A preferred stock would be entitled to nominate, vote and elect two
additional members to the Company's Board of Directors and to receive cash
dividends on the par value of the stock at the New York prime plus two
percent. Such dividends are cumulative.
Investor Agreement: On April 1, 1996, certain stockholders entered into an
Investor Agreement, which became effective on June 10, 1996, the effective
date of the Registration Statement filed in connection with the Company's
initial public offering, and which was amended on October 23, 1996. This
agreement provides for the election of directors designated by certain
principal stockholders and prevents certain principal stockholders from
disposing of any equity securities of the Company for a period of two years
unless consented to by the Board of Directors. In addition, certain principal
stockholders agreed that for a period of three years they will not acquire any
securities or options issued by the Company, except as allowed by previous
agreements or by the Board of Directors.
Note 9. Employment Agreements
Employment, Confidentiality and Noncompetition Agreements: During the year
ended December 31, 1996, the Company entered into employment, confidentiality
and noncompetition agreements with 54 members of senior management, which
provide that during their term of employment and for a two-year period
following termination of employment, the executive employee will not compete
with the Company. The two-year period is reduced to a one-year period for
senior management employees who are not executive employees. As partial
consideration for signing these agreements, the senior management employees
have been granted options to purchase an aggregate of 919,500 shares of Class
A common stock, at exercise prices ranging from $20.00 to $28.50 per share.
These options vest with respect to one-third of the shares underlying the
options in the last month of the fourth year following the date of grant, and
one-third in each of the two subsequent seven-month periods. The agreements
also provide that the senior management employees may not disclose any
confidential information during or after employment.
F-17
Note 9. Employment Agreements--(Continued)
Change-of-Control Agreements: On May 29, 1996, the Company also entered
into change-of-control agreements with the senior management executive
employees discussed above, which provide for certain payments in connection
with termination of employment after a change of control (as defined within
the agreements) of the Company. The change-of-control agreements terminate on
December 31, 2006 unless a change of control occurs during the six-month
period prior to December 31, 2006, in which case the agreements terminate on
December 31, 2007. The agreements provide that if an executive terminates his
or her employment within six months after a change of control or if the
executive's employment is terminated within 24 months after a change of
control in accordance with the terms and conditions set forth in the
agreements, the executive will be entitled to certain benefits. The benefits
include cash compensation, immediate vesting of outstanding stock options and
coverage under the Company's group health plan.
Note 10. Retirement Plans
The Company has various 401(k) profit-sharing plans available to eligible
employees. The Company's contributions to the plans are discretionary. The
Company contributed approximately $242,000, $44,000 and $12,000 for the years
ended December 31, 1996, 1995 and 1994, respectively.
Note 11. Acquisitions
MWR Telecom, Inc. (MWR): On April 28, 1995, the Company issued 3,676,058
shares or approximately $8.3 million of the Company's Class B common stock in
exchange for all of the outstanding common stock of MWR. MWR provides fiber
optics telecommunication services between interexchange carriers and their
customers in the Des Moines, Iowa area. In addition, the Company granted an
option to the seller to purchase 3,529,414 shares of Class B common stock for
$2.27 per share. This option was exercised on June 15, 1995.
Ruffalo, Cody & Associates, Inc. (Ruffalo, Cody): On July 15, 1996, the
Company acquired Ruffalo, Cody for a total purchase price of approximately
$17.3 million, which consisted of approximately $5.1 million in cash
(including approximately $243,000 in direct acquisition costs), 361,420 shares
of Class A common stock and 158,009 options to purchase shares of Class A
common stock granted to the holders of Ruffalo, Cody options. An additional
$50,782 in cash and 113,387 shares of Class A common stock were placed into
escrow for delivery to certain stockholders of Ruffalo, Cody contingent upon
certain conditions relating to ongoing revenues from an agreement with a major
long distance carrier to provide telemarketing services . The long distance
carrier terminated this contract effective December 31, 1996. In January 1997,
a total of $50,782 in cash and 37,107 shares were distributed pursuant to the
escrow agreement.
McLeodUSA Publishing: On September 20, 1996, the Company acquired
McLeodUSA Publishing for a total purchase price of approximately $76.1
million, which consisted of approximately $74.5 million in cash (including
approximately $436,000 in direct acquisition costs) and $1.6 million resulting
from the Company entering into an incentive compensation program with all
holders of nonvested McLeodUSA Publishing options, which provides for payments
to be made to these individuals on January 1 of the year following the year in
which the corresponding options would have vested.
Total Communications Systems, Inc. (TCSI): On December 9, 1996, the
Company purchased the customer base and certain other assets of TCSI for a
cash purchase price of approximately $534,000.
F-18
Note 11. Acquisitions--(Continued)
The following table summarizes the purchase price allocations for the
Company's business acquisitions:
Ruffalo, McLeod USA
MWR Cody Publishing TCSI
--------- ------------- ----------- ----------
(In thousands)
Cash purchase price............. $ -- $ 4,808 $74,060 $534
Acquisition costs............... -- 243 436 --
Incentive agreements............ -- -- 1,610 --
Stock issued.................... 8,333 8,945 -- --
Options to purchase Class A..... -- 3,911 -- --
common stock
Less cash to be received upon... -- (610) -- --
exercise of options............ ------ ------- ------- ----
$8,333 $17,297 $76,106 $534
====== ======= ======= ====
Working capital acquired, net... $ 393 $ 758 $ 8,367 $ 13
Fair value of other assets
acquired, primarily............ 5,298 1,379 4,408 30
telecommunications networks
and equipment
Intangibles, primarily.......... 2,642 15,160 64,315 491
goodwill and customer lists
Liabilities assumed............. -- -- (984) --
------ ------- ------- ----
$8,333 $17,297 $76,106 $534
====== ======= ======= ====
These acquisitions have been accounted for as purchases and the results of
operations are included in the consolidated financial statements since the
dates of acquisition.
The unaudited consolidated results of operations for the year ended
December 31, 1996 and 1995 on a pro forma basis as though MWR, Ruffalo, Cody,
McLeodUSA Publishing and TCSI had been acquired as of the beginning of the
respective periods are as follows:
1996 1995
---------- ---------
(In thousands)
Revenue..................................$128,624 $ 86,476
Net loss................................. (22,889) (17,249)
Loss per common and common equivalent
share................................... (0.53) (0.46)
- -------------------
* Includes MWR's results of operations for the period from January 1, 1995 to
April 28, 1995.
The pro forma financial information is presented for informational purposes
only and is not necessarily indicative of the operating results that would
have occurred had the acquisitions been consummated as of the above dates, nor
are such operating results necessarily indicative of future operating results.
F-19
Note 12. Related Party Transactions
During 1995, the Company entered into agreements with two stockholders that
gives certain rights-of-way to the Company for the construction of its
telecommunications network in exchange for capacity on the network. These
agreements were renegotiated in 1996 to clarify various terms of the
agreements.
The Company provided and purchased services from various companies, the
principals of which are stockholders or directors of McLeod, Inc. or are
affiliates. Revenues provided totaled $254,000, $103,000 and none and services
purchased, primarily rent and legal services, totaled $934,000, $675,000 and
$173,000, for the years ended December 31, 1996, 1995 and 1994, respectively.
In addition, at December 31, 1996 the Company has two $75,000 notes
receivable from officers. The notes bear interest at the applicable federal
interest rate for mid-term loans and require interest-only payments for two
years and then annual $25,000 payments plus interest until paid in full.
Note 13. Subsequent Events
Debt offering: On March 4, 1997, the Company completed a private offering
of 10 1/2% Senior Discount Notes due March 1, 2007 at an original issue
discount in which the Company received approximately $289.5 million in net
proceeds. The notes will accrete at a rate of 10 1/2% per year, compounded
semi-annually, to an aggregate principal amount of $500 million by March 1,
2002. Interest will not accrue on the notes for five years, after which time
the notes will accrue interest at 10 1/2%, payable semi-annually. The notes
will contain certain covenants which, among other things, will restrict the
ability of the Company to incur additional indebtedness, pay dividends or make
distributions of the Company's or its subsidiaries' stock, enter into sale and
leaseback transactions, create liens, enter into transactions with affiliates
or related persons, or consolidate, merge or sell all of their assets. The
Notes will not be registered under the Securities Act of 1933, and therefore
will not be tradeable securities, however, the Company has agreed to file a
registration statement with the Securities and Exchange Commission with
respect to a registered offer to exchange the notes for new notes that will be
tradeable.
Personal Communications Services (PCS) licenses: In January 1997, the
Company was notified by the Federal Communications Commission (FCC) that it
was the successful bidder for 26 PCS licenses in 24 market areas covering all
of Iowa and certain cities in Illinois, Minnesota, Nebraska and South Dakota.
The PCS licenses will allow the Company to provide wireless telecommunications
services to its customers in the markets covered by the licenses. The Company
bid approximately $32.8 million for the licenses, which it will be required to
pay following grant of the licenses, which is expected to occur in the second
or third quarter of 1997. The Company made a $4,800,000 deposit with the FCC
at the beginning of the bidding process in 1996, which will be applied to the
Company's payment in 1997. This deposit is included in other long-term assets
at December 31, 1996.
Acquisitions: In January 1997, the Company issued 84,430 shares of Class A
common stock in exchange for all the outstanding shares of Digital
Communications of Iowa, Inc. (DCI), in a transaction accounted for as a
purchase. The total purchase price was approximately $2.3 million based on the
average closing market price of the Company's Class A common stock at the time
of the acquisition.
Also in January 1997, McLeodUSA Publishing exercised its option to acquire
six directories from Fronteer Financial Holdings, Ltd. for a total purchase
price of approximately $4 million.
F-20
INDEPENDENT AUDITOR'S REPORT
ON THE FINANCIAL STATEMENT SCHEDULES
To the Board of Directors
McLeod, Inc.
Cedar Rapids, Iowa
Our audits were made for the purpose of forming an opinion on the basic
consolidated financial statements taken as a whole. The consolidated
supplemental schedule II is presented for purposes of complying with the
Securities and Exchange Commission's rules and is not a part of the basic
consolidated financial statements. This schedule has been subjected to the
auditing procedures applied in our audits of the basic consolidated financial
statements and, in our opinion, is fairly stated in all material respects in
relation to the basic consolidated financial statements taken as a whole.
McGladrey & Pullen, LLP
Cedar Rapids, Iowa
January 31, 1997
S-1
MCLEOD, INC.
SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS
Column A Column B Column C Column D Column E
Additions
-----------------------
Balance Charged Charged Balance
at to to at
Beginning Cost and Other End of
Description of Period Expenses Accounts Deductions Period
----------- ----------- ------------- -------- ---------- ------------
Year Ended December 31, 1994:
Allowance for uncollectible accounts
and discounts................... $ -- $ 84,000 $ -- $ -- $ 84,000
Valuation reserve on deferred tax
assets............................. 789,000 4,622,000 -- -- 5,411,000
---------- ----------- -------- ---------- -----------
$ 789,000 $ 4,706,000 $ -- $ -- $ 5,495,000
========== =========== ======== ========== ===========
Year Ended December 31, 1995:
Allowance for doubtful accounts
and discounts................... $ 84,000 $ 135,000 $ -- $ -- $ 219,000
Valuation reserve on deferred tax
assets............................. 5,411,000 3,007,000 -- -- 8,418,000
---------- ----------- -------- ---------- -----------
$5,495,000 $ 3,142,000 $ -- $ -- $ 8,637,000
========== =========== ======== ========== ===========
Year Ended December 31, 1996:
Allowance for doubtful accounts
and discounts................... $ 219,000 $ 3,680,000* $ -- $ -- $ 3,899,000
Valuation reserve on deferred tax
assets............................. 8,418,000 7,793,000 -- -- 16,211,000
---------- ----------- -------- ---------- -----------
$8,637,000 $11,473,000 $ -- $ -- $20,110,000
========== =========== ======== ========== ===========
- ----------------------------
* Includes $2,768,000 of allowance for doubtful accounts and discounts related
to acquisitions during the year.
S-2
INDEX TO EXHIBITS
Exhibit
Number Exhibit Description
------- -------------------
2.1 Agreement and Plan of Reorganization dated April 28, 1995 among
Midwest Capital Group Inc., MWR Telecom, Inc. and McLeod, Inc. (Filed
as Exhibit 2.1 to Registration Statement on Form S-1, File No. 333-
3112 ("Initial Form S-1"), and incorporated herein by reference).
2.2 Agreement and Plan of Reorganization dated as of July 12, 1996 among
Ruffalo, Cody & Associates, Inc., certain shareholders of Ruffalo,
Cody & Associates, Inc. and McLeod, Inc. (Filed as Exhibit 2 to
Current Report on Form 8-K, File No. 0-20763, filed with the
Commission on July 29, 1996 and incorporated herein by reference).
2.3 Agreement and Plan of Reorganization dated as of August 15, 1996 among
Telecom*USA Publishing Group, Inc. and McLeod, Inc. (Filed as Exhibit
2 to Current Report on Form 8-K, File No. 0-20763, filed with the
Commission on August 26, 1996 and incorporated herein by reference).
2.4 Agreement and Plan of Reorganization dated as of January 27, 1997
among McLeod, Inc., Digital Communications of Iowa, Inc., Clark E.
McLeod and Mary E. McLeod. (Filed as Exhibit 2 to Current Report on
Form 8-K, File No. 0-20763, filed with the Commission on February 24,
1997 and incorporated herein by reference).
3.1 Amended and Restated Certificate of Incorporation of McLeod, Inc.
(Filed as Exhibit 3.1 to Initial Form S-1 and incorporated herein by
reference).
3.2 Amended and Restated Bylaws of McLeod, Inc. (Filed as Exhibit 3.2 to
Registration Statement on Form S-1, File No. 333-13885 ("November Form
S-1"), and incorporated herein by reference).
4.1 Form of Class A Common Stock Certificate of McLeod, Inc. (Filed as
Exhibit 4.1 to Initial Form S-1 and incorporated herein by reference).
4.2 Indenture dated March 4, 1997 between McLeod, Inc. and United States
Trust Company of New York, as Trustee, relating to the 10 1/2% Senior
Discount Notes Due 2007 of McLeod, Inc.
4.3 Initial Global 10 1/2% Senior Discount Note Due March 1, 2007 of
McLeod, Inc., dated March 4, 1997.
4.4 Form of Certificated 10 1/2% Senior Discount Note Due March 1, 2007 of
McLeod, Inc.
4.5 Registration Agreement dated March 4, 1997 among McLeod, Inc., Salomon
Brothers Inc and Morgan Stanley & Co. Incorporated.
4.6 Investor Agreement dated as of April 1, 1996 among McLeod, Inc., IES
Investments Inc., Midwest Capital Group Inc., MWR Investments Inc.,
Clark and Mary McLeod, and certain other stockholders. (Filed as
Exhibit 4.8 to Initial Form S-1 and incorporated herein by reference).
4.7 Amendment No. 1 to Investor Agreement dated as of October 23, 1996 by
and among McLeod, Inc., IES Investments Inc., Midwest Capital Group
Inc., MWR Investments Inc., Clark E. McLeod and Mary E. McLeod. (Filed
as Exhibit 4.3 to November Form S-1 and incorporated herein by
reference).
10.1 Credit Agreement dated as of May 16, 1994 among McLeod, Inc., McLeod
Network Services, Inc., McLeod Telemanagement, Inc., McLeod
Telecommunications, Inc. and The First National Bank of Chicago.
(Filed as Exhibit 10.1 to Initial Form S-1 and incorporated herein by
reference).
Exhibit
Number Exhibit Description
------- -------------------
10.2 First Amendment to Credit Agreement dated as of June 17, 1994 among
McLeod, Inc., McLeod Network Services, Inc., McLeod Telemanagement,
Inc., McLeod Telecommunications, Inc. and The First National Bank of
Chicago. (Filed as Exhibit 10.2 to Initial Form S-1 and incorporated
herein by reference).
10.3 Second Amendment to Credit Agreement dated as of December 1, 1994
among McLeod, Inc., McLeod Network Services, Inc., McLeod
Telemanagement, Inc., McLeod Telecommunications, Inc. and The First
National Bank of Chicago. (Filed as Exhibit 10.3 to Initial Form S-1
and incorporated herein by reference).
10.4 Third Amendment to Credit Agreement dated as of May 31, 1995 among
McLeod, Inc., McLeod Network Services, Inc., McLeod Telemanagement,
Inc., McLeod Telecommunications, Inc., MWR Telecom, Inc. and The First
National Bank of Chicago. (Filed as Exhibit 10.4 to Initial Form S-1
and incorporated herein by reference).
10.5 Fourth Amendment to Credit Agreement dated as of July 28, 1995 among
McLeod, Inc., McLeod Network Services, Inc., McLeod Telemanagement,
Inc., McLeod Telecommunications, Inc., MWR Telecom, Inc. and The First
National Bank of Chicago. (Filed as Exhibit 10.5 to Initial Form S-1
and incorporated herein by reference).
10.6 Fifth Amendment to Credit Agreement dated as of October 18, 1995 among
McLeod, Inc., McLeod Network Services, Inc., McLeod Telemanagement,
Inc., McLeod Telecommunications, Inc., MWR Telecom, Inc. and The First
National Bank of Chicago. (Filed as Exhibit 10.6 to Initial Form S-1
and incorporated herein by reference).
10.7 Sixth Amendment to Credit Agreement dated as of March 29, 1996 among
McLeod, Inc., McLeod Network Services, Inc., McLeod
Telecommunications, Inc., MWR Telecom, Inc. and The First National
Bank of Chicago. (Filed as Exhibit 10.7 to Initial Form S-1 and
incorporated herein by reference).
10.8 Security Agreement dated as of May 16, 1994 among McLeod, Inc., McLeod
Network Services, Inc., McLeod Telemanagement, Inc., McLeod
Telecommunications, Inc. and The First National Bank of Chicago.
(Filed as Exhibit 10.8 to Initial Form S-1 and incorporated herein by
reference).
10.9 First Amendment to Security Agreement dated as of December 1, 1994
among McLeod, Inc., McLeod Network Services, Inc., McLeod
Telemanagement, Inc., McLeod Telecommunications, Inc. and The First
National Bank of Chicago. (Filed as Exhibit 10.9 to Initial Form S-1
and incorporated herein by reference).
10.10 Support Agreement dated as of December 1, 1994 among IES Diversified
Inc., McLeod, Inc., McLeod Network Services, Inc., McLeod
Telemanagement, Inc., McLeod Telecommunications, Inc. and The First
National Bank of Chicago. (Filed as Exhibit 10.10 to Initial Form S-1
and incorporated herein by reference).
10.11 Agreement Regarding Support Agreement dated December 1994 between
McLeod, Inc. and IES Diversified Inc. (Filed as Exhibit 10.11 to
Initial Form S-1 and incorporated herein by reference).
10.12 Agreement Regarding Guarantee dated May 16, 1994 between McLeod, Inc.
and IES Diversified Inc. (Filed as Exhibit 10.12 to Initial Form S-1
and incorporated herein by reference).
10.13 Joinder to and Assumption of Credit Agreement dated as of April 28,
1995 between McLeod Merging Co. and The First National Bank of
Chicago. (Filed as Exhibit 10.13 to Initial Form S-1 and incorporated
herein by reference).
2
Exhibit
Number Exhibit Description
------- -------------------
10.14 Joinder to and Assumption of Security Agreement dated as of April 28,
1995 between McLeod Merging Co. and The First National Bank of
Chicago. (Filed as Exhibit 10.14 to Initial Form S-1 and incorporated
herein by reference).
10.15 Letter from The First National Bank of Chicago to James L. Cram dated
April 28, 1995 regarding extension of the termination date under the
Credit Agreement. (Filed as Exhibit 10.15 to Initial Form S-1 and
incorporated herein by reference).
10.16 Credit Agreement dated as of March 29, 1996 among McLeod, Inc., McLeod
Network Services, Inc., McLeod Telemanagement, Inc., McLeod
Telecommunications, Inc. MWR Telecom, Inc. and The First National Bank
of Chicago. (Filed as Exhibit 10.16 to Initial Form S-1 and
incorporated herein by reference).
10.17 Agreement for Construction Related Services dated as of October 17,
1995 between City Signal Fiber Services, Inc. and McLeod Network
Services, Inc. (Filed as Exhibit 10.17 to Initial Form S-1 and
incorporated herein by reference).
10.18 Construction Services Agreement dated March 27, 1996 between City
Signal Fiber Services, Inc. and McLeod Network Services, Inc. (Filed
as Exhibit 10.18 to Initial Form S-1 and incorporated herein by
reference).
10.19 Fiber Optic Use Agreement dated as of February 14, 1996 between McLeod
Network Services, Inc. and Galaxy Telecom, L.P. (Filed as Exhibit
10.19 to Initial Form S-1 and incorporated herein by reference).
10.20 Agreement dated as of July 11, 1994 between McLeod Network Services,
Inc. and KLK Construction. (Filed as Exhibit 10.20 to Initial Form S-1
and incorporated herein by reference).
10.21 Lease Agreement dated September 5, 1995 between State of Iowa and MWR
Telecom, Inc. (Filed as Exhibit 10.21 to Initial Form S-1 and
incorporated herein by reference).
10.22 Lease Agreement dated September 5, 1995 between State of Iowa and
McLeod Network Services, Inc. (Filed as Exhibit 10.22 to Initial Form
S-1 and incorporated herein by reference).
10.23 Contract dated September 5, 1995 between Iowa Telecommunications and
Technology Commission and MWR Telecom, Inc. (Filed as Exhibit 10.23 to
Initial Form S-1 and incorporated herein by reference).
10.24 Contract dated June 27, 1995 between Iowa National Guard and McLeod
Network Services, Inc. (Filed as Exhibit 10.24 to Initial Form S-1 and
incorporated herein by reference).
10.25 Addendum Number One to Contract dated September 5, 1995 between Iowa
National Guard and McLeod Network Services, Inc. (Filed as Exhibit
10.25 to Initial Form S-1 and incorporated herein by reference).
10.26 U S WEST Centrex Plus Service Rate Stability Plan dated October 15,
1993 between McLeod Telemanagement, Inc. and U S WEST Communications,
Inc. (Filed as Exhibit 10.26 to Initial Form S-1 and incorporated
herein by reference).
10.27 U S WEST Centrex Plus Service Rate Stability Plan dated July 17, 1993
between McLeod Telemanagement, Inc. and U S WEST Communications, Inc.
(Filed as Exhibit 10.27 to Initial Form S-1 and incorporated herein by
reference).
3
Exhibit
Number Exhibit Description
------- -------------------
10.28 Ameritech Centrex Service Confirmation of Service Orders dated various
dates in 1994, 1995 and 1996 between McLeod Telemanagement, Inc. and
Ameritech Information Industry Services. (Filed as Exhibit 10.28 to
Initial Form S-1 and incorporated herein by reference).
10.29 Lease Agreement dated as of December 28, 1993 between 2060 Partnership
and McLeod Telemanagement, Inc., as amended by Amendments First to
Ninth dated as of July 3, 1994, March 25, 1994, June 22, 1994, August
12, 1994, September 12, 1994, September 20, 1994, November 16, 1994,
September 20, 1995 and January 6, 1996, respectively. (Filed as
Exhibit 10.29 to Initial Form S-1 and incorporated herein by
reference).
10.30 Lease Agreement dated as of May 24, 1995 between 2060 Partnership and
McLeod Telemanagement, Inc. (Filed as Exhibit 10.30 to Initial Form
S-1 and incorporated herein by reference).
10.31 Lease Agreement dated October 31, 1995 between I.R.F.B. Joint Venture
and McLeod Telemanagement, Inc. (Filed as Exhibit 10.31 to Initial
Form S-1 and incorporated herein by reference).
10.32 First Amendment to Lease Agreement dated as of November 20, 1995
between I.R.F.B. Joint Venture and McLeod Telemanagement, Inc. (Filed
as Exhibit 10.32 to Initial Form S-1 and incorporated herein by
reference).
10.33 Uniform Purchase Agreement dated July 22, 1993 between McLeod, Inc.
and Hill's Maple Crest Farms Partnership. (Filed as Exhibit 10.33 to
Initial Form S-1 and incorporated herein by reference).
10.34 Master Right-of-Way Agreement dated July 27, 1994 between McLeod
Network Services, Inc. and IES Industries Inc. (Filed as Exhibit 10.34
to Initial Form S-1 and incorporated herein by reference).
10.35 Master Right-of-Way and Tower Use Agreement dated February 13, 1996
between IES Industries Inc. and McLeod, Inc. (Filed as Exhibit 10.35
to Initial Form S-1 and incorporated herein by reference).
10.36 Master Pole, Duct and Tower Use Agreement dated February 20, 1996
between MidAmerican Energy Company and McLeod, Inc. (Iowa and South
Dakota). (Filed as Exhibit 10.36 to Initial Form S-1 and incorporated
herein by reference).
10.37 Master Pole, Duct and Tower Use Agreement dated February 20, 1996
between MidAmerican Energy Company and McLeod, Inc. (Illinois). (Filed
as Exhibit 10.37 to Initial Form S-1 and incorporated herein by
reference).
10.38 Settlement Agreement dated March 18, 1996 between U S WEST
Communications, Inc. and McLeod Telemanagement, Inc. (Filed as Exhibit
10.38 to Initial Form S-1 and incorporated herein by reference).
10.39 Agreement dated August 4, 1995 between Vadacom, Inc. and McLeod
Telemanagement, Inc. (Filed as Exhibit 10.39 to Initial Form S-1 and
incorporated herein by reference).
10.40 McLeod Telecommunications, Inc. 1992 Incentive Stock Option Plan.
(Filed as Exhibit 10.40 to Initial Form S-1 and incorporated herein by
reference).
10.41 McLeod, Inc. 1993 Incentive Stock Option Plan. (Filed as Exhibit 10.41
to Initial Form S-1 and incorporated herein by reference).
10.42 McLeod, Inc. 1995 Incentive Stock Option Plan. (Filed as Exhibit 10.42
to Initial Form S-1 and incorporated herein by reference).
4
Exhibit
Number Exhibit Description
------- -------------------
10.43 McLeod Telecommunications, Inc. Director Stock Option Plan. (Filed as
Exhibit 10.43 to Initial Form S-1 and incorporated herein by
reference).
10.44 Promissory Note dated July 18, 1995 between Kirk E. Kaalberg and
McLeod, Inc. (Filed as Exhibit 10.44 to Initial Form S-1 and
incorporated herein by reference).
10.45 Promissory Note dated March 29, 1996 between Stephen K. Brandenburg
and McLeod, Inc. (Filed as Exhibit 10.45 to Initial Form S-1 and
incorporated herein by reference).
10.46 Agreement dated April 28, 1995 among McLeod, Inc., McLeod
Telecommunications, Inc., McLeod Telemanagement, Inc., McLeod Network
Services, Inc. and Clark E. McLeod. (Filed as Exhibit 10.46 to Initial
Form S-1 and incorporated herein by reference).
+10.47 Telecommunications Services Agreement dated March 14, 1994 between
WilTel, Inc. and McLeod Telemanagement, Inc., as amended. (Filed as
Exhibit 10.47 to Initial Form S-1 and incorporated herein by
reference).
10.48 Amendment to Contract Addendum A to Contract No. 2102 dated March 31,
1993 between the Iowa Department of General Services and McLeod
Telecommunications, Inc. (Filed as Exhibit 10.48 to Initial Form S-1
and incorporated herein by reference).
10.49 Construction Services Agreement dated June 30, 1995 between MFS
Network Technologies, Inc. and MWR Telecom, Inc. (Filed as Exhibit
10.49 to Initial Form S-1 and incorporated herein by reference).
10.50 First Amendment to Agreement Regarding Support Agreement dated May 14,
1996 among McLeod, Inc., IES Diversified Inc. and IES Investments Inc.
(Filed as Exhibit 10.50 to Initial Form S-1 and incorporated herein by
reference).
10.51 First Amendment to Agreement Regarding Guarantee dated May 14, 1996
among McLeod, Inc., IES Diversified Inc. and IES Investments Inc.
(Filed as Exhibit 10.51 to Initial Form S-1 and incorporated herein by
reference).
10.52 Amended and Restated Directors Stock Option Plan of McLeod, Inc.
(Filed as Exhibit 10.52 to Initial Form S-1 and incorporated herein by
reference).
10.53 Forms of Employment, Confidentiality and Non-Competition Agreement
between McLeod, Inc. and certain employees of McLeod, Inc. (Filed as
Exhibit 10.53 to Initial Form S-1 and incorporated herein by
reference).
10.54 Form of Change-of-Control Agreement between McLeod, Inc. and certain
employees of McLeod, Inc. (Filed as Exhibit 10.54 to Initial Form S-1
and incorporated herein by reference).
10.55 McLeod, Inc. 1996 Employee Stock Option Plan, as amended. (Filed as
Exhibit 10.55 to November Form S-1 and incorporated herein by
reference).
10.56 McLeod, Inc. Employee Stock Purchase Plan, as amended.
10.57 Form of Indemnity Agreement between McLeod, Inc. and certain officers
and directors of McLeod, Inc. (Filed as Exhibit 10.57 to Initial Form
S-1 and incorporated herein by reference).
10.58 License Agreement dated April 24, 1996 between PageMart, Inc. and MWR
Telecom, Inc. (Filed as Exhibit 10.58 to Initial Form S-1 and
incorporated herein by reference).
5
Exhibit
Number Exhibit Description
------- -------------------
10.59 Assignment of Purchase Agreement dated August 15, 1996 between Ryan
Properties, Inc. and McLeod, Inc. (Filed as Exhibit 10.59 to November
Form S-1 and incorporated herein by reference).
10.60 Assignment of Purchase Agreement dated August 14, 1996 between Ryan
Properties, Inc. and McLeod, Inc. (Filed as Exhibit 10.60 to November
Form S-1 and incorporated herein by reference).
10.61 Asset Purchase Agreement dated September 4, 1996 between Total
Communication Services, Inc. and McLeod Telemanagement, Inc. (Filed as
Exhibit 10.61 to November Form S-1 and incorporated herein by
reference).
10.62 First Amendment to Asset Purchase Agreement dated September 30, 1996
between Total Communication Services, Inc. and McLeod Telemanagement,
Inc. (Filed as Exhibit 10.62 to November Form S-1 and incorporated
herein by reference).
10.63 McLeod, Inc. Incentive Plan. (Filed as Exhibit 10.63 to November Form
S-1 and incorporated herein by reference).
10.64 Amended and Restated Credit Agreement dated as of May 5, 1996 among
Teleco*USA Publishing Group, Inc., Telecom*USA Publishing Company and
Telecom*USA Neighborhood Directories, Inc. and Norwest Bank Iowa,
National Association. (Filed as Exhibit 10.64 to November Form S-1 and
incorporated herein by reference).
10.65 First Amendment to Amended and Restated Credit Agreement dated as of
January 31, 1996 by and between Telecom*USA Publishing Group, Inc.,
Telecom*USA Publishing Company and Telecom*USA Neighborhood
Directories, Inc. and Norwest Bank Iowa, National Association. (Filed
as Exhibit 10.65 to November Form S-1 and incorporated herein by
reference).
10.66 Lease Agreement dated as of September 26, 1994 between Ryan
Properties, Inc. and Ruffalo, Cody & Associates, Inc. (Filed as
Exhibit 10.66 to November Form S-1 and incorporated herein by
reference).
10.67 First Lease Amendment dated as of April 12, 1995 between Ryan
Properties, Inc. and Ruffalo, Cody & Associates, Inc. (Filed as
Exhibit 10.67 to November Form S-1 and incorporated herein by
reference).
10.68 Lease Agreement dated as of July 18, 1995 between 2060 Partnership,
L.P. and Telecom*USA Publishing Company. (Filed as Exhibit 10.68 to
November Form S-1 and incorporated herein by reference).
10.69 Lease Agreement dated April 26, 1995 by and between A.M. Henderson and
Telecom*USA Publishing Company. (Filed as Exhibit 10.69 to November
Form S-1 and incorporated herein by reference).
10.70 License Agreement dated as of April 19, 1994, between Ameritech
Information Industry Services and Telecom*USA Publishing Company.
(Filed as Exhibit 10.70 to November Form S-1 and incorporated herein
by reference).
10.71 License Agreement dated September 13, 1993 between U S WEST
Communications, Inc. and Telecom*USA Publishing Company. (Filed as
Exhibit 10.71 to November Form S-1 and incorporated herein by
reference).
10.72 Form of McLeod, Inc. Directors Stock Option Plan Option Agreement.
(Filed as Exhibit 10.72 to November Form S-1 and incorporated herein
by reference).
6
Exhibit
Number Exhibit Description
------- -------------------
10.73 Forms of McLeod, Inc. 1996 Employee Stock Option Plan Incentive Stock
Option Agreement. (Filed as Exhibit 10.73 to November Form S-1 and
incorporated herein by reference).
10.74 Forms of McLeod, Inc. 1996 Employee Stock Option Plan Non-Incentive
Stock Option Agreement. (Filed as Exhibit 10.74 to November Form S-1
and incorporated herein by reference).
10.75 Option Agreement dated April 27, 1995 between Fronteer Directory
Company, Inc. and Telecom*USA Publishing Company. (Filed as Exhibit
10.75 to November Form S-1 and incorporated herein by reference).
10.76 Promissory Note dated May 5, 1995 between Telecom*USA Publishing
Company and Fronteer Directory Company, Inc. (Filed as Exhibit 10.76
to November Form S-1 and incorporated herein by reference).
10.77 Security Agreement dated May 5, 1995 between Telecom*USA Publishing
Company and Fronteer Directory Company, Inc. (Filed as Exhibit 10.77
to November Form S-1 and incorporated herein by reference).
10.78 Design/Build Construction Contract dated September 17, 1996 between
Ryan Construction Company of Minnesota, Inc. and McLeod, Inc. (Filed
as Exhibit 10.78 to November Form S-1 and incorporated herein by
reference).
10.79 Guaranty Agreement dated as of October 17, 1996 by McLeod, Inc. in
favor of Kirkwood Community College. (Filed as Exhibit 10.79 to
November Form S-1 and incorporated herein by reference).
10.80 Industrial New Jobs Training Agreement dated as of October 31, 1996
between Kirkwood Community College and McLeod Telemanagement, Inc.
(Filed as Exhibit 10.80 to November Form S-1 and incorporated herein
by reference).
10.81 Industrial New Jobs Training Agreement dated as of October 31, 1996
between Kirkwood Community College and McLeod Telecommunications, Inc.
(Filed as Exhibit 10.81 to November Form S-1 and incorporated herein
by reference).
10.82 Industrial New Jobs Training Agreement dated as of October 31, 1996
between Kirkwood Community College and McLeod Network Services, Inc.
(Filed as Exhibit 10.82 to November Form S-1 and incorporated herein
by reference).
10.83 Industrial New Jobs Training Agreement dated as of October 31, 1996
between Kirkwood Community College and McLeod, Inc. (Filed as Exhibit
10.83 to November Form S-1 and incorporated herein by reference).
10.84 Change Order No. 1 to the Construction Services Agreement dated
November 22, 1995 by and between MWR TeIecom, Inc. and MFS Network
Technologies, Inc. (Filed as Exhibit 10.84 to November Form S-1 and
incorporated herein by reference).
10.85 Change Order No. 2 to the Construction Services Agreement dated August
14, 1996 between MWR Telecom, Inc. and MFS Network Technologies, Inc.
(Filed as Exhibit 10.85 to November Form S-1 and incorporated herein
by reference).
10.86 Change Order No. 3 to the Construction Services Agreement dated
October 31, 1996 between MWR Telecom, Inc. and MFS Network
Technologies, Inc. (Filed as Exhibit 10.86 to November Form S-1 and
incorporated herein by reference).
10.87 Independent Contractor Sales Agreement dated May, 1995 between Sprint
Communications Company L.P. and Ruffalo, Cody & Associates, Inc.
(Filed as Exhibit 10.87 to November Form S-1 and incorporated herein
by reference).
7
Exhibit
Number Exhibit Description
------- -------------------
10.88 Second Amendment to Asset Purchase Agreement dated October 31, 1996
between Total Communication Services, Inc. and McLeod Telemanagement,
Inc. (Filed as Exhibit 10.88 to November Form S-1 and incorporated
herein by reference)
10.89 Escrow Agreement dated July 15, 1996 among McLeod, Inc., certain
shareholders of Ruffalo, Cody & Associates, Inc., Albert P. Ruffalo
and Norwest Bank N.A. (Filed as Exhibit 10.89 to November Form S-1 and
incorporated herein by reference).
10.90 Sale and Purchase Agreement dated January 27, 1997 among McLeodUSA
Publishing Company, Fronteer Financial Holdings, Ltd., Classified
Directories, Inc., Larry A. Scott, James Greff, Randall L. Gowin and
Edwin Dressler and certain directors, officers and shareholders of
Fronteer Financial Holdings, Ltd.
10.91 Sale and Purchase Agreement dated February 27, 1997 among McLeodUSA
Publishing Company, Indiana Directories, Inc., John Morgan, Hank
Meijer, Jack Hendricks, Brad Nelson and Talking Directories, Inc.
10.92 Amendment to Sale and Purchase Agreement dated February 28, 1997
between McLeodUSA Publishing Company and Indiana Directories, Inc.
10.93 Ameritech Centrex Service Confirmation of Service Orders dated
August 21, 1996 between McLeod Telemanagement, Inc. and Ameritech
Information Industry Services.
*10.94 Amended and Restated Program Enrollment Terms dated November 1, 1996
between WorldCom Network Services, Inc. d/b/a WilTel and McLeod
Telemanagement, Inc.
11.1 Statement regarding Computation of Per Share Earnings.
16.1 Letter regarding Change in Certifying Accountant.
21.1 Subsidiaries of McLeod, Inc.
23.1 Consent of McGladrey & Pullen, LLP.
27.1 Financial Data Schedule.
99.1 Purchase Agreement dated as of August 15, 1996 between Iowa Land and
Building Company and Ryan Properties, Inc. (Filed as Exhibit 99.1 to
November Form S-1 and incorporated herein by reference).
99.2 Purchase Agreement dated as of June 28, 1996 between Donald E. Zvacek,
Dennis E. Zvacek and Robert J. Zvacek and Ryan Properties, Inc. (Filed
as Exhibit 99.2 to November Form S-1 and incorporated herein by
reference).
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+ Confidential treatment has been granted. The copy filed as an exhibit
omits the information subject to the confidential treatment request.
* To be filed by amendment.
8