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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(MARK ONE)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 1997
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD TO
------------ -------------
COMMISSION FILE NUMBER 0-20763
MCLEODUSA INCORPORATED
------------------------------------------------------
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 42-1407240
------------------------ ---------------------------------
(STATE OF INCORPORATION) (IRS EMPLOYER IDENTIFICATION NO.)
MCLEODUSA TECHNOLOGY PARK
6400 C STREET SW
P.O. BOX 3177
CEDAR RAPIDS, IOWA 52406-3177
--------------------------------------- ----------
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICE) (ZIP CODE)
319-364-0000
-------------------------------
(REGISTRANT'S TELEPHONE NUMBER,
INCLUDING AREA CODE)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [_]
The number of shares outstanding of each class of the issuer's common stock as
of July 31, 1997:
Common Stock Class A: ($.01 par value)............. 52,665,055 shares
Common Stock Class B: ($.01 par value)............. None
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INDEX
Page
PART I. FINANCIAL INFORMATION ----
- ------ ---------------------
Item 1. Financial Statements.................................................................................. 3
Consolidated Balance Sheets, June 30, 1997 (unaudited) and December 31, 1996.......................... 3
Unaudited Consolidated Statements of Operations for the three and six months ended
June 30, 1997 and 1996............................................................................. 4
Unaudited Consolidated Statements of Cash Flows for the six months ended
June 30, 1997 and 1996............................................................................. 5
Notes to Consolidated Financial Statements (unaudited)................................................ 6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations................. 10
PART II. OTHER INFORMATION
- ------- -----------------
Item 1. Legal Proceedings..................................................................................... 17
Item 4. Submission of Matters to a Vote of Security Holders................................................... 20
Item 5. Other Information..................................................................................... 21
Item 6. Exhibits and Reports on Form 8-K...................................................................... 22
Signatures.................................................................................................... 23
2
PART I
FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
MCLEODUSA INCORPORATED AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARES)
JUNE 30, DECEMBER 31,
1997 1996 *
----------- -------------
(UNAUDITED)
ASSETS
Current Assets
Cash and cash equivalents..................................... $285,032 $ 96,480
Investment in available-for-sale securities................... 77,358 80,518
Trade receivables, net (Note 2)............................... 36,704 27,560
Inventory (Note 2)............................................ 3,342 1,600
Deferred expenses............................................. 10,502 12,156
Prepaid expenses and other.................................... 10,380 6,087
-------- --------
TOTAL CURRENT ASSETS..................................... 423,318 224,401
-------- --------
Property and Equipment
Land and building............................................. 14,546 2,246
Telecommunications networks................................... 48,126 32,041
Furniture, fixtures and equipment............................. 40,392 22,302
Networks in progress.......................................... 60,373 35,481
Building in progress.......................................... 1,082 6,103
-------- --------
164,519 98,173
Less accumulated depreciation................................. 10,908 6,050
-------- --------
153,611 92,123
-------- --------
Investments, Intangible and Other Assets
Investment in available-for-sale securities................... 16,259 47,474
Goodwill, net................................................. 71,219 57,012
Customer lists, net........................................... 23,122 17,095
Noncompete agreements, net.................................... 13,637 6,737
Deferred line installation costs, net......................... 5,774 2,083
PCS licenses (Note 5)......................................... 32,794 4,800
Other......................................................... 11,480 1,269
-------- --------
174,285 136,470
-------- --------
$751,214 $452,994
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities
Current maturities of long-term debt.......................... $ 2,140 $ 793
Contracts payable............................................. 1,806 ---
Accounts payable.............................................. 19,906 15,807
Accrued payroll and payroll related expenses.................. 8,775 7,259
Other accrued liabilities..................................... 2,816 3,095
Due on PCS licenses (Note 5).................................. 807 ---
Deferred revenue, current portion............................. 2,236 1,793
Customer deposits............................................. 9,343 9,686
-------- --------
TOTAL CURRENT LIABILITIES................................ 47,829 38,433
-------- --------
Long-term Debt, less current maturities (Note 3)................... 314,609 2,573
-------- --------
Deferred Revenue, less current portion............................. 10,012 8,559
-------- --------
Commitments (Note 5)
Stockholders' Equity
Capital Stock:
Preferred, $.01 par value; authorized 2,000,000 shares,
none issued; terms determined upon issuance................. --- ---
Common, Class A, $.01 par value; authorized 250,000,000
shares; issued and outstanding 1997 52,627,506 shares;
1996 36,172,817 shares...................................... 526 362
Common, Class B, convertible, $.01 par value; authorized
22,000,000 shares; issued and outstanding 1997 none;
1996 15,625,929 shares...................................... --- 156
Additional paid-in capital.................................... 455,914 450,736
Accumulated deficit........................................... (77,676) (47,825)
-------- --------
378,764 403,429
-------- --------
$751,214 $452,994
======== ========
*Condensed from audited financial statements.
See Notes to Consolidated Financial Statements
3
MCLEODUSA INCORPORATED AND SUBSIDIARIES
UNAUDITED CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
--------------------- -------------------
1997 1996 1997 1996
---------- --------- --------- --------
Revenue................................................... $ 46,523 $13,918 $ 82,270 26,406
Operating expenses:
Cost of service...................................... 27,563 9,474 48,763 18,724
Selling, general and administrative.................. 28,398 7,631 52,383 13,976
Depreciation and amortization........................ 5,231 1,604 9,353 2,573
Other................................................ 999 --- 2,607 ---
-------- ------- -------- -------
TOTAL OPERATING EXPENSES........................ 62,191 18,709 113,106 35,273
-------- ------- -------- -------
OPERATING LOSS.................................. (15,668) (4,791) (30,836) (8,867)
Nonoperating income (expense):
Interest income...................................... 6,199 504 10,452 505
Interest (expense)................................... (7,039) (256) (9,486) (521)
Other income......................................... 12 --- 19 ---
-------- ------- -------- -------
TOTAL NONOPERATING INCOME
(EXPENSE).................................. (828) 248 985 (16)
-------- ------- -------- -------
LOSS BEFORE INCOME TAXES........................ (16,496) (4,543) (29,851) (8,883)
Income taxes.............................................. --- --- --- ---
-------- ------- -------- -------
NET LOSS........................................ $(16,496) $(4,543) $(29,851) $(8,883)
======== ======= ======== =======
Loss per common and common equivalent..................... $ (0.31) $ (0.11) $ (0.57) $ (0.23)
share.................................................... ======== ======= ======== =======
Weighted average common and common
equivalent shares outstanding............................ 52,583 39,968 52,456 38,512
======== ======= ======== =======
See Notes to Consolidated Financial Statements
4
MCLEODUSA INCORPORATED AND SUBSIDIARIES
UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
SIX MONTHS ENDED
JUNE 30,
--------------------
1997 1996
--------- ---------
Cash Flows from Operating Activities
Net Loss..................................................................................... $(29,851) $ (8,883)
Adjustments to reconcile net loss to net cash (used in) operating activities:
Depreciation............................................................................. 4,751 1,197
Amortization............................................................................. 4,602 1,717
Accretion of interest on senior discount notes........................................... 10,482 ---
Changes in assets and liabilities, net of effects of acquisitions (Note 5):
(Increase) decrease in trade receivables................................................. (6,650) (6,286)
(Increase) in inventory.................................................................. (264) (437)
Decrease in deferred expenses............................................................ 1,654 ---
(Increase) in deferred line installation costs........................................... (4,397) (500)
Increase in accounts payable and accrued expenses........................................ 4,296 7,003
Increase in deferred revenue............................................................. 1,522 3,518
(Decrease) in customer deposits.......................................................... (343) ---
Other, net............................................................................... (4,138) (1,167)
-------- --------
NET CASH (USED IN) OPERATING ACTIVITIES............................................... (18,336) (3,838)
-------- --------
Cash Flows from Investing Activities
Purchase of property and equipment.......................................................... (62,292) (17,997)
Available-for-sale securities:
Purchases................................................................................ (89,120) ---
Sales.................................................................................... 79,193 ---
Maturities............................................................................... 44,302 ---
Acquisitions (Note 5)....................................................................... (22,757) ---
Payments on PCS licenses (Note 5)........................................................... (27,187) ---
Other....................................................................................... (458) (258)
-------- --------
NET CASH (USED IN) INVESTING ACTIVITIES............................................... (78,319) (18,255)
-------- --------
Cash Flows from Financing Activities
Proceeds from line of credit agreements.................................................... --- 34,400
Payments on line of credit agreements...................................................... --- (38,000)
Payments on contracts payable.............................................................. (3,925) ---
Net proceeds from long-term debt........................................................... 289,575 ---
Payments on long-term debt................................................................. (898) ---
Net proceeds from issuance of common stock................................................. 455 258,631
Other...................................................................................... --- (919)
-------- --------
NET CASH PROVIDED BY FINANCING ACTIVITIES............................................. 285,207 254,112
-------- --------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS.................................. 188,552 232,019
Cash and cash equivalents:
Beginning................................................................................ 96,480 ---
-------- --------
Ending................................................................................... $285,032 $232,019
======== ========
See Notes to Consolidated Financial Statements
5
MCLEODUSA INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(INFORMATION AS OF AND FOR THE THREE AND SIX MONTHS ENDED
JUNE 30, 1997 AND 1996 IS UNAUDITED)
NOTE 1: BASIS OF PRESENTATION
Interim Financial Information (unaudited): The financial statements and
notes related thereto as of June 30, 1997, and for the three and six month
periods ended June 30, 1997 and 1996, are unaudited, but in the opinion of
management include all adjustments, consisting only of normal recurring
adjustments, necessary for a fair presentation of the Company's financial
position and results of operations. The operating results for the interim
periods are not indicative of the operating results to be expected for a full
year or for other interim periods. Not all disclosures required by generally
accepted accounting principles necessary for a complete presentation have been
included. It is recommended that these consolidated condensed financial
statements be read in conjunction with the Company's Annual Report on Form 10-K
filed with the Securities and Exchange Commission on March 31, 1997.
NOTE 2: SUPPLEMENTAL ASSET DATA
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 and all certificates of deposit, regardless of maturity,
to be cash equivalents.
Trade Receivables: The composition of trade receivables, net is as
follows:
JUNE 30, DECEMBER 31,
1997 1996
--------- ------------
(IN THOUSANDS)
Trade Receivables:
Billed....................................... $29,224 $22,846
Unbilled..................................... 11,802 8,613
------- -------
41,026 31,459
Allowance for doubtful accounts and discounts..... (4,322) (3,899)
------- -------
$36,704 $27,560
======= =======
Inventory: Inventory is carried principally at the lower of average cost
or market and consists primarily of new and reusable parts required to maintain
fiber optic networks and parts and equipment used in the maintenance and
installation of telephone systems. Of the $3.3 million in inventory as of June
30, 1997, inventories of approximately $1.5 million used to support a
maintenance agreement are being amortized on a straight-line basis over the 10-
year life of the agreement.
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 $2,340,000
and $1,049,000 and accumulated amortization on customer lists totaled $1,223,000
and $432,000 at June 30, 1997 and December 31, 1996, respectively.
Noncompete agreements: Noncompete agreements primarily relate to
directories acquired by McLeodUSA Media Group, Inc. ("McLeodUSA Publishing") and
are being amortized by the straight-line method over various periods.
Accumulated amortization on noncompete agreements totaled $767,000 and $250,000
at June 30, 1997 and December 31, 1996, respectively.
6
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 $1,854,000 and
$1,148,000 at June 30, 1997 and December 31, 1996, respectively.
NOTE 3: DEBT OFFERING AND SUBSEQUENT EVENTS
On March 4, 1997, the Company completed a private offering of $500 million
principal amount at maturity of 10 1/2% Senior Discount Notes due March 1, 2007
(the "Discount Notes"). The Discount Notes were issued at an original issue
discount in which the Company received approximately $289.6 million in net
proceeds. The Discount Notes accrete from March 4, 1997 at a rate of 10 1/2%
per year, compounded semi-annually, to an aggregate principal amount of $500
million by March 1, 2002. At June 30, 1997, the accreted balance of the
Discount Notes was $310.5 million. Interest will not accrue on the Discount
Notes prior to March 1, 2002. Thereafter, interest on the Discount Notes will
accrue at a rate of 10 1/2% per annum, payable in cash semi-annually on March 1
and September 1 commencing September 1, 2002. The indenture relating to the
Discount Notes contains, subject to certain exceptions and qualifications,
certain covenants which, among other things, restrict the ability of the Company
and certain of 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, enter into transactions with affiliates or related
persons, sell assets, or consolidate, merge or sell all or substantially all of
its assets. As of June 30, 1997, the Discount Notes had not been registered
under the Securities Act of 1933 (the "Securities Act"), and therefore cannot be
offered for resale, resold or otherwise transferred unless so registered or
unless an applicable exemption from the registration requirements of the
Securities Act is available. The Company has filed a registration statement
with the Securities and Exchange Commission ("SEC") for the registration of $500
million principal amount at maturity of 10 1/2% Senior Discount Notes due March
1, 2007 (the "Exchange Notes") to be offered in exchange for the Discount Notes
(the "Exchange Offer"). The form and terms of the Exchange Notes are identical
in all material respects to the form and terms of the Discount Notes except that
(i) the Exchange Notes have been registered under the Securities Act and (ii)
holders of the Exchange Notes will not be entitled to certain rights under a
registration agreement relating to the Discount Notes. The registration
statement was declared effective by the SEC on July 28, 1997 and the Exchange
Offer was commenced. The Exchange Offer is scheduled to expire on August 24,
1997, unless extended.
On July 21, 1997, the Company completed a private offering of $225 million
aggregate principal amount of 9 1/4% Senior Notes due July 15, 2007 (the "Senior
Notes"). The Company received net proceeds of approximately $218 million from
the Senior Note offering. Interest on the Senior Notes will be payable in cash
semi-annually in arrears on July 15 and January 15 of each year at a rate of 9
1/4% per annum, commencing January 15, 1998. The Senior Notes rank pari passu
in right of payment with the Discount Notes and Exchange Notes. As of June 30,
1997, the Senior Notes had not been registered under the Securities Act and
therefore cannot be offered for resale, resold or otherwise transferred unless
so registered or unless an applicable exemption from the registration
requirements of the Securities Act is available. The Company has agreed
pursuant to a registration agreement to file not later than 60 days after the
closing of the Senior Notes offering a registration statement with the SEC with
respect to a registered offer to exchange the Senior Notes for new registered
notes of the Company having terms substantially identical in all material
respects to the Senior Notes.
The indenture relating to the Senior Notes imposes operating and financial
restrictions on the Company and its subsidiaries that are substantially the same
as the restrictions governing the Discount Notes and the Exchange Notes.
7
NOTE 4: SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
SIX MONTHS ENDED
JUNE 30,
----------------------
1997 1996
-------- --------
(IN THOUSANDS)
(UNAUDITED)
Supplemental Disclosure of Cash Flow Information
Cash payment for interest, net of interest capitalized 1997 $1,427,000;
1996 $204,000................................................................ $ --- $ 408
======== ========
Supplemental Schedule of Noncash Investing and Financing Activities
Release of 56,177 shares of Class A Common Stock from escrow to
certain of the shareholders of Ruffalo, Cody & Associates,
Inc. ("Ruffalo Cody") as additional consideration
for the Company's acquisition of Ruffalo, Cody in July 1996................... $ 1,347
========
Capital leases incurred for the acquisition of property and equipment.......... $ 2,988
========
Acquisition of Digital Communications of Iowa, Inc. (Note 5)
Cash acquisition costs................................................... $ 29
Stock issued............................................................. 2,250
--------
$ 2,279
========
Working capital acquired, net............................................ $ 543
Fair value of other assets acquired, principally
furniture, fixtures and equipment....................................... 658
Goodwill................................................................. 1,118
Long-term debt assumed................................................... (40)
--------
$ 2,279
========
Acquisition of Fronteer Financial Holdings, Ltd. directories (Note 5):
Cash purchase price...................................................... $ 1,500
========
Customer list............................................................ $ 1,350
Noncompete agreement..................................................... 2,350
Contract payable......................................................... (1,700)
Option agreement......................................................... (500)
--------
$ 1,500
========
Acquisition of Indiana Directories, Inc. directories (Note 5)
Cash purchase price...................................................... $ 6,000
========
Furniture, fixtures and equipment........................................ $ 150
Customer list............................................................ 4,880
Noncompete agreement..................................................... 5,001
Contract payable......................................................... (4,031)
--------
$ 6,000
========
Acquisition of ESI Communications, Inc. (Note 5)
Cash purchase price...................................................... $ 15,228
========
Working capital acquired, net............................................ $ 2,170
Fair value of other assets acquired...................................... 493
Goodwill................................................................. 12,960
Customer list............................................................ 358
Noncompete agreement..................................................... 18
Long-term debt assumed................................................... (771)
--------
$ 15,228
========
8
NOTE 5: ACQUISITIONS AND COMMITMENTS
Digital Communications of Iowa, Inc. ("Digital Communications"): On
January 30, 1997, the Company issued 84,430 shares of Class A common stock in
exchange for all the outstanding shares of Digital Communications, 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.
Directories: On February 25, 1997, McLeodUSA Publishing acquired six
directories from Fronteer Financial Holdings, Ltd., ("Fronteer") for a total
estimated purchase price of approximately $3.7 million.
On March 31, 1997, McLeodUSA Publishing acquired 26 telephone directories
published by Indiana Directories, Inc. ("Indiana Directories") at a purchase
price of approximately $10 million.
On June 10, 1997, the Company acquired substantially all of the assets of
ESI Communications, Inc. ("ESI") and related entities for an aggregate of
approximately $15.2 million.
Personal Communications Services ("PCS") licenses: In April and June 1997,
the Federal Communications Commission ("FCC") awarded the Company a total of 26
"D" and "E" block frequency PCS licenses in 24 market areas of Iowa, 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 paid the FCC an aggregate of approximately
$32.8 million for these PCS licenses. The Company made a $4.8 million deposit
with the FCC at the beginning of the bidding process in 1996, made an additional
$1.8 million deposit in January 1997 and paid $25.4 million on May 12, 1997.
The Company made a final payment of $807,000 for these licenses on July 11,
1997.
NOTE 6: PROPOSED MERGER
On June 14, 1997, the Company entered into an Agreement and Plan of
Reorganization with Consolidated Communications, Inc. ("CCI") pursuant to which
the Company agreed, subject to certain conditions, to acquire CCI for an
aggregate of 8,488,613 shares of Class A Common Stock and $155 million in cash
(the "CCI Transaction").
Consummation of the CCI Transaction is subject to the satisfaction or
waiver of certain conditions, including receipt of required regulatory approvals
and other customary conditions, and the completion of the Company's due
diligence investigation and review of CCI and its subsidiaries. There can be no
assurance that the CCI Transaction will be consummated.
NOTE 7: CAPITAL STOCK
On May 29, 1997, the Company's stockholders approved an increase in the
authorized Class A Common Stock from 75,000,000 shares to 250,000,000 shares and
approved the cancellation of the Class A Preferred Stock, $5.50 par value, of
which no shares were issued or outstanding.
9
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Unless otherwise indicated, all dollar amounts in the following
Management's Discussion and Analysis of Financial Condition and Results of
Operations that exceed $1 million have been rounded to one decimal place and all
dollar amounts less than $1 million have been rounded to the nearest thousand.
OVERVIEW
The Company derives its revenue from (i) the sale of local and long
distance telecommunications services to end users, (ii) advertising in telephone
directories, (iii) special access and private line services, (iv)
telecommunications network maintenance services, and (v) additional
telecommunications services, including the provision of direct marketing and
telemarketing services and the sale, installation and service of business
telephone systems. The Company began providing telephone directory advertising
as a result of its acquisition of McLeodUSA Publishing in September 1996, and
the additional telecommunications services as a result of its acquisitions of
Ruffalo, Cody & Associates, Inc. ("Ruffalo, Cody") in July 1996, Digital
Communications in January 1997 and ESI in June 1997. The table set forth below
summarizes the Company's percentage of revenues from these sources:
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------ ------------------
1997 1996 1997 1996
-------- -------- -------- --------
Local and long distance
telecommunications services............... 40% 69% 41% 68%
Telephone directory advertising............ 44% --- 42% ---
Special access and private line services... 5% 20% 6% 21%
Telecommunications network
maintenance services...................... 3% 11% 3% 11%
Additional telecommunications services..... 8% --- 8% ---
---- ---- ---- ----
100% 100% 100% 100%
==== ==== ==== ====
The Company began offering integrated 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 certain
additional cities in Iowa and Illinois during the first six months of 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 have been 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 nineteen states in the midwestern and Rocky
Mountain regions of the United States, including most of the Company's target
markets.
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 of
printing and distributing the telephone directories published by McLeodUSA
Publishing, costs associated with maintaining the Iowa Communications Network
and costs associated with operating the Company's network. The Iowa
Communications Network is a fiber optic network that links certain of the State
of
10
Iowa's schools, libraries and other public buildings. SG&A consists of sales
and marketing, customer service and administrative expenses. Depreciation and
amortization include depreciation of the Company's telecommunications network
and equipment; amortization of goodwill, customer lists and noncompete
agreements related to the Company's acquisitions, 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 local telecommunications service.
As the Company expands into new markets, both cost of service and SG&A will
increase. The Company expects to incur cost of service and SG&A expenses prior
to achieving significant revenues in new markets. Fixed costs related to
leasing of central office facilities needed to provide telephone services must
be incurred prior to generating revenue in new markets, while significant levels
of marketing activity may be necessary in the new markets in order for the
Company to build a customer base large enough to generate sufficient revenue to
offset such fixed costs and marketing expenses.
In January and February 1996, the Company granted options to purchase an
aggregate of 965,166 and 688,502 shares of its 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 is being
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. 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.
THREE MONTHS ENDED JUNE 30, 1997 COMPARED WITH THREE MONTHS ENDED JUNE 30, 1996
Revenue increased from $13.9 million for the three months ended June 30,
1996 to $46.5 million for the three months ended June 30, 1997, representing an
increase of $32.6 million or 234%. Revenue from the sale of local and long
distance telecommunications services accounted for $9 million of this increase.
In addition, revenue from McLeodUSA Publishing, which was acquired in September
1996, contributed $20.3 million to the increase. The remaining increase was
primarily due to the acquisitions of Ruffalo, Cody, Digital Communications and
ESI in July 1996, January 1997 and June 1997, respectively.
Cost of service increased from $9.5 million for the three months ended June
30, 1996, to $27.6 million for the three months ended June 30, 1997,
representing an increase of $18.1 million or 191%. This increase in cost of
service was due primarily to the growth in the Company's local and long distance
11
telecommunications services and to the acquisitions of Ruffalo, Cody and
McLeodUSA Publishing, which contributed $818,000 and $7.3 million, respectively,
to the increase. Cost of service as a percentage of revenue decreased from 68%
for the three months ended June 30, 1996 to 59% for the three months ended June
30, 1997, primarily as a result of these acquisitions. The cost of providing
local and long distance services as a percentage of local and long distance
telecommunications revenue increased from 72% for the three months ended June
30, 1996 to 82% for the three months ended June 30, 1997, primarily as a result
of increased line costs associated with the Company's accelerated expansion into
new markets.
SG&A increased from $7.6 million for the three months ended June 30, 1996
to $28.4 million for the three months ended June 30, 1997, an increase of $20.8
million or 272%. The acquisitions of Ruffalo, Cody and McLeodUSA Publishing
contributed $980,000 and $8.8 million, respectively, to the increase. Also
contributing to this increase were increased costs of $11 million related
primarily to expansion of selling, customer support and administration
activities to support the Company's growth.
Depreciation and amortization expenses increased from $1.6 million for the
three months ended June 30, 1996 to $5.2 million for the three months ended June
30, 1997, representing an increase of $3.6 million or 226%. This increase
consisted of $2.1 million related to the acquisitions of Ruffalo, Cody,
McLeodUSA Publishing, Digital Communications and ESI and $1.5 million due
primarily to the growth of the Company's network.
Other operating expenses 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.
Interest income increased from $504,000 for the three-month period ended
June 30, 1996, to $6.2 million for the same period in 1997. This increase
resulted from increased earnings on investments made with a portion of the
proceeds from the Company's offerings of Class A Common Stock in June and
November 1996 and from the private offering of the Discount Notes in March 1997.
Gross interest expense increased from $399,000 for the second quarter of
1996 to $8.2 million for the second quarter of 1997. This increase was
primarily a result of accretion of interest on the Discount Notes of $7.9
million. Interest expense of approximately $1.1 million and $143,000 was
capitalized as part of the Company's construction of fiber optic network during
the second quarter of 1997 and 1996, respectively.
Net loss increased from $4.5 million for the three months ended June 30,
1996 to $16.5 million for the three months ended June 30, 1997, an increase of
$12 million. This increase resulted primarily from the expansion of Bell
central office operations, the opening of new sales offices and costs related to
the acquisition of Ruffalo, Cody, McLeodUSA Publishing, Digital Communications
and ESI. 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.
SIX MONTHS ENDED JUNE 30, 1997 COMPARED WITH SIX MONTHS ENDED JUNE 30, 1996
Revenue increased from $26.4 million for the six months ended June 30, 1996
to $82.3 million for the six months ended June 30, 1997, representing an
increase of $55.9 million or 212%. Revenue from the sale of local and long
distance telecommunications services accounted for $15.5 million of this
increase. In addition, revenues from McLeodUSA Publishing, which was acquired
in September 1996, contributed $34.5 million to the increase. The remaining
increase was primarily due to the acquisitions of Ruffalo, Cody, Digital
Communications and ESI in July 1996, January 1997 and June 1997, respectively.
Cost of service increased from $18.7 million for the six months ended June
30, 1996, to $48.8 million for the six months ended June 30, 1997, representing
an increase of $30.1 million or 160%. 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
12
contributed $1.8 million and $12.7 million, respectively, to the increase. Cost
of service as a percentage of revenue decreased from 71% for the six months
ended June 30, 1996 to 59% for the six months ended June 30, 1997, primarily as
a result of these acquisitions. The cost of providing local and long distance
services as a percentage of local and long distance telecommunications revenue
increased from 72% for the six months ended June 30, 1996 to 79% for the six
months ended June 30, 1997, primarily as a result of increased line costs
associated with the Company's accelerated expansion into new markets.
SG&A increased from $14 million for the six months ended June 30, 1996 to
$52.4 million for the six months ended June 30, 1997, an increase of $38.4
million or 275%. The acquisitions of Ruffalo, Cody and McLeodUSA Publishing
contributed $1.9 million and $15.4 million, respectively, to the increase. Also
contributing to this increase were increased costs of $21.1 million primarily
related to expansion of selling, customer support and administration activities
to support the Company's growth.
Depreciation and amortization expenses increased from $2.6 million for the
six months ended June 30, 1996 to $9.4 million for the six months ended June 30,
1997, representing an increase of $6.8 million or 264%. This increase consisted
of $3.9 million related to the acquisitions of Ruffalo, Cody, McLeodUSA
Publishing, Digital Communications and ESI and $2.9 million due primarily to the
growth of the Company's network.
Other operating expenses 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.
Interest income increased from $505,000 for the six-month period ended June
30, 1996, to $10.5 million for the same period in 1997. This increase resulted
from increased earnings on investments made with a portion of the proceeds from
the Company's offerings of Class A Common Stock in June and November 1996 and
from the private offering of the Discount Notes in March 1997.
Gross interest expense increased from $725,000 for the second quarter of
1996 to $10.9 million for the second quarter of 1997. This increase was
primarily a result of accretion of interest on the Discount Notes of $10.5
million. Interest expense of approximately $1.4 million and $204,000 was
capitalized as part of the Company's construction of fiber optic network during
the first six months of 1997 and 1996, respectively.
Net loss increased from $8.9 million for the six months ended June 30, 1996
to $29.9 million for the six months ended June 30, 1997, an increase of $21
million. This increase resulted primarily from the expansion of Bell central
office operations, the opening of new sales offices and costs related to the
acquisition of Ruffalo, Cody, McLeodUSA Publishing, Digital Communications and
ESI. 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.
LIQUIDITY AND CAPITAL RESOURCES
The Company's total assets increased from $453 million at December 31, 1996
to $751.2 million at June 30, 1997, primarily due to the net proceeds of
approximately $289.6 million from the Company's March 1997 private offering of
the Discount Notes. At June 30, 1997, the Company's current assets of $423.3
million exceeded its current liabilities of $47.8 million, providing working
capital of $375.5 million, which represents an increase of $189.5 million
compared to December 31, 1996 primarily attributable to the net proceeds from
the Discount Notes. At December 31, 1996, the Company's current assets of
$224.4 million exceeded current liabilities of $38.4 million, providing working
capital of $186 million.
The net cash used in operating activities totaled $18.3 million for the six
months ended June 30, 1997 and $3.8 million for the six months ended June 30,
1996. During the six months ended June 30, 1997, cash for operating activities
was used primarily to fund the Company's net loss of $29.9 million for such
period. The Company also required cash to fund the growth in accounts
receivable and deferred
13
line installation costs of $6.7 million and $4.4 million, respectively, as a
result of the expansion of the Company's local and long distance
telecommunications services. During the six months ended June 30, 1996, cash for
operating activities was used primarily to fund the Company's net loss of $8.9
million for such period. The Company also required cash to fund the growth in
trade receivables and other assets of $6.3 million and $1.2 million,
respectively, offset by an increase in accounts payable and accrued expenses of
$7 million.
The Company's investing activities used cash of $78.3 million during the
six months ended June 30, 1997 and $18.3 million during the six months ended
June 30, 1996. The equipment required for the expansion of the Company's local
and long distance telecommunications services, the Company's development and
construction of its fiber optic telecommunications network and other capital
expenditures resulted in purchases of equipment and fiber optic cable and other
property and equipment totaling $62.3 million and $18 million during the six
months ended June 30, 1997 and 1996, respectively.
In April and June 1997, the FCC granted the Company 26 "D" and "E" block
frequency PCS licenses in 24 markets covering areas of Iowa, Illinois,
Minnesota, Nebraska and South Dakota. The Company paid the FCC an aggregate of
approximately $32.8 million for these PCS licenses. The Company made a deposit
of $4.8 million with the FCC at the beginning of the bidding process in 1996 and
paid an additional $27.2 million during the six months ended June 30, 1997. The
remaining $807,000 was paid on July 11, 1997. The Company will be required to
make significant additional expenditures to develop, construct and operate a PCS
system.
The Company used cash of $22.8 million to acquire Digital Communications,
Fronteer, the Indiana Directories and ESI in January 1997, February 1997, March
1997 and June 1997, respectively.
These uses of cash for investing activities during the six months ended
June 30, 1997 were partially offset by net proceeds of $34.4 million from the
sales and maturities of available-for-sale securities.
On June 14, 1997, the Company entered into an Agreement and Plan of
Reorganization with CCI pursuant to which the Company agreed, subject to certain
conditions, to acquire CCI for an aggregate of 8,488,613 shares of Class A
Common Stock and $155 million in cash.
Consummation of the CCI Transaction is subject to the satisfaction or
waiver of certain conditions, including receipt of required regulatory approvals
and other customary conditions, and the completion of the Company's due
diligence investigation and review of CCI and its subsidiaries. There can be no
assurance that the CCI Transaction will be consummated
Cash received from net financing activities was $285.2 million during the
six months ended June 30, 1997, primarily as a result of the Company's private
offering of the Discount Notes in March 1997. Cash received from financing
activities during the six months ended June 30, 1996 was $254.1 million and was
primarily obtained from the Company's initial public offering of Class A Common
Stock in June 1996. The Company paid off and canceled its bank line of credit
facility with a portion of the proceeds from this offering.
On March 4, 1997, the Company received net proceeds of approximately $289.6
million from a private offering of the Discount Notes. The Discount Notes will
accrete to an aggregate principal amount of $500 million by March 1, 2002.
Interest will not accrue on the Discount 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 each year, commencing
September 1, 2002. The Discount 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
14
Company may, at its option, use all or a portion of the net proceeds therefrom
to redeem up to a maximum of 33 1/3% of the original principal amount of the
Discount 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
Discount Notes will have the right to require the Company to repurchase all or
any part of such holder's Discount 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 Discount 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 Discount 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 Discount Notes also are effectively subordinated to all
existing and future third-party indebtedness and other liabilities of the
Company's subsidiaries. The Company has filed a registration statement with the
SEC for the registration of the Exchange Notes to be offered in exchange for the
Discount Notes (the "Exchange Offer"). The form and terms of the Exchange Notes
are identical in all material respects to the form and terms of the Discount
Notes except that (i) the Exchange Notes have been registered under the
Securities Act and (ii) holders of the Exchange Notes will not be entitled to
certain rights under a registration agreement relating to the Discount Notes.
The registration statement was declared effective by the SEC on July 28, 1997
and the Exchange Offer was commenced. The Exchange Offer is scheduled to expire
on August 24, 1997, unless extended.
On July 21, 1997, the Company completed a private offering of the Senior
Notes. The Company received net proceeds of approximately $218 million from the
Senior Note offering. Interest on the Senior Notes will be payable in cash semi-
annually in arrears on July 15 and January 15 of each year at a rate of 9 1/4%
per annum, commencing January 15, 1998. The Senior Notes will rank pari passu in
right of payment with the Discount Notes. The Senior Notes will mature on July
15, 2007 and will be payable after the maturity of the Discount Notes.
The indentures relating to the Discount Notes, the Exchange Notes and the
Senior Notes impose 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.
As of June 30, 1997, the Company estimates that its aggregate capital
requirements for the remainder of 1997, 1998 and 1999 will be approximately $350
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) developing, constructing and operating a PCS system,
and (iv) constructing its new corporate headquarters and associated buildings.
In June 1997, the Company entered into an agreement to acquire CCI pursuant to
which the Company will be required to pay $155 million in cash upon consummation
of the transaction. These capital requirements are expected to be funded, in
large part, out of the net proceeds from the Company's private offering of the
Senior Notes in July 1997, approximately $218 million, the net proceeds from the
Company's March 1997 private offering of the Discount Notes, approximately
$289.6 million, the net proceeds remaining from the Company's public offering of
Class A Common Stock in November 1996 (approximately $89 million as of June 30,
1997) and lease payments to the Company for portions of the Company's networks.
15
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.
The Company's estimate of its future capital requirements contained in this
report 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 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.
EFFECTS OF NEW ACCOUNTING STANDARDS
In February 1997, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards No. 128, "Earnings per Share" (SFAS
128), and Statement of Financial Accounting Standards No. 129, "Disclosure of
Information about Capital Structure" (SFAS 129). SFAS 128 specifies the
computation, presentation and disclosure requirements for earnings per share for
entities with publicly held common stock. Its objective is to simplify the
computation of earnings per share and to make the U.S. standard for computing
earnings per share more compatible with the standards of other countries and
with that of the International Accounting Standards Committee. SFAS 129
incorporates related disclosure requirements from APB Opinion No. 10,
"Disclosure of Long-Term Obligations," and SFAS No. 47, "Disclosure of Long-Term
Obligations," for entities that were subject to the requirements for those
standards. Both statements are effective for fiscal years beginning after
December 15, 1997. The Company will adopt the statements effective January 1,
1998 and does not expect adoption of the statements to have a significant impact
on its current earnings per share calculation and disclosures.
INFLATION
The Company does not believe that inflation has had a significant impact on
the Company's consolidated operations.
16
PART II
OTHER INFORMATION
ITEM 1. 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.
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 Communications, Inc. ("U S WEST") and Ameritech
Corporation ("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.
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
17
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. On February 3, 1997, the
Company and other parties appealed the order of the Public Service Commission to
the Nebraska Court of Appeals. The appeal remains pending.
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. On January
31, 1997, the Company filed its own complaint with the Idaho Public Utilities
Commission. As of the date hereof, the Idaho Public Utilities Commission has
not yet ruled on the Company's complaint.
In Utah, on September 26, 1996, the Public Service Commission rejected the
U S WEST Centrex Action and ordered U S WEST to continue the availability of
Centrex service for resale. Upon rehearing, however, the Utah Public Service
Commission issued an order on April 29, 1997 imposing temporary restrictions on
Centrex resale. The Company is currently evaluating its options regarding these
temporary restrictions. 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 was suspended to allow the Colorado Public
Utilities Commission to rule on the same issues in a U S WEST tariff proceeding.
On July 28, 1997, the Colorado Commission issued a written order which
concluded that the restrictions in U S WEST's tariffs were inconsistent with
both state and federal law, and required that they be removed from the tariff.
U S WEST has until August 18, 1997, to request reconsideration of this ruling.
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 U S 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. The matter
remains pending before the FCC.
18
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.
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.
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 had imposed a limit of processing one
new local service order of the Company per hour for each U S WEST central
office, creating a significant backlog of local service orders of the Company.
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
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 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. U S WEST has agreed to process the Company's
service orders within a standard five-day period. 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.
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 were appealed to the U.S. Eighth Circuit Court of
Appeals. In July 1997, the U.S. Eighth Circuit Court of Appeals vacated
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 decision vacating 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
has announced that it plans to appeal the decision to the U.S. Supreme Court.
There can be no assurance that the Company will be able to obtain
interconnection agreements on terms acceptable to the Company.
On June 14, 1997, the Company entered into the Merger Agreement with CCI.
CCI is involved in various routine legal proceedings incidental to its
business. In addition, on June 20, 1996, Direct
19
Media Corporation ("Direct Media"), a publisher of independent directories,
filed a complaint in the U.S. District Court of Georgia against a wholly owned
subsidiary of CCI, Consolidated Communications Directories, Inc. ("CCD"), Camden
Telephone and Telegraph Co., Inc. ("Camden"), and TDS Telecom, Inc. ("TDS"), the
majority owner of Camden, alleging violations of Sections 1 and 2 of the Sherman
Antitrust Act by contracting in restraint of trade and attempting to monopolize
commerce as it relates to a telephone directory covering Camden's service area.
Direct Media has alleged that in 1993 Camden quoted to Direct Media an
excessively high price per listing of "white pages" listings. Additionally,
Direct Media has alleged that CCD acted in concert with Camden and TDS to deny
Direct Media the information on a timely and complete basis. The relief sought
includes over $150,000 for the antitrust violations; treble, exemplary and
punitive damages for alleged violations of the Georgia Fair Business Practices
Act; an order compelling the defendants to supply at reasonable, incremental
cost, updated white pages listings; and costs of the suit; including reasonable
attorneys' fees. The suit remains pending.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Annual Meeting of Stockholders of the Company was held on May 29, 1997.
All of the proposals presented for stockholder consideration at the Annual
Meeting were approved. The following is a tabulation of the voting on each
proposal presented at the Annual Meeting and a listing of the directors whose
term of office as a director continued after the meeting. Each share of Class B
Common Stock voted on the proposals set forth below had .40 votes per share. As
of June 30, 1997, all shares of Class B Common Stock had been converted into
shares of Class A Common Stock.
Proposal 1 -- Election of Directors
Term
Expires Votes For Votes Withheld
------- ------------------- ---------------
Elected Director
Clark E. McLeod 2000 32,889,885 Class A 334,406 Class A
6,250,371.6 Class B
Blake O. Fisher, Jr. 2000 32,889,885 Class A 334,406 Class A
6,250,371.6 Class B
Lee Liu 2000 32,889,885 Class A 334,406 Class A
6,250,371.6 Class B
Continuing Directors
Stephen C. Gray 1999
Russell E. Christiansen 1998
Thomas M. Collins 1998
Paul D. Rhines 1999
Proposal 2 -- Amendment to the Certificate of Incorporation to Change the
Company's Name
Votes For 33,204,773 Class A; 6,250,371.6 Class B
Votes Against 12,452 Class A
Votes Withheld 7,066 Class A
Broker Non-Votes 0
Proposal 3 -- Amendment to the Certificate of Incorporation to Eliminate the
Class A Preferred Stock
Votes For 31,108,860 Class A; 6,250,371.6 Class B
Votes Against 15,831 Class A
Votes Withheld 18,399 Class A
Broker Non-Votes 2,081,201 Class A
20
Proposal 4 -- Amendment to the Certificate of Incorporation to Increase the
Number of Authorized Shares of Class A Common Stock
Votes For 29,320,966 Class A; 6,250,371.6 Class B
Votes Against 3,408,485 Class A
Votes Withheld 48,440 Class A
Broker Non-Votes 446,400 Class A
Proposal 5 -- Amendment to the 1996 Employee Stock Option Plan to Increase the
Number of Shares of Class A Common Stock That May Be Issued Thereunder
Votes For 22,016,420 Class A; 6,250,371.6 Class B
Votes Against 9,102,636 Class A
Votes Withheld 24,034 Class A
Broker Non-Votes 2,081,201 Class A
Proposal 6 -- Ratification of the Appointment of the Company's Independent
Public Accountants
Votes For 33,097,255 Class A; 6,250,371.6 Class B
Votes Against 115,186 Class A
Votes Withheld 11,850 Class A
Broker Non-Votes 0
ITEM 5. OTHER INFORMATION
On July 21, 1997, the Company completed a private offering of $225 million
aggregate principal amount of 9 1/4% Senior Notes due July 15, 2007 (the "Senior
Notes"). The Company received net proceeds of approximately $218 million from
the Senior Note offering. Interest on the Senior Notes will be payable in cash
semi-annually in arrears on July 15 and January 15 of each year at a rate of 9
1/4% per annum, commencing January 15, 1998. The Senior Notes rank pari passu
in right of payment with the Discount Notes and Exchange Notes. As of June 30,
1997, the Senior Notes had not been registered under the Securities Act and
therefore cannot be offered for resale, resold or otherwise transferred unless
so registered or unless an applicable exemption from the registration
requirements of the Securities Act is available. The Company has agreed
pursuant to a registration agreement to file not later than 60 days after the
closing of the Senior Notes offering a registration statement with the SEC with
respect to a registered offer to exchange the Senior Notes for new registered
notes of the Company having terms substantially identical in all material
respects to the Senior Notes. The net proceeds to the Company from the offering
will be used to fund expanded development and construction costs of the
Company's fiber optic network; accelerated market expansion activities of the
Company's telecommunications business; potential acquisitions, joint ventures
and strategic alliances; the development, construction and operation of a PCS
system; construction of the Company's corporate headquarters buildings; and for
additional working capital and general corporate purposes, including funding
operating deficits and net losses.
The indenture relating to the Senior Notes imposes operating and financial
restrictions on the Company and its subsidiaries that are substantially the same
as the restrictions governing the Discount Notes and Exchange Notes described
above in Note 3 to the Consolidated Financial Statements and incorporated by
reference herein.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
EXHIBIT
NUMBER EXHIBIT DESCRIPTION
- ------- -------------------
11.1 Statement regarding computation of loss per common share.
27.1 Financial Data Schedule.
99.1 Press release dated July 30, 1997.
21
(b) Reports on Form 8-K
--- -------------------
On June 26, 1997, the Company filed a Current Report on Form 8-K which
reported (i) the adoption of an amendment to Article 1 of the Company's Amended
and Restated Certificate of Incorporation to change the name of the Company to
"McLeodUSA Incorporated"; (ii) the Company's entering into an Asset Purchase
Agreement with ESI Communications, Inc. ("ESI") et al. pursuant to which the
Company agreed to acquire certain assets of ESI for an aggregate cash purchase
price of $15,323,889; and (iii) the Company's entering into an Agreement and
Plan of Reorganization with Consolidated Communications Inc. ("CCI") pursuant to
which CCI will be merged with and into a newly formed wholly owned subsidiary of
the Company (the "Merger"). As a result of the Merger, all of CCI's issued and
outstanding capital stock will be converted into an aggregate of 8,488,613
shares of the Company's Class A common stock and $155 million in cash.
On July 17, 1997, the Company filed a Current Report on Form 8-K to disclose
that the Company had acquired substantially all of the assets of ESI pursuant to
the above-referenced Asset Purchase Agreement.
22
SIGNATURES
PURSUANT TO THE REQUIREMENTS 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.
MCLEODUSA INCORPORATED
(registrant)
Date: August 11, 1997 By: /s/ Stephen C. Gray
-------------------
Stephen C. Gray
President and Chief Operating
Officer
Date: August 11, 1997 By: /s/ Blake O. Fisher, Jr.
------------------------
Blake O. Fisher, Jr.
Chief Financial Officer, Executive
Vice President, Corporate
Administration and Treasurer
23
INDEX TO EXHIBITS
SEQUENTIALLY
EXHIBIT NUMBERED
NUMBER EXHIBIT DESCRIPTION PAGE
- ------- ------------------- ------------
11.1 Statement regarding computation of loss per common share.
27.1 Financial Data Schedule.
99.1 Press release dated July 30, 1997.