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 SEPTEMBER 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 October 31, 1997:
Common Stock Class A: ($.01 par value)................. 61,572,248 shares
Common Stock Class B: ($.01 par value)................. None
INDEX
Page
----
PART I. FINANCIAL INFORMATION
- ------------------------------
Item 1. Financial Statements................................................................. 3
Consolidated Balance Sheets, September 30, 1997 (unaudited) and December 31, 1996.... 3
Unaudited Consolidated Statements of Operations for the three and nine months ended
September 30, 1997 and 1996........................................................ 4
Unaudited Consolidated Statements of Cash Flows for the nine months ended
September 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...................................................................... 11
PART II. OTHER INFORMATION
- --------------------------
Item 1. Legal Proceedings.................................................................... 19
Item 6. Exhibits and Reports on Form 8-K..................................................... 22
Signatures.................................................................................... 24
2
PART I
FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
MCLEODUSA INCORPORATED AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARES)
SEPTEMBER 30, DECEMBER 31,
1997 1996 *
-------------- -------------
(UNAUDITED)
ASSETS
Current Assets
Cash and cash equivalents $ 336,074 $ 96,480
Investment in available-for-sale securities 84,395 80,518
Trade receivables, net (Note 2) 106,070 27,560
Inventory 3,781 1,600
Deferred expenses 30,403 12,156
Prepaid expenses and other 13,346 6,087
---------- --------
TOTAL CURRENT ASSETS 574,069 224,401
---------- --------
Property and Equipment
Land and building 35,608 2,246
Telecommunications networks 171,885 32,041
Furniture, fixtures and equipment 62,953 22,302
Networks in progress 76,853 35,481
Building in progress 3,673 6,103
---------- --------
350,972 98,173
Less accumulated depreciation 14,761 6,050
---------- --------
336,211 92,123
---------- --------
Investments, Intangible and Other Assets
Investment in available-for-sale securities 5,421 47,474
Other investments 30,913 ---
Goodwill, net 273,827 57,012
Customer lists, net 59,058 17,095
Noncompete agreements, net 15,089 6,737
Deferred line installation costs, net 7,533 2,083
PCS licenses (Note 5) 32,807 4,800
Other 27,071 1,269
---------- --------
451,719 136,470
---------- --------
$1,361,999 $452,994
========== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities
Current maturities of long-term debt $ 4,383 $ 793
Contracts and notes payable 19,900 ---
Accounts payable 41,200 15,807
Accrued payroll and payroll related expenses 22,952 7,259
Other accrued liabilities 30,834 3,095
Deferred revenue, current portion 9,638 1,793
Customer deposits 12,302 9,686
---------- --------
TOTAL CURRENT LIABILITIES 141,209 38,433
---------- --------
Long-term Debt, less current maturities (Note 3) 607,247 2,573
---------- --------
Deferred Revenue, less current portion 12,882 8,559
---------- --------
Other long-term liabilities 21,205 ---
---------- --------
Commitments
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 61,429,429 shares; 1996 36,172,817 shares 614 362
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 680,223 450,736
Accumulated deficit (101,381) (47,825)
---------- --------
579,456 403,429
---------- --------
$1,361,999 $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 NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------- ---------------------
1997 1996 1997 1996
---------- --------- ---------- ---------
Revenues:
Telecommunications:
Local and long distance $ 26,783 $10,991 $ 60,182 $ 28,934
Private line and data 2,848 2,604 7,517 8,115
Network maintenance and equipment 6,396 1,475 11,815 4,427
-------- ------- -------- --------
Total telecommunications revenue 36,027 15,070 79,514 41,476
Directory 11,073 --- 45,560 ---
Telemarketing 2,225 4,021 6,521 4,021
-------- ------- -------- --------
TOTAL REVENUES 49,325 19,091 131,595 45,497
Operating expenses:
Cost of service 31,917 12,969 80,680 31,693
Selling, general and administrative 31,045 11,650 83,428 25,626
Depreciation and amortization 6,355 2,161 15,708 4,734
Other 82 --- 2,689 ---
-------- ------- -------- --------
TOTAL OPERATING EXPENSES 69,399 26,780 182,505 62,053
-------- ------- -------- --------
OPERATING LOSS (20,074) (7,689) (50,910) (16,556)
Nonoperating income (expense):
Interest income 7,618 2,899 18,070 3,404
Interest (expense) (11,270) (23) (20,756) (544)
Other income 21 278 40 278
-------- ------- -------- --------
TOTAL NONOPERATING INCOME
(EXPENSE) (3,631) 3,154 (2,646) 3,138
-------- ------- -------- --------
LOSS BEFORE INCOME TAXES (23,705) (4,535) (53,556) (13,418)
Income taxes --- --- --- ---
-------- ------- -------- --------
NET LOSS $(23,705) $(4,535) $(53,556) $(13,418)
======== ======= ======== ========
Loss per common and common equivalent share $ (0.45) $ (0.10) $ (1.02) $ (0.33)
======== ======= ======== ========
Weighted average common and common
equivalent shares outstanding 53,335 46,233 52,752 41,188
======== ======= ======== ========
See Notes to Consolidated Financial Statements
4
MCLEODUSA INCORPORATED AND SUBSIDIARIES
UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
NINE MONTHS ENDED
SEPTEMBER 30,
----------------------
1997 1996
---------- ----------
CASH FLOWS FROM OPERATING ACTIVITIES
Net Loss $ (53,556) $ (13,418)
Adjustments to reconcile net loss to net cash (used in)
operating activities:
Depreciation 8,290 2,243
Amortization 7,418 2,832
Accretion of interest on senior discount notes 18,343 ---
Changes in assets and liabilities, net of effects
of acquisitions (Note 5):
(Increase) in trade receivables (13,510) (6,598)
(Increase) in inventory (320) (2,694)
(Increase) in deferred expenses (1,544) (730)
(Increase) in deferred line installation costs (6,731) (842)
Increase in accounts payable and accrued expenses 19,077 4,095
Increase in deferred revenue 6,661 6,354
Increase in customer deposits 2,616 1,027
Other, net (3,260) (2,727)
--------- ---------
NET CASH (USED IN) OPERATING ACTIVITIES (16,516) (10,458)
--------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of property and equipment (104,138) (39,742)
Available-for-sale securities:
Purchases (107,126) (123,012)
Sales 88,177 39,047
Maturities 86,497 ---
Acquisitions (Note 5) (180,373) (78,868)
Payments on PCS licenses (Note 5) (28,007) (4,889)
Other (892) (950)
--------- ---------
NET CASH (USED IN) INVESTING ACTIVITIES (245,862) (208,414)
--------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from line of credit agreements --- 50,238
Payments on line of credit agreements --- (52,441)
Payments on contracts and notes payable (5,455) ---
Net proceeds from long-term debt 508,038 2,012
Payments on long-term debt (1,221) (8)
Net proceeds from issuance of common stock 610 258,131
Other --- (302)
--------- ---------
NET CASH PROVIDED BY FINANCING ACTIVITIES 501,972 257,630
--------- ---------
NET INCREASE IN CASH AND CASH EQUIVALENTS 239,594 38,758
CASH AND CASH EQUIVALENTS:
Beginning 96,480 ---
--------- ---------
Ending $ 336,074 $ 38,758
========= =========
See Notes to Consolidated Financial Statements
5
MCLEODUSA INCORPORATED AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(INFORMATION AS OF AND FOR THE THREE AND NINE MONTHS ENDED
SEPTEMBER 30, 1997 AND 1996 IS UNAUDITED)
NOTE 1: BASIS OF PRESENTATION
Interim Financial Information (unaudited): The financial statements and
notes related thereto as of September 30, 1997, and for the three and nine month
periods ended September 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. Certain information and footnote disclosure
normally included in financial statements, prepared in accordance with generally
accepted accounting principles, have been condensed or omitted pursuant to
instructions, rules and regulations prescribed by the Securities and Exchange
Commission (the "Commission"). Although the Company believes that the
disclosures provided are adequate to make the information presented not
misleading, it recommends that these consolidated condensed financial statements
be read in conjunction with the audited consolidated financial statements and
the footnotes thereto included in the Company's Annual Report on Form 10-K for
the fiscal year ended December 31, 1996, filed with the 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:
SEPTEMBER 30, DECEMBER 31,
1997 1996
-------------- -------------
(IN THOUSANDS)
Trade Receivables:
Billed $ 83,964 $22,846
Unbilled 30,347 8,613
-------- -------
114,311 31,459
Allowance for doubtful accounts and discounts (8,241) (3,899)
-------- -------
$106,070 $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.
Goodwill and customer lists: Goodwill and customer lists resulting from
the Company's acquisitions are being amortized over a range of 5 to 30 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 $3,200,000
and $1,049,000 and accumulated amortization on customer lists totaled $1,689,000
and $432,000 at September 30, 1997 and December 31, 1996, respectively.
Noncompete agreements: Noncompete agreements primarily relate to
directories acquired by McLeodUSA Media Group, Inc., previously doing business
as Telecom*USA Publishing Company ("McLeodUSA Publishing") and are being
amortized by the straight-line method over various periods. Accumulated
amortization on noncompete agreements totaled $1,038,000 and $250,000 at
September 30, 1997 and December 31, 1996, 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.
6
Accumulated amortization on deferred line installation costs totaled $2,429,000
and $1,148,000 at September 30, 1997 and December 31, 1996, respectively.
NOTE 3: LONG-TERM DEBT
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 "Senior Discount Notes"). The Senior Discount Notes were issued at
an original issue discount in which the Company received approximately $289.6
million in net proceeds. The Company filed a registration statement with the
Commission for the registration of $500 million principal amount at maturity of
10 1/2% Senior Discount Notes due March 1, 2007 (the "Senior Discount Exchange
Notes") to be offered in exchange for the Senior Discount Notes (the "Senior
Discount Note Exchange Offer"). The registration statement was declared
effective by the Commission on July 28, 1997 and the Senior Discount Note
Exchange Offer was commenced. The Senior Discount Note Exchange Offer expired on
August 24, 1997, and all of the Senior Discount Notes were exchanged for the
Senior Discount Exchange Notes. The form and terms of the Senior Discount
Exchange Notes are identical in all material respects to the form and terms of
the Senior Discount Notes except that (i) the Senior Discount Exchange Notes
have been registered under the Securities Act of 1933 (the "Securities Act") and
(ii) holders of the Senior Discount Exchange Notes are not entitled to certain
rights under a registration agreement relating to the Senior Discount Notes. The
Senior Discount Exchange 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 September 30, 1997, the accreted balance of the
Senior Discount Exchange Notes was $318.3 million. Interest will not accrue on
the Senior Discount Exchange Notes prior to March 1, 2002. Thereafter, interest
on the Senior Discount Exchange 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 Senior Discount Exchange 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.
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 $218.5
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 all existing and future senior
unsecured indebtedness of the Company and rank senior in right of payment to all
existing and future subordinated indebtedness of the Company. As of September
30, 1997, the Company had no outstanding subordinated indebtedness and, other
than the Senior Discount Exchange Notes, had no outstanding indebtedness that
would rank pari passu with the Senior Notes. As of September 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 filed a registration
statement with the Commission for the registration of $225 million aggregate
principal amount of 9 1/4% Senior Notes due July 15, 2007 (the "Exchange Notes")
to be offered in exchange for the Senior 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 Senior Notes except that (i) the Exchange Notes will 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 Senior Notes. As of September 30, 1997, the registration statement had
not been declared effective and the Exchange Offer had not been commenced.
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 Senior Discount
Exchange Notes.
In connection with its acquisition of CCI (as defined herein) on
September 24, 1997, the Company assumed approximately $62.3 million in long-term
debt including $2.1 million of current maturities.
7
NOTE 4: SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
NINE MONTHS ENDED
SEPTEMBER 30,
---------------------
1997 1996
-------- --------
(IN THOUSANDS)
(UNAUDITED)
Supplemental Disclosure of Cash Flow Information
Cash payment for interest, net of interest capitalized 1997
$2,881,000; 1996 $204,000 $ --- $ 761
======== ========
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
Contract payable 1,700
Option agreement 500
--------
$ 3,700
========
Customer list $ 1,350
Noncompete agreement 2,350
--------
$ 3,700
========
Acquisition of Indiana Directories, Inc. directories (Note 5)
Cash purchase price $ 6,000
Contract payable 4,031
--------
$ 10,031
========
Furniture, fixtures and equipment $ 150
Customer list 4,880
Noncompete agreement 5,001
--------
$ 10,031
========
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 4: SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION - CONTINUED
NINE MONTHS ENDED
SEPTEMBER 30,
---------------------
1997 1996
-------- --------
(IN THOUSANDS)
(UNAUDITED)
Acquisition of Smart Pages, Inc and Yellow Pages Publishers, Inc.
directories (Note 5):
Cash purchase price $ 749
Contract payable 1,124
Promissory note 100
--------
1,973
========
Customer list $ 967
Noncompete agreement 1,006
--------
$ 1,973
========
Acquisition of Consolidated Communications, Inc. (Note 5)
Cash purchase price $155,000
Acquisition costs 3,207
Stock issued 223,675
--------
381,822
========
Working capital acquired, net $ 40,999
Fair value of other assets acquired 182,799
Goodwill 203,480
Customer list 35,434
Noncompete agreement 713
Long-term debt and other liabilities assumed (81,543)
--------
381,822
========
NOTE 5: ACQUISITIONS AND COMMITMENTS
Digital Communications of Iowa, Inc. ("Digital Communications"): On
January 30, 1997, the Company issued 84,430 shares of the Company's Class A
common stock, par value $.01 per share (the "Class A Common Stock"), in exchange
for all the outstanding shares of Digital Communications, in a transaction
accounted for using the purchase method of accounting. The total purchase price
was approximately $2.3 million based on the average closing market price of the
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 cash 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
cash purchase price of approximately $10 million.
On September 22, 1997, McLeodUSA Publishing acquired two telephone
directories published by Smart Pages, Inc. and Yellow Pages Publishers, Inc.
("Smart Pages") at a purchase price to be determined based on the sum of the
revenues derived from the last Smart Pages editions of the directories. The
cash purchase price is currently estimated to be approximately $2 million.
ESI Communications, Inc. ("ESI"): On June 10, 1997, the Company acquired
substantially all of the assets of ESI and related entities for an aggregate
cash purchase price of approximately $15.2 million.
9
NOTE 5: ACQUISITIONS AND COMMITMENTS - CONTINUED
Personal Communications Services ("PCS") licenses: In April and June
1997, the Federal Communications Commission ("FCC") granted to the Company a
total of 26 "D" and "E" block frequency PCS licenses and in September 1997 the
Company acquired one such license in connection with its acquisition of CCI (the
"CCI PCS license"), in a total of 25 markets covering areas of Iowa, Illinois,
Minnesota, Nebraska and South Dakota. The PCS licenses 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 the 26 PCS licenses granted to the Company by the FCC in April
and June 1997. Prior to the completion of the Company's acquisition of CCI, CCI
paid the FCC for the CCI PCS license acquired by the Company in September 1997.
Consolidated Communications, Inc. ("CCI"): On September 24, 1997,
pursuant to the terms and conditions of that certain Agreement and Plan of
Reorganization dated as of June 14, 1997 (the "Merger Agreement"), the Company
issued 8,488,586 shares of Class A Common Stock and paid approximately $155
million in cash to the shareholders of CCI in exchange for all of the
outstanding shares of CCI in a transaction accounted for using the purchase
method of accounting. The total purchase price was approximately $381.8 million
based on the average price of the Class A Common Stock five days before and
after the date of the Merger Agreement. The purchase price includes
approximately $3.2 million of estimated direct acquisition costs.
The unaudited consolidated results of operations for the nine months
ended September 30, 1997 and 1996 on a pro forma basis as though CCI had been
acquired as of the beginning of the respective periods are as follows:
1997 1996
---------- ----------
(IN THOUSANDS)
(UNAUDITED)
Revenue $325,900 $231,932
Net loss (61,053) (14,024)
Loss per common and common equivalent share (1.00) (0.28)
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.
10
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Statements included in this discussion relating, but not limited to,
future revenues, operating expenses, capital requirements, growth rates, cash
flows, operational performance, sources and uses of funds, acquisitions,
technological changes and development of a PCS system, are forward-looking
statements that involve certain risks and uncertainties. Factors that may cause
the actual results, performance, achievements or investments expressed or
implied by such forward-looking statements to differ materially from any future
results, performance, achievements or investments expressed or implied by such
forward-looking statements include, among other things, the availability of
financing and regulatory approvals, the number of potential customers in a
target market, the existence of strategic alliances and relationships,
technological, regulatory or other developments in the Company's business,
changes in the competitive climate in which the Company operates and the
emergence of future opportunities and other factors more fully described under
the caption "Business--Risk Factors" in the Company's Annual Report on Form
10-K for the fiscal year ended December 31, 1996, filed with the Commission on
March 31, 1997 and which section is incorporated herein by reference.
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) telecommunications
network maintenance services and telephone equipment sales, service and
installation, (iii) private line and data services, (iv) the sale of advertising
space in telephone directories, (v) the operation of an independent local
exchange company, ICTC (as defined below), acquired as a result of the
acquisition of CCI, and (vi) telemarketing services.
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 offering 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 and began offering the service to
customers in North Dakota and South Dakota during the first nine 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 and its September 1997 acquisition of CCI, including its subsidiary CCD
(as defined below), which publishes and distributes "white" and "yellow page"
directories in 38 states and the United States Virgin Islands.
In September 1997, the Company completed its acquisition of CCI, a
diversified telecommunications holding company based in Mattoon, Illinois. CCI's
wholly owned subsidiary Illinois Consolidated Telephone Company ("ICTC") is an
independent local exchange carrier serving approximately 71,400 customers in
east central Illinois. CCI's wholly owned subsidiary Consolidated Communications
Telecom Services Inc. ("CCTS") is a competitive local exchange carrier offering
integrated local, long distance and other telecommunications services to
approximately 5,800 customers in central and southern Illinois. CCI's wholly
owned subsidiary Consolidated Communications Directories Inc. ("CCD") publishes
and distributes "white page" and "yellow page" telephone directories in 38
states and the United States Virgin Islands. CCI also operates an operator
service company, an inmate pay-phone company and a full service telemarketing
agency. In addition, CCI owns a majority interest in a cable television company
serving customers in Greene, Sangamon and Menard counties in Illinois and in
Benton Harbor, Michigan, and owns a minority interest in a cellular telephone
partnership. The Company believes the acquisition of CCI will allow it to
enhance its efforts to offer its telecommunications services in adjoining target
markets including expansion into Indiana and Missouri, states where CCI
currently is providing telecommunications services.
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
11
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. Additionally, in
September 1997, the Company granted options to purchase an aggregate of 1,483,
245 shares of its Class A Common Stock at an exercise price of $24.50 to certain
officers and employees of CCI. The fair market value of these options, in the
aggregate, at the date of grant exceeded the aggregate exercise price by
approximately $15.9 million. These amounts are 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.
While the merger with CCI is expected to have a positive effect on operating
losses and cash flows from operations, the Company anticipates that with the
projected increases in capital expenditures it will continue to generate
significant negative cash flows during the next several years while it 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 SEPTEMBER 30, 1997 COMPARED WITH THREE MONTHS ENDED SEPTEMBER
30, 1996
Total revenue increased from $19.1 million for the three months ended
September 30, 1996 to $49.3 million for the three months ended September 30,
1997, representing an increase of $30.2 million or 158%. Revenue from the sale
of local and long distance telecommunications services accounted for $15.8
million of the increase, including $2.8 million contributed by CCI, which was
acquired on September 24, 1997. In addition, revenue from McLeodUSA Publishing,
which was acquired in September 1996, contributed $11.1 million to the increase.
The remaining increase was primarily due to the acquisitions of Digital
Communications and ESI in January 1997 and June 1997, respectively, offset by
a decrease of
12
$1.8 million in telemarketing revenues caused by the December 1996 termination
of Ruffalo Cody's contract with a major long distance company to provide
telemarketing services.
Cost of service increased from $13 million for the three months ended
September 30, 1996, to $31.9 million for the three months ended September 30,
1997, representing an increase of $18.9 million or 146%. 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 McLeodUSA
Publishing, Digital Communications, ESI and CCI, which contributed an aggregate
of $8.8 million to the increase. Ruffalo Cody's cost of service for the three
months ended September 30, 1997 decreased $1.3 million as compared to the same
period in 1996 due to the loss of the major contract. Cost of service as a
percentage of revenue decreased from 68% for the three months ended September
30, 1996 to 65% for the three months ended September 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 73% for the three months ended September 30, 1996 to 75% for the
three months ended September 30, 1997, primarily as a result of increased line
costs associated with the Company's accelerated expansion into new markets.
SG&A increased from $11.7 million for the three months ended September
30, 1996 to $31 million for the three months ended September 30, 1997, an
increase of $19.3 million or 167%. The acquisitions of McLeodUSA Publishing,
Digital Communications, ESI and CCI contributed an aggregate of $9 million to
the increase offset by a $749,000 decrease in Ruffalo Cody's SG&A expenses.
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 $2.2 million for
the three months ended September 30, 1996 to $6.4 million for the three months
ended September 30, 1997, representing an increase of $4.2 million or 194%. This
increase consisted of $1.8 million related to the acquisitions of Ruffalo Cody,
McLeodUSA Publishing, Digital Communications, ESI and CCI, and $2.4 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 CCD
directories in progress at the time the Company acquired CCI.
Interest income increased from $2.9 million for the three-month period
ended September 30, 1996, to $7.6 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 offerings of the Senior Discount Notes and
the Senior Notes in March and July 1997, respectively.
Gross interest expense increased from $23,000 for the third quarter of
1996 to $12.7 million for the third quarter of 1997. This increase was primarily
a result of accretion of interest on the Senior Discount Notes of $7.9 million
and accrual of interest on the Senior Notes of $4.3 million. Interest expense of
approximately $1.5 million and $0 was capitalized as part of the Company's
construction of fiber optic network during the third quarter of 1997 and 1996,
respectively.
Net loss increased from $4.5 million for the three months ended
September 30, 1996 to $23.7 million for the three months ended September 30,
1997, an increase of $19.2 million. This increase resulted primarily from the
expansion of the Company's local and long distance telecommunications services
and costs related to the Company's acquisitions. 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.
13
NINE MONTHS ENDED SEPTEMBER 30, 1997 COMPARED WITH NINE MONTHS ENDED
SEPTEMBER 30, 1996
Total revenue increased from $45.5 million for the nine months ended
September 30, 1996 to $131.6 million for the nine months ended September 30,
1997, representing an increase of $86.1 million or 189%. Revenue from the sale
of local and long distance telecommunications services accounted for $31.2
million of this increase, including $2.8 million contributed by CCI. In
addition, revenues from McLeodUSA Publishing contributed $45.6 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 $31.7 million for the nine months ended
September 30, 1996, to $80.7 million for the nine months ended September 30,
1997, representing an increase of $49 million or 155%. 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, McLeodUSA
Publishing, Digital Communications, ESI and CCI which contributed an aggregate
of $23.5 million to the increase. Cost of service as a percentage of revenue
decreased from 70% for the nine months ended September 30, 1996 to 61% for the
nine months ended September 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 nine months ended September 30, 1996 to 77% for the nine months
ended September 30, 1997, primarily as a result of increased line costs
associated with the Company's accelerated expansion into new markets.
SG&A increased from $25.6 million for the nine months ended September
30, 1996 to $83.4 million for the nine months ended September 30, 1997, an
increase of $57.8 million or 226%. The acquisitions of Ruffalo Cody, McLeodUSA
Publishing, Digital Communications, ESI and CCI contributed an aggregate of
$27.6 million to the increase. Also contributing to this increase were increased
costs of $30.2 million primarily related to expansion of selling, customer
support and administration activities to support the Company's growth.
Depreciation and amortization expenses increased from $4.7 million for
the nine months ended September 30, 1996 to $15.7 million for the nine months
ended September 30, 1997, representing an increase of $11 million or 231%. This
increase consisted of $4.7 million related to the acquisitions of Ruffalo Cody,
McLeodUSA Publishing, Digital Communications, ESI and CCI and $6.3 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 CCD
directories in progress at the time the Company acquired CCI.
Interest income increased from $3.4 million for the nine-month period
ended September 30, 1996, to $18.1 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 offerings of the Senior Discount Notes and
the Senior Notes in March 1997 and July 1997, respectively.
Gross interest expense increased from $748,000 for the first nine months
of 1996 to $23.6 million for the first nine months of 1997. This increase was
primarily a result of accretion of interest on the Senior Discount Notes of
$18.3 million and accrual of interest on the Senior Notes of $4.3 million.
Interest expense of approximately $2.9 million and $204,000 was capitalized as
part of the Company's construction of fiber optic network during the first nine
months of 1997 and 1996, respectively.
Net loss increased from $13.4 million for the nine months ended
September 30, 1996 to $53.6 million for the nine months ended September 30,
1997, an increase of $40.2 million. This increase resulted primarily from the
expansion of the Company's local and long distance telecommunications services
and costs related to the Company's acquisitions. The development of the
Company's business
14
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 $1.4 billion at September 30, 1997, primarily due to the net proceeds of
approximately $508 million from the Company's March 1997 and July 1997 private
offerings of the Senior Discount Notes and Senior Notes, respectively, and the
acquisition of CCI in September 1997. At September 30, 1997, the Company's
current assets of $574.1 million exceeded its current liabilities of $141.2
million, providing working capital of $432.9 million, which represents an
increase of $246.9 million compared to December 31, 1996 primarily attributable
to the net proceeds from the Senior Discount Notes and the Senior 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 $16.5 million for the
nine months ended September 30, 1997 and $10.5 million for the nine months ended
September 30, 1996. During the nine months ended September 30, 1997, cash for
operating activities was used primarily to fund the Company's net loss of $53.6
million for such period. The Company also required cash to fund the growth in
accounts receivable and deferred line installation costs of $13.5 million and
$6.7 million, respectively, as a result of the expansion of the Company's local
and long distance telecommunications services. During the nine months ended
September 30, 1996, cash for operating activities was used primarily to fund the
Company's net loss of $13.4 million for such period. The Company also required
cash to fund the growth in trade receivables and other assets of $6.6 million
and $2.7 million, respectively, offset by an increase in accounts payable and
accrued expenses of $4.1 million.
The Company's investing activities used cash of $245.9 million during
the nine months ended September 30, 1997 and $208.4 million during the nine
months ended September 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 $104.1 million and $39.7 million
during the nine months ended September 30, 1997 and 1996, respectively.
In April and June 1997, the FCC granted to the Company a total of 26
"D" and "E" block frequency PCS licenses and in September 1997 the Company
acquired the CCI PCS license, in a total of 25 markets covering areas of Iowa,
Illinois, Minnesota, Nebraska and South Dakota. The PCS licenses 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 the 26 PCS licenses granted to the Company by
the FCC in April and June 1997. Prior to the completion of the Company's
acquisition of CCI, CCI paid the FCC for the CCI PCS license acquired by the
Company in September 1997.
The Company used cash of $23.5 million to acquire Digital Communications
and ESI in January 1997 and June 1997, respectively, and directories from
Fronteer, Indiana Directories, and Smart Pages in February 1997, March 1997, and
September 1997, respectively.
On September 24, 1997, pursuant to the terms and conditions of the
Merger Agreement, the Company issued 8,488,586 shares of Class A Common Stock
and paid approximately $155 million in cash to the shareholders of CCI in
exchange for all of the outstanding shares of CCI in a transaction accounted for
using the purchase method of accounting. The total purchase price was
approximately $381.8 million based on the average price of the Class A Common
Stock five days before and after the date of the Merger Agreement. The purchase
price includes approximately $3.2 million of estimated direct acquisition costs.
These uses of cash for investing activities during the nine months ended
September 30, 1997 were partially offset by net proceeds of $67.5 million from
the sales and maturities of available-for-sale securities.
15
Cash received from net financing activities was $502 million during the
nine months ended September 30, 1997, primarily as a result of the Company's
private offerings of the Senior Discount Notes in March 1997 and the Senior
Notes in July 1997. Cash received from financing activities during the nine
months ended September 30, 1996 was $257.6 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 Senior Discount Notes. The Company
filed a registration statement with the Commission for the registration of the
Senior Discount Exchange Notes to be offered in exchange for the Senior Discount
Notes. The registration statement was declared effective by the Commission on
July 28, 1997 and the Senior Discount Note Exchange Offer was commenced. The
Senior Discount Note Exchange Offer expired on August 24, 1997, and all of the
Senior Discount Notes were exchanged for the Senior Discount Exchange Notes. The
form and terms of the Senior Discount Exchange Notes are identical in all
material respects to the form and terms of the Senior Discount Notes except that
(i) the Senior Discount Exchange Notes have been registered under the Securities
Act and (ii) holders of the Senior Discount Exchange Notes are not entitled to
certain rights under a registration agreement relating to the Senior Discount
Notes. The Senior Discount Exchange Notes will accrete to an aggregate principal
amount of $500 million by March 1, 2002. Interest will not accrue on the Senior
Discount Exchange 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 Senior Discount
Exchange 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 33 1/3% of the original principal amount of the Senior Discount
Exchange Notes at a redemption price of 110.5% of the accreted value thereof. In
addition, in the event of a Change of Control (as defined in the Indenture
relating to the Senior Discount Exchange Notes) of the Company, each holder of
Senior Discount Exchange Notes will have the right to require the Company to
repurchase all or any part of such holder's Senior Discount Exchange Notes at a
purchase 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 Senior Discount Exchange Notes will
mature on March 1, 2007.
The Senior Discount Exchange 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 Senior Discount
Exchange 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 Senior Discount Exchange Notes also
are effectively subordinated to all existing and future third-party indebtedness
and other liabilities of the Company's subsidiaries.
On July 21, 1997, the Company completed a private offering of the Senior
Notes. The Company received net proceeds of approximately $218.5 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 all existing and future senior unsecured indebtedness
of the Company and rank senior in right of payment to all existing and future
subordinated indebtedness of the Company. As of September 30, 1997, the Company
had no outstanding subordinated indebtedness and, other than the Senior Discount
Exchange Notes, had no outstanding indebtedness that would rank pari passu with
the Senior Notes. The Senior Notes will mature on July 15, 2007. As of
September 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
filed a registration statement with the Commission for the registration of $225
million aggregate principal amount of Exchange Notes to be offered in exchange
for the Senior
16
Notes. The form and terms of the Exchange Notes are identical in all material
respects to the form and terms of the Senior Notes except that (i) the Exchange
Notes will 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 Senior Notes (the Senior Notes and the Exchange Notes
are referred to collectively, as the "Notes"). As of September 30, 1997, the
Exchange Offer had not been commenced. Interest on the Notes will accrue at the
rate of 9 1/4% per annum and will be payable in cash semi-annually in arrears on
July 15 and January 15, commencing January 15, 1998. The Notes will be
redeemable at the option of the Company, in whole or in part, at any time on or
after July 15, 2002 at 104.625% of their principal amount at maturity, plus
accrued and unpaid interest, declining to 103.083% of their principal amount at
maturity, plus accrued and unpaid interest, on or after July 15, 2003 and
declining to 101.542% of their principal amount at maturity, plus accrued and
unpaid interest, on or after July 15, 2004. In the event of certain equity
investments in the Company by certain strategic investors on or before July 15,
2000, the Company may, at its option, use all or a portion of the net proceeds
from such sale to redeem up to 33 1/3% of the originally issued principal amount
of the Notes at a redemption price equal to 109.25% of the principal amount of
the Notes plus accrued and unpaid interest thereon, if any, to the redemption
date, provided that at least 66 2/3% of the originally issued principal amount
of the Notes would remain outstanding immediately after giving effect to such
redemption. In addition, in the event of a Change of Control (as defined in the
Indenture relating to the Notes) of the Company, each holder of Notes shall have
the right to require the Company to repurchase all or any part of such holder's
Notes at a purchase price equal to 101% of the principal amount of the Notes
tendered by such holder plus accrued and unpaid interest, if any, to any Change
of Control Payment Date (as defined in the Indenture relating to the Notes).
The indentures relating to the Senior Discount Exchange Notes and the
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 September 30, 1997, the Company estimates that its aggregate
capital requirements for the remainder of 1997, 1998 and 1999 will be
approximately $404 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. These capital requirements are expected to be funded, in large part,
out of the approximately $218.5 million in net proceeds from the Company's
private offering of the Senior Notes in July 1997, the approximately $174
million in net proceeds remaining from the Company's March 1997 private offering
of the Senior Discount Notes, 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.
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
17
requirements for those standards. Both statements are effective for fiscal years
ending after December 15, 1997. The Company will adopt the statements effective
December 31, 1997 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.
18
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 or, in the case of customers served in central Illinois,
to local lines. The Company uses such access to either partition the local
switch or transmit traffic over unbundled local line segments and provide local
service to its customers.
The Company purchases access to local switches in the form of a product
generally known as "Centrex." Without such access, the Company could not
currently provide bundled local and long distance services to most of its
customers, 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 the filing. 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
19
exceptions to this ruling. The Minnesota Public Utilities Commission denied U S
WEST's exceptions on February 20, 1997. On July 29, 1997, the Minnesota Public
Utilities Commission denied the petition for 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.
On October 1, 1997, the FCC issued a decision addressing the preemption
of certain statutory and regulatory provisions of Texas law which had been
challenged as impermissible under the Telecommunications Act of 1996 (the
"Telecommunications Act"). As part of its decision, the FCC ruled that
restrictions on the resale of Southwestern Bell Telephone Company's Centrex
service, which had been allowed by the Texas Public Utility Commission, were
preempted by the Telecommunications Act. Specifically, the FCC held that the
resale of Centrex service could not be limited to "continuous property", as
Southwestern Bell had requested and the Texas Public Utility Commission had
approved, because such a limitation constituted a barrier to entry in violation
of section 253(a); was not competitively neutral, and was therefore
impermissible under section 253(b); and was unreasonable and discriminatory
restriction on resale, in violation of section 251(c)(4)(B). The FCC declined to
preempt another limitation (which contained a minimum station line requirement)
on the grounds that an arbitration decision in Texas made such a restriction
"presumptively unreasonable." While the Company believes that this decision
supports its position with respect to the resale of Centrex service, there can
be no guarantee that this decision will not be challenged on appeal, or that it
will be consistently applied without further litigation in the states in which
the Company operates.
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
20
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.
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's requested reconsideration of the Colorado Public Utilities Commission
decision to allow the resale of Centrex service to residential customers was
denied on September 9, 1997.
In January 1997, U S WEST proposed to implement certain interconnection
surcharges in several 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.
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 significant use of the Centrex product to service
most of its customers, 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. Although U S WEST agreed to process the
Company's service orders within a standard five-day period, order backlogs
continue to occur. There can be no assurance, however, that the decision of or
any further action by the Iowa Utilities Board
21
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 a decision implementing the
interconnection portions of the Telecommunications Act (the "Interconnection
Decision"). Certain provisions of the Interconnection Decision were appealed to
the U.S. Eighth Circuit Court of Appeals. In July and October, 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 decisions of the Eighth Circuit Court of Appeals 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 September 24, 1997, the Company completed its acquisition of CCI.
CCI is involved in various routine legal proceedings incidental to its business.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
EXHIBIT
NUMBER EXHIBIT DESCRIPTION
- ------- -------------------
4.1 Amendment No. 1 to Stockholders' Agreement dated as of September
19, 1997 by and among McLeodUSA Incorporated, IES Investments,
Inc., Midwest Capital Group, Inc., MWR Investments, Inc., Clark
E. McLeod, Mary E. McLeod and Richard A. Lumpkin on behalf of
each of the shareholders of Consolidated Communications Inc.,
listed on Revised Schedule 1 thereto.
11.1 Statement regarding computation of loss per common share.
27.1 Financial Data Schedule.
99.1 Press release dated July 30, 1997 (Filed as Exhibit 99.1 to the
Quarterly Report on Form 10-Q, File No. 0-20763, filed with the
Commission on August 11, 1997 and incorporated herein by
reference).
99.2 Press Release dated September 24, 1997 (Filed as Exhibit 99.1 to
the Current Report on Form 8-K, File No. 0-20763, filed with the
Commission on October 9, 1997 and incorporated herein by
reference).
99.3 Press Release dated October 29, 1997.
99.4 Press Release dated October 30, 1997.
(b) Reports on Form 8-K
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 that certain Asset Purchase Agreement filed
22
as Exhibit 2.1 to the Current Report on Form 8-K filed by the Company on June
26, 1997. The Company paid an aggregate cash purchase price of approximately
$15.2 million for such assets.
On October 9, 1997, the Company filed a Current Report on Form 8-K to
disclose that the Company had acquired CCI on September 24, 1997 (the "Merger"),
pursuant to the Merger Agreement, filed as Exhibit 2.2 to the Current Report on
Form 8-K filed by the Company on June 26, 1997. As consideration for the
acquisition of CCI, the Company issued an aggregate of 8,488,596 shares of Class
A Common Stock, and paid approximately $155 million in cash to the shareholders
of CCI. Upon consummation of the acquisition of CCI, former CCI shareholders
owned approximately 13.8% of the outstanding Class A Common Stock. Pursuant to
the Merger Agreement, Richard A. Lumpkin, the Chairman and Chief Executive
Officer of CCI, and Robert J. Currey, the President and Chief Operating Officer
of CCI, were appointed directors of the Company and joined the Company's
executive management team.
23
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: November 14, 1997 By: /s/ Stephen C. Gray
-------------------------------------
Stephen C. Gray
President and Chief Operating Officer
Date: November 14, 1997 By: /s/ Blake O. Fisher, Jr.
-------------------------------------
Blake O. Fisher, Jr.
Chief Financial Officer, Executive
Vice President, Corporate Administration
and Treasurer
24
INDEX TO EXHIBITS
SEQUENTIALLY
EXHIBIT NUMBERED
NUMBER EXHIBIT DESCRIPTION PAGE
- ------- ------------------- ------------
4.1 Amendment No. 1 to Stockholders' Agreement dated as of September 19,
1997 by and among McLeodUSA Incorporated, IES Investments, Inc.,
Midwest Capital Group, Inc., MWR Investments, Inc., Clark E. McLeod,
Mary E. McLeod and Richard A. Lumpkin on behalf of the shareholders of
Consolidated Communications, Inc., listed on Revised Schedule 1 thereto.
11.1 Statement regarding computation of loss per common share.
27.1 Financial Data Schedule.
99.1 Press Release dated July 30, 1997 (Filed as Exhibit 99.1 to the Quarterly
Report on Form 10-Q, File No. 0-20763, filed with the Commission on
August 11, 1997 and incorporated herein by reference).
99.2 Press Release dated September 24, 1997 (Filed as Exhibit 99.1 to the
Current Report on Form 8-K, File No. 0-20763, filed with the Commission
on October 9, 1997 and incorporated herein by reference).
99.3 Press Release dated October 29, 1997.
99.4 Press Release dated October 30, 1997.