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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, 1998
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, 1998:
Common Stock Class A: ($.01 par value)..... 62,894,327 shares
Common Stock Class B: ($.01 par value)..... None
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INDEX
Page
----
PART I. Financial Information
- ------ ---------------------
Item 1. Financial Statements..................................................................... 3
Consolidated Balance Sheets, June 30, 1998 (unaudited) and December 31, 1997............. 3
Unaudited Consolidated Statements of Operations and Comprehensive Income
for the three and six months ended June 30, 1998 and 1997.............................. 4
Unaudited Consolidated Statements of Cash Flows for the six months ended
June 30, 1998 and 1997................................................................. 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....................................................................... 20
Item 2. Changes in Securities and Use of Proceeds............................................... 21
Item 4. Submission of Matters to a Vote of Security Holders..................................... 22
Item 6. Exhibits and Reports on Form 8-K........................................................ 23
Signatures......................................................................................... 24
2
PART I
FINANCIAL INFORMATION
Item 1. Financial Statements
McLEODUSA INCORPORATED AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In thousands, except shares)
June 30, December 31,
1998 1997
------------ -------------
(Unaudited)
ASSETS
Current Assets
Cash and cash equivalents.............................................................. $ 250,695 $ 331,941
Investment in available-for-sale securities............................................ 280,917 34,696
Trade receivables, net................................................................. 118,230 108,472
Inventory.............................................................................. 4,352 3,992
Deferred expenses...................................................................... 24,917 27,641
Prepaid expenses and other............................................................. 13,509 11,044
---------- ----------
TOTAL CURRENT ASSETS.................................................................. 692,620 517,786
---------- ----------
Property and Equipment
Land and building...................................................................... 37,027 35,420
Telecommunications networks............................................................ 236,187 198,046
Furniture, fixtures and equipment...................................................... 110,874 70,579
Networks in progress................................................................... 108,540 81,432
Building in progress................................................................... 20,971 10,002
---------- ----------
513,599 395,479
Less accumulated depreciation.......................................................... 45,256 21,675
---------- ----------
468,343 373,804
---------- ----------
Investments, Intangible and Other Assets
Other investments...................................................................... 33,532 30,189
Goodwill, net.......................................................................... 279,734 273,442
Other intangibles, net................................................................. 104,407 97,935
Other.................................................................................. 58,396 52,496
---------- ----------
476,069 454,062
---------- ----------
$1,637,032 $1,345,652
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities
Current maturities of long-term debt................................................... $ 8,370 $ 6,004
Contracts and notes payable............................................................ 4,145 6,556
Accounts payable....................................................................... 59,737 45,354
Accrued payroll and payroll related expenses........................................... 17,451 21,454
Other accrued liabilities.............................................................. 45,015 36,793
Deferred revenue, current portion...................................................... 8,422 10,381
Customer deposits...................................................................... 12,383 12,710
---------- ----------
TOTAL CURRENT LIABILITIES............................................................. 155,523 139,252
---------- ----------
Long-term Debt, less current maturities................................................. 930,146 613,384
---------- ----------
Deferred Revenue, less current portion.................................................. 15,345 12,664
---------- ----------
Other long-term liabilities............................................................. 20,106 20,973
---------- ----------
Stockholders' Equity
Capital Stock:
Common, Class A, $.01 par value; authorized 250,000,000 shares;
issued and outstanding 1998 62,878,867 shares; 1997 61,799,412
shares............................................................................... 629 618
Common, Class B, convertible, $.01 par value; authorized 22,000,000
shares; issued and outstanding 1998 and 1997 none.................................... --- ---
Additional paid-in capital............................................................. 704,242 688,964
Accumulated deficit.................................................................... (187,793) (127,735)
Accumulated other comprehensive income................................................. (1,166) (2,468)
---------- ----------
515,912 559,379
---------- ----------
$1,637,032 $1,345,652
========== ==========
The accompanying notes are an integral part of these consolidated financial
statements
3
McLEODUSA INCORPORATED AND SUBSIDIARIES
UNAUDITED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME
(In thousands, except per share data)
Three Months Ended Six Months Ended
June 30, June 30,
--------------------- ----------------------
1998 1997 1998 1997
--------- --------- ---------- ---------
Revenues:
Telecommunications:
Local and long distance........................................ $ 63,658 $ 18,551 $125,316 $ 33,399
Local exchange services........................................ 16,610 --- 32,553 ---
Private line and data.......................................... 10,584 2,256 19,969 4,669
Network maintenance and equipment.............................. 7,604 3,434 15,085 5,419
Other telecommunications....................................... 6,892 --- 13,776 ---
-------- -------- -------- --------
Total telecommunications revenue.............................. 105,348 24,241 206,699 43,487
Directory....................................................... 45,514 20,273 73,478 34,487
Telemarketing................................................... 4,833 2,009 9,849 4,296
-------- -------- -------- --------
TOTAL REVENUES................................................. 155,695 46,523 290,026 82,270
Operating expenses:
Cost of service................................................. 83,068 26,520 158,113 46,758
Selling, general and administrative............................. 66,981 29,441 125,749 54,388
Depreciation and amortization................................... 21,046 5,231 40,477 9,353
Other........................................................... 1,900 999 3,800 2,607
-------- -------- -------- --------
TOTAL OPERATING EXPENSES....................................... 172,995 62,191 328,139 113,106
-------- -------- -------- --------
OPERATING LOSS................................................. (17,300) (15,668) (38,113) (30,836)
Nonoperating income (expense):
Interest income................................................. 7,821 6,199 12,434 10,452
Interest (expense).............................................. (20,410) (7,039) (35,164) (9,486)
Other income.................................................... 98 12 785 19
-------- -------- -------- --------
TOTAL NONOPERATING INCOME (EXPENSE)............................ (12,491) (828) (21,945) 985
-------- -------- -------- --------
LOSS BEFORE INCOME TAXES....................................... (29,791) (16,496) (60,058) (29,851)
Income taxes..................................................... --- --- --- ---
-------- -------- -------- --------
NET LOSS....................................................... $(29,791) $(16,496) $(60,058) $(29,851)
======== ======== ======== ========
Loss per common share............................................ $ (0.47) $ (0.31) $ (0.96) $ (0.57)
======== ======== ======== ========
Weighted average common shares outstanding....................... 62,644 52,583 62,436 52,456
======== ======== ======== ========
Other comprehensive income (loss), net of tax:
Unrealized gains on securities:
Unrealized holding gains (losses) arising during the
period........................................................ (4,616) --- 2,271 ---
Less: reclassification adjustment for gains included in
net income.................................................... (157) --- (969) ---
-------- -------- -------- --------
TOTAL OTHER COMPREHENSIVE INCOME (LOSS)........................ (4,773) --- 1,302 ---
-------- -------- -------- --------
COMPREHENSIVE LOSS............................................. $(34,564) $(16,496) $(58,756) $(29,851)
======== ======== ======== ========
The accompanying notes are an integral part of these consolidated financial
statements
4
MCLEODUSA INCORPORATED AND SUBSIDIARIES
UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
SIX MONTHS ENDED
JUNE 30,
-----------------------------------------
1998 1997
---------------- ----------------
Cash Flows From Operating Activities
Net Loss............................................................................... $ (60,058) $(29,851)
Adjustments to reconcile net loss to net cash provided by (used in) operating
activities:
Depreciation.......................................................................... 23,554 4,751
Amortization.......................................................................... 16,923 4,602
Accretion of interest on senior discount notes........................................ 17,124 10,482
Changes in assets and liabilities, net of effects of acquisitions:
(Increase) in trade receivables....................................................... (8,467) (6,650)
(Increase) in inventory............................................................... (101) (264)
Decrease in deferred expenses......................................................... 2,724 1,654
(Increase) in deferred line installation costs........................................ (6,914) (4,397)
Increase in accounts payable and accrued expenses..................................... 18,103 4,296
Increase in deferred revenue.......................................................... 571 1,522
(Decrease) in customer deposits....................................................... (329) (343)
Other, net............................................................................ (2,203) (4,138)
--------- --------
NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES.................................. 927 (18,336)
--------- --------
Cash Flows from Investing Activities
Purchases of property and equipment.................................................... (110,665) (62,292)
Available-for-sale securities:
Purchases............................................................................. (476,730) (89,120)
Sales................................................................................. 202,095 79,193
Maturities............................................................................ 29,716 44,302
Acquisitions........................................................................... (7,451) (22,757)
Payments on PCS licenses............................................................... --- (27,187)
Other.................................................................................. (3,758) (458)
--------- --------
NET CASH (USED IN) INVESTING ACTIVITIES (366,793) (78,319)
--------- --------
Cash Flows from Financing Activities
Payments on contracts and notes payable................................................ (3,158) (3,925)
Net proceeds from long-term debt....................................................... 291,794 289,575
Payments on long-term debt............................................................. (6,002) (898)
Net proceeds from issuance of common stock............................................. 1,986 455
--------- --------
NET CASH PROVIDED BY FINANCING ACTIVITIES............................................ 284,620 285,207
--------- --------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS................................. (81,246) 188,552
Cash and cash equivalents:
Beginning.............................................................................. 331,941 96,480
--------- --------
Ending................................................................................. $ 250,695 $285,032
========= ========
The accompanying notes are an integral part of these 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, 1998 AND 1997 IS UNAUDITED)
NOTE 1: BASIS OF PRESENTATION
Interim Financial Information (unaudited): The financial statements and
notes related thereto as of June 30, 1998, and for the three and six month
periods ended June 30, 1998 and 1997, 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 ("SEC"). 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, 1997, filed with the SEC on March 9, 1998.
Reclassifications: Certain items in the December 31, 1997 balance sheet
and the unaudited statement of operations for the three and six month periods
ended June 30, 1997 have been reclassified to be consistent with the
presentation in the June 30, 1998 unaudited financial statements.
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,
1998 1997
---------- -----------
(IN THOUSANDS)
TRADE RECEIVABLES:
Billed........................................................... $ 90,181 $ 86,309
Unbilled......................................................... 41,558 34,114
-------- --------
131,739 120,423
Allowance for doubtful accounts and discounts..................... (13,509) (11,951)
-------- --------
$118,230 $108,472
======== ========
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: Goodwill resulting from the Company's acquisitions is being
amortized over a range of 15 to 30 years using the straight-line method and is
periodically reviewed for impairment based upon an assessment of future
operations to ensure that it is appropriately valued. Accumulated amortization
on goodwill totaled $11,102,000 and $5,834,000, at June 30, 1998 and December
31, 1997, respectively.
6
Other intangibles: Other intangibles consist of customer lists and noncompete
agreements related to the Company's acquisitions, deferred line installation
costs incurred in the establishment of local access lines for customers and
franchise rights to provide cable services to customers in three Illinois
counties and in a Michigan city. The customer lists and noncompete agreements
are being amortized using the straight-line method over periods ranging from 3
to 15 years. The deferred line installation costs are being amortized using the
straight-line method over 36 to 60 months, which approximates the average lives
of residential and business customer contracts. The franchise rights are being
amortized using the straight-line method over periods ranging from 10 to 15
years. Accumulated amortization on the other intangibles totaled $17,531,000 and
$9,158,000 at June 30, 1998 and December 31, 1997, respectively.
NOTE 3: LONG-TERM DEBT
On March 16, 1998, the Company completed a private offering of its 8 3/8%
Senior Notes due March 15, 2008 (the "1998 Privately Placed Senior Notes"), for
which the Company received net proceeds of approximately $291.9 million. The
Company filed a registration statement with the SEC for the registration of $300
million principal amount of 8 3/8% Senior Notes due March 15, 2008 (the
"Exchange Notes," together with the 1998 Privately Placed Senior Notes, the
"1998 Senior Notes") to be offered in exchange for the 1998 Privately Placed
Senior Notes (the "Exchange Offer"). The registration statement was declared
effective by the SEC on May 15, 1998 and the Exchange Offer was commenced. The
Exchange Offer expired on June 25, 1998, at which time all of the 1998 Privately
Placed Senior Notes were exchanged for the Exchange Notes. The form and terms of
the Exchange Notes are identical in all material respects to the form and terms
of the 1998 Privately Placed Senior Notes except that (i) the Exchange Notes
have been registered under the Securities Act of 1933 (the ''Securities Act'')
and (ii) holders of the Exchange Notes are not entitled to certain rights under
a registration agreement relating to the 1998 Privately Placed Senior Notes.
Interest on the 1998 Senior Notes will be payable in cash semi-annually in
arrears on March 15 and September 15 of each year at a rate of 8 3/8% per annum,
commencing September 15, 1998. The 1998 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 June 30, 1998, the Company had
no outstanding subordinated indebtedness and had $568.9 million outstanding
indebtedness that would rank pari passu with the 1998 Senior Notes. The 1998
Senior Notes will mature on March 15, 2008. The 1998 Senior Notes will be
redeemable at the option of the Company, in whole or in part, at any time on or
after March 15, 2003 at 104.188% of their principal amount at maturity, plus
accrued and unpaid interest, declining to 100.000% of their principal amount at
maturity, plus accrued and unpaid interest, on or after March 15, 2006. In the
event of certain equity investments in the Company by certain strategic
investors on or before March 15, 2001, 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 1998 Senior Notes at a redemption
price equal to 108.375% of the principal amount of the 1998 Senior 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 1998
Senior 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 dated as of March 16, 1998 between the Company and the United States
Trust Company of New York as trustee, governing the 1998 Senior Notes (the "1998
Senior Note Indenture")) of the Company, each holder of 1998 Senior Notes shall
have the right to require the Company to repurchase all or any part of such
holder's 1998 Senior Notes at a purchase price equal to 101% of the principal
amount of the 1998 Senior Notes tendered by such holder plus accrued and unpaid
interest, if any, to any Change of Control Payment Date (as defined in the 1998
Senior Note Indenture).
The 1998 Senior Note Indenture imposes operating and financial restrictions on
the Company and its subsidiaries. These restrictions affect, and in certain
cases significantly limit or prohibit, among other things, the ability of the
Company and its subsidiaries to incur additional indebtedness, pay dividends or
make distributions in respect of the Company's or such subsidiaries' capital
stock, make other restricted payments, enter into sale and leaseback
transactions, create liens upon assets, enter into transactions with affiliates
or related persons, sell assets, or consolidate, merge or sell all or
substantially all of their assets. There can be no assurance that such covenants
will not adversely affect the Company's ability to finance its future operations
or capital needs or to engage in other business activities that may be in the
interest of the Company.
7
NOTE 4: SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
SIX MONTHS ENDED
JUNE 30,
----------------------------
1998 1997
--------- ----------
(IN THOUSANDS)
(UNAUDITED)
Supplemental Disclosure of Cash Flow Information
Cash payment for interest, net of interest capitalized 1998 $3,478,000;
1997 $1,427,000....................................................................... $ 8,956 $ ---
======= =======
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.................. $ 5,568 $2,988
======= ======
Acquisition of F.D.S.D. Rapid City, Inc. directory:
Cash purchase price................................................................... $ 2,226
=======
Other intangibles..................................................................... $ 2,226
=======
Acquisition of Bi-Rite Directories, Inc. directory:
Cash purchase price................................................................... $ 3,500
Long-term debt........................................................................ 190
-------
$ 3,690
=======
Other intangibles..................................................................... $ 3,690
=======
Acquisition of Smart Pages, Inc. and Yellow Pages Publishers, Inc. directory:
Cash purchase price................................................................... $ 628
Contract payable...................................................................... 628
-------
$ 1,256
=======
Other intangibles..................................................................... $ 1,256
=======
Acquisition of NewCom Technologies, Inc. and NewCom OSP Services, Inc.:
Cash purchase price................................................................... $ 1,019
Stock issued.......................................................................... 3,217
-------
$ 4,236
=======
Working capital acquired, net......................................................... $ 341
Fair value of other assets acquired, primarily property and equipment................. 906
Goodwill.............................................................................. 3,864
Long-term debt assumed................................................................ (875)
-------
$ 4,236
=======
Acquisition of certain assets of Communications Cable-Laying Company, Inc.:
Acquisition costs..................................................................... $ 78
Stock issued.......................................................................... 5,965
-------
$ 6,043
=======
Working capital acquired, net......................................................... (475)
Fair value of other assets acquired, primarily property and equipment................. 954
Goodwill.............................................................................. 5,715
Other intangibles..................................................................... 1,341
Long-term debt assumed................................................................ (1,492)
-------
$ 6,043
=======
8
SIX MONTHS ENDED
JUNE 30,
-----------------------------
1998 1997
---------- --------
(IN THOUSANDS)
(UNAUDITED)
Acquisition of Digital Communications of Iowa, Inc.:
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:
Cash purchase price................................................................... $ 1,500
Contract payable...................................................................... 1,867
Option agreement...................................................................... 500
-------
$ 3,867
=======
Other intangibles..................................................................... $ 3,867
=======
Acquisition of Indiana Directories, Inc. directories:
Cash purchase price................................................................... $ 6,000
Contract payable...................................................................... 4,031
-------
$10,031
=======
Furniture, fixtures and equipment..................................................... $ 150
Other intangibles..................................................................... 9,881
-------
$10,031
=======
Acquisition of assets of ESI Communications, Inc.:
Cash purchase price................................................................... $15,228
=======
Working capital acquired, net......................................................... $ 2,170
Fair value of other assets acquired................................................... 493
Goodwill.............................................................................. 12,960
Other intangibles..................................................................... 376
Long-term debt assumed................................................................ (771)
-------
Other intangibles..................................................................... $15,228
=======
NOTE 5: ACQUISITIONS
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.
ESI Communications, Inc. ("ESI"): On June 10, 1997, the Company acquired
substantially all of the assets of ESI and related entities at a cash purchase
price of approximately $15.2 million.
Directories: On February 25, 1997, McLeodUSA Publishing (as defined herein)
acquired six directories from Fronteer Financial Holdings, Ltd., ("Fronteer")
for a cash purchase price of approximately $3.9 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.
9
On March 17, 1998, McLeodUSA Publishing acquired a telephone directory
published by F.D.S.D. Rapid City Directories, Inc. at a cash purchase price of
approximately $2.2 million.
On March 20, 1998, McLeodUSA Publishing acquired a telephone directory
published by Bi-Rite Directories, Inc. for a cash purchase price of
approximately $3.7 million.
On April 8, 1998, McLeodUSA Publishing acquired a telephone directory
published by Smart Pages, Inc. and Yellow Pages Publishers, Inc. for a cash
purchase price of approximately $1.3 million.
NewCom Technologies, Inc. and NewCom OSP Services, Inc. ("NewCom"): On April
24, 1998, the Company issued 70,508 shares of Class A common stock and paid
approximately $1 million cash for all of the outstanding shares of NewCom, in a
transaction accounted for using the purchase method of accounting. The total
purchase price was approximately $4.2 million based on the average closing
market price of the Class A Common Stock at the time of the acquisition.
Communications Cable-Laying Company, Inc. ("CCC"): On June 29, 1998, the
Company issued 151,019 shares of Class A common stock to acquire certain of the
assets of CCC. The total purchase price was approximately $6 million based on
the average closing market price of the Class A Common Stock at the time of the
acquisition and including $78,000 of cash acquisition costs.
Consolidated Communications Inc. ("CCI"): On September 24, 1997, pursuant to
the terms and conditions of an Agreement and Plan of Reorganization dated 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 $382.1 million based on the average closing
price of the Company's Class A Common Stock five days before and after the date
of the Merger Agreement. The purchase price includes approximately $3.4 million
of direct acquisition costs.
The acquisitions of Digital Communications, CCI and NewCom have been accounted
for as purchases and the results of operations are included in the consolidated
financial statements since the dates of acquisition.
The unaudited consolidated results of operations for the six months ended June
30, 1997 on a pro forma basis as though the above entities had been acquired as
of the beginning of the period is as follows (in thousands, except per share
data):
1997
----------
Revenue..................................................... $210,137
Net loss.................................................... (32,190)
Loss per common share....................................... (0.53)
The pro forma financial information is presented for informational purposes
only and is not necessarily indicative of the operating results that would have
occurred had the acquisitions been consummated as of the above dates, nor are
such operating results necessarily indicative of future operating results.
NOTE 6: SUBSEQUENT EVENTS
In July 1998, the Company signed a definitive agreement to acquire all of the
outstanding capital stock of QST Communications Inc. for $20 million in cash and
options to acquire 245,536 shares of the Company's Class A common stock at an
exercise price of the lower of $40.00 or the closing price of the Class A common
stock on the day prior to the closing date of the acquisition.
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, the ability of the
Company and its third party vendors to make their computer software Year 2000
compliant by the projected deadlines and on budgeted costs, 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, 1997, filed with the Commission on March 9, 1998
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 "bundled" 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) local exchange services through the
operation of an independent local exchange company, Illinois Consolidated
Telephone Company ("ICTC"), acquired as part of the acquisition of CCI in
September 1997 (the "CCI Acquisition"), (vi) telemarketing services and (vii)
other telecommunications services, including cellular, operator, payphone and
paging services. The Company began providing local exchange services and other
telecommunications services as a result of the CCI Acquisition in September
1997, telephone directory advertising as a result of its acquisition of Telecom
USA Publishing Group, Inc., now known as McLeodUSA Media Group, Inc. ("McLeodUSA
Publishing") in September 1996, and telemarketing services as a result of its
acquisition of Ruffalo, Cody & Associates, Inc. ("Ruffalo Cody") in July 1996.
The Company began offering "bundled" local and long distance services to
business customers in January 1994. At the end of 1995, the Company began
offering, 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. By the end of 1997, the Company had expanded the states in which
it offers service to business customers to include Iowa, Illinois, Indiana,
Minnesota, Wisconsin, North Dakota, South Dakota, Colorado and Wyoming. The
Company also had expanded its PrimeLine(R) service to certain additional cities
in Iowa and Illinois and had begun offering the service to customers in North
Dakota, South Dakota, Wisconsin and Colorado. On June 29, 1998, the Company
began offering "bundled" local and long distance services to business customers
in Springfield, Missouri, through its acquisition of assets of Communications
Cable-Laying Company, Inc. The Company had previously been offering long
distance only services to business customers in St. Louis, Missouri. Also in
1998, the Company began offering Primeline(R) service to residential customers
in Wyoming. The Company plans to continue its efforts to market and provide
local, long distance and other telecommunications services to business customers
and 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,
its September 1996 acquisition of McLeodUSA Publishing, which publishes and
distributes competitive "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 Consolidated Communications
Directories
11
Inc. ("CCD"), which publishes and distributes "white page" and "yellow page"
telephone directories in 38 states and the United States Virgin Islands.
In September 1997, the Company completed the CCI Acquisition. As a result
of the CCI Acquisition, the Company now owns all of the former CCI subsidiaries,
including ICTC, an independent local exchange carrier serving east central
Illinois; Consolidated Communications Telecom Services Inc. ("CCTS"), a
competitive local exchange carrier which offers integrated local, long distance
and other telecommunications services in central and southern Illinois and in
Indiana; CCD, a telephone directory publishing company; an operator service
company; an inmate pay-phone company; a full service telemarketing agency; a
majority interest in a cable television company serving customers in Greene,
Sangamon and Menard counties in Illinois and Benton Harbor, Michigan; and a
minority interest in a cellular telephone partnership serving parts of east
central Illinois. The Company believes the CCI Acquisition has enhanced its
efforts to offer its telecommunications services in adjoining target markets
including its expansion into Indiana and Missouri, states where CCI provided
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
Regional Bell Operating Companies, costs to terminate the long distance calls of
the Company's customers through interexchange carriers, costs of printing and
distributing the telephone directories published by McLeodUSA Publishing and
CCD, 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 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 and other intangibles 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
1,468,945 shares of its Class A Common Stock at an exercise price of $24.50 to
certain 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 $15.8 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,
all of which may have a negative impact on operating results. In addition, the
projected increases in capital expenditures will continue to generate negative
cash flows from construction activities during the next several years while the
Company installs and expands its fiber optic network and develops and constructs
its proposed PCS system. The Company may also 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.
12
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, 1998 COMPARED WITH THREE MONTHS ENDED JUNE 30, 1997
Total revenue increased from $46.5 million for the three months ended June
30, 1997 to $155.7 million for the three months ended June 30, 1998,
representing an increase of $109.2 million or 235%. Revenue from the sale of
local and long distance telecommunications services accounted for $45.1 million
of the increase, including $16.6 million contributed by CCI, which was acquired
on September 24, 1997. Local exchange services generated by ICTC represented
$16.6 million for the period, for which there were no corresponding 1997
revenues. Private line and data revenues accounted for $8.3 million of
increased revenues over 1997, which was primarily attributable to the CCI
Acquisition. Network maintenance and equipment revenue increased $4.2 million
over 1997 due primarily to the acquisitions of Digital Communications of Iowa,
Inc. ("Digital Communications"), ESI Communications, Inc. ("ESI
Communications"), CCI and NewCom Technologies, Inc. and NewCom OSP Services,
Inc. ("NewCom"). Other telecommunications revenue, which was due entirely to
the CCI Acquisition, represented $6.9 million of the second quarter 1998
revenues with no corresponding 1997 amount. Directory revenues increased $25.2
million from the second quarter of 1997 to the second quarter of 1998 due to
revenues from new directories acquired in 1997 and the acquisition of CCD on
September 24, 1997. The $2.8 million increase in telemarketing revenues from
the second quarter of 1997 to the second quarter of 1998 was due almost entirely
to the CCI Acquisition.
Cost of service increased from $26.5 million for the three months ended
June 30, 1997, to $83.1 million for the three months ended June 30, 1998,
representing an increase of $56.6 million or 213%. 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 Digital Communications,
ESI Communications, CCI and NewCom, which contributed an aggregate of $37.6
million to the increase. Cost of service as a percentage of revenue decreased
from 57% for the three months ended June 30, 1997 to 53% for the three months
ended June 30, 1998, as a result of the effect of these acquisitions and as a
result of reductions in the cost of providing competitive local and long
distance services as a percentage of competitive local and long distance
telecommunications revenue, which decreased from 82% to 71% during those same
periods. This decrease was primarily due to the realization of benefits
associated with new wholesale line cost rate agreements with the Regional Bell
Operating Companies and reduced long distance costs resulting from migration of
over 50% of customer long distance traffic to the Company's fiber optic network.
SG&A increased from $29.4 million for the three months ended June 30, 1997
to $67 million for the three months ended June 30, 1998, an increase of $37.6
million or 128%. The acquisitions of Digital Communications, ESI
Communications, CCI and NewCom contributed an aggregate of $23.8 million to the
increase. Also contributing to this increase were increased costs of $13.8
million related primarily to expansion of selling, customer support and
administration activities to support the Company's growth.
Depreciation and amortization expenses increased from $5.2 million for the
three months ended June 30, 1997 to $21 million for the three months ended June
30, 1998, representing an increase of $15.8 million or 302%. This increase
consisted of $11 million related to the acquisitions of Digital Communications,
ESI Communications, CCI and NewCom, and $4.8 million due primarily to the growth
of the Company's network.
Other operating expenses represented the amortization of capitalized costs
associated with CCD directories in progress at the time the Company acquired
CCI.
Interest income increased from $6.2 million for the three-month period
ended June 30, 1997, to $7.8 million for the same period in 1998. This increase
resulted from increased earnings on investments made with the remaining proceeds
from the Company's issuance, in March 1997, of $500 million aggregate principal
amount at maturity of 10 1/2% Senior Discount Notes due March 15, 2007 (the
"1997 Senior Discount Notes") and, in July 1997, of $225 million principal
amount of 9 1/4% Senior Notes due July 15, 2007 (the "1997 Senior Notes") as
well as the proceeds from the Company's issuance, in March
13
1998, of $300 million principal amount of 8 3/8% Senior Notes due March 15, 2008
(the "1998 Senior Notes").
Gross interest expense increased from $8.2 million for the first quarter of
1997 to $22.2 million for the first quarter of 1998. This increase was
primarily a result of an increase in the accretion of interest on the Senior
Discount Notes of $846,000 and accrual of interest on the 1997 Senior Notes and
the 1998 Senior Notes of $11.5 million. Interest expense of approximately $1.8
million and $1.1 million was capitalized as part of the Company's construction
of fiber optic network during the second quarter of 1998 and 1997, respectively.
Net loss increased from $16.5 million for the three months ended June 30,
1997 to $29.8 million for the three months ended June 30, 1998, an increase of
$13.3 million. This increase resulted primarily from the following three
factors: the expansion of the Company's local and long distance services, which
requires significant expenditures, a substantial portion of which is incurred
before the realization of revenues; the increased depreciation expense related
to the construction and expansion of the Company's networks and amortization of
intangibles related to acquisitions; and net interest expense on indebtedness to
fund market expansion, network development and acquisitions.
SIX MONTHS ENDED JUNE 30, 1998 COMPARED WITH SIX MONTHS ENDED JUNE 30, 1997
Total revenue increased from $82.3 million for the six months ended June
30, 1997 to $290 million for the six months ended June 30, 1998, representing an
increase of $207.7 million or 253%. Revenue from the sale of local and long
distance telecommunications services accounted for $91.9 million of this
increase, including $35.8 million contributed by CCI. Local exchange services
generated by ICTC represented $32.5 million for the period, for which there were
no corresponding 1997 revenues. Private line and data revenues accounted for
$15.3 million of increased revenues over 1997, which was primarily attributable
to the CCI Acquisition. Network maintenance and equipment revenue increased
$9.7 million over 1997 due primarily to the acquisitions of Digital
Communications, ESI Communications, CCI and NewCom. Other telecommunications
revenue, which was due entirely to the CCI Acquisition, represented $13.8
million of the revenues for the first six months of 1998 with no corresponding
1997 amount. Directory revenues increased $39 million from the first six months
of 1997 to the first six months of 1998 due to revenues from new directories
acquired in 1997 and the acquisition of CCD. The $5.5 million increase in
telemarketing revenues from the first six months of 1997 to the first six months
of 1998 was due almost entirely to the CCI Acquisition.
Cost of service increased from $46.8 million for the six months ended June
30, 1997, to $158.1 million for the six months ended June 30, 1998, representing
an increase of $111.3 million or 238%. 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 Digital Communications,
ESI Communications, CCI and NewCom, which contributed an aggregate of $71.7
million to the increase. Cost of service as a percentage of revenue decreased
from 57% for the six months ended June 30, 1997 to 55% for the six months ended
June 30, 1998, as a result of these acquisitions and as a result of reductions
in the cost of providing local and long distance services as a percentage of
local and long distance telecommunications revenue, which decreased from 79% to
70% for those same periods. This decrease was primarily due to the realization
of benefits associated with new wholesale line cost rate agreements with the
Regional Bell Operating Companies and reduced long distance costs resulting from
migration of over 50% of customer long distance traffic to the Company's fiber
optic network.
SG&A increased from $54.4 million for the six months ended June 30, 1997 to
$125.7 million for the six months ended June 30, 1998, an increase of $71.3
million or 131%. The acquisitions of Digital Communications, ESI Communications,
CCI and NewCom contributed an aggregate of $46.4 million to the increase. Also
contributing to this increase were increased costs of $24.9 million primarily
related to expansion of selling, customer support and administration activities
to support the Company's growth.
Depreciation and amortization expenses increased from $9.4 million for the
six months ended June 30, 1997 to $40.5 million for the six months ended June
30, 1998, representing an increase of $31.1 million or 333%. This increase
consisted of $21.5 million related to the acquisitions of Digital
Communications, ESI Communications, CCI and NewCom, and $9.6 million due
primarily to the growth of the Company's network.
Other operating expenses represented the amortization of capitalized costs
associated with CCD directories in progress at the time the Company acquired
CCI.
14
Interest income increased from $10.5 million for the six-month period ended
June 30, 1997, to $12.4 million for the same period in 1997. This increase
resulted from increased earnings on investments made with the remaining proceeds
from the Company's debt offerings in March and July 1997 and the proceeds from
the Company's offering of the 1998 Senior Notes in March 1998.
Gross interest expense increased from $10.9 million for the first six
months of 1997 to $38.6 million for the first six months of 1998. This increase
was primarily a result of an increase in the accretion of interest on the Senior
Discount Notes of $6.6 million and accrual of interest on the 1997 Senior Notes
and the 1998 Senior Notes of $17.7 million. Interest expense of approximately
$3.5 million and $1.4 million was capitalized as part of the Company's
construction of fiber optic network during the first half of 1998 and 1997,
respectively.
Net loss increased from $29.9 million for the six months ended June 30,
1997 to $60.1 million for the six months ended June 30, 1998, an increase of
$30.2 million. This increase resulted primarily from the following three
factors: the expansion of the Company's local and long distance services, which
requires significant expenditures, a substantial portion of which is incurred
before the realization of revenues; the increased depreciation expense related
to the construction and expansion of the Company's networks and amortization of
intangibles related to acquisitions; and net interest expense on indebtedness to
fund market expansion, network development and acquisitions.
LIQUIDITY AND CAPITAL RESOURCES
The Company's total assets increased from $1.3 billion at December 31, 1997
to $1.6 billion at June 30, 1998, primarily due to the net proceeds of
approximately $291.9 million from the Company's March 1998 offering of the 1998
Senior Notes. At June 30, 1998, the Company's current assets of $692.6 million
exceeded its current liabilities of $155.5 million, providing working capital of
$537.1 million, which represents an increase of $158.6 million compared to
December 31, 1997 primarily attributable to the net proceeds from the 1998
Senior Notes. At December 31, 1997, the Company's current assets of $517.8
million exceeded current liabilities of $139.3 million, providing working
capital of $378.5 million.
The net cash provided by operating activities totaled $927,000 for the six
months ended June 30, 1998 compared to net cash used in operating activities of
$18.3 million for the six months ended June 30, 1997. During the six months
ended June 30, 1998, cash for operating activities was used primarily to fund
the Company's net loss of $60.1 million for such period. The Company also
required cash to fund the growth in trade receivables and deferred line
installation costs of $8.5 million and $6.9 million, respectively, primarily as
a result of the expansion of the Company's local and long distance
telecommunications services. These uses of cash for operating activities during
the six months ended June 30, 1998, were offset by a decrease in deferred
expenses of $2.7 million, an increase in accounts payable and accrued expenses
of $18.1 million and cumulative non-cash expenses of $57.6 million. 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 trade receivables and deferred line
installation costs of $6.7 million and $4.4 million, respectively.
The Company's investing activities used cash of $366.8 million during the
six months ended June 30, 1998 and $78.3 million during the six months ended
June 30, 1997. 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 $110.7 million and $62.3 million during the six
months ended June 30, 1998 and 1997, respectively. The Company also used cash
of $476.7 million and $89.1 million to acquire available-for-sale securities
during the first six months of 1998 and 1997, respectively, offset by proceeds
from sales and maturities of available-for-sale securities of $231.8 million and
$123.5 million, respectively, during those periods.
The Company used an aggregate of $7.5 million cash during the six months
ended June 30, 1998 to acquire directories from F.D.S.D. Rapid City Directories,
Inc., Bi-Rite Directories, Inc. and Smart Pages, Inc. and Yellow Pages
Publishers, Inc. on March 17, 1998, March 20, 1998, and April 8, 1998,
respectively, and in its acquisitions of NewCom capital stock and Communications
Cable-Laying Company, Inc. assets in April and June 1998, respectively.
15
The Company used cash of $22.8 million during the six months ended June 30,
1997 to acquire Digital Communications, Fronteer, the Indiana Directories and
ESI in January 1997, February 1997, March 1997 and June 1997, respectively.
In July 1998, the Company signed a definitive agreement to acquire all of
the outstanding capital stock of QST Communications Inc. for $20 million in cash
and options to acquire 245,536 shares of the Company's Class A common stock at
an exercise price of the lower of $40.00 or the closing price of the Class A
common stock on the day prior to the closing date of the acquisition.
Cash received from net financing activities was $284.6 million during the
six months ended June 30, 1998, primarily as a result of the Company's offering
of the 1998 Senior Notes in March 1998. Cash received from financing activities
during the six months ended June 30, 1997 was $285.2 million and was primarily
obtained from the Company's private offering of the Senior Discount Notes, in
March 1997.
On March 16, 1998, the Company completed a private offering of its 8 3/8%
Senior Notes due March 15, 2008 (the "1998 Privately Placed Senior Notes"), for
which the Company received net proceeds of approximately $291.9 million. The
Company filed a registration statement with the SEC for the registration of $300
million principal amount of 8 3/8% Senior Notes due March 15, 2008 (the
"Exchange Notes," together with the 1998 Privately Placed Senior Notes, the
"1998 Senior Notes") to be offered in exchange for the 1998 Privately Placed
Senior Notes (the "Exchange Offer"). The registration statement was declared
effective by the SEC on May 15, 1998 and the Exchange Offer was commenced. The
Exchange Offer expired on June 25, 1998, at which time all of the 1998 Privately
Placed Senior Notes were exchanged for the Exchange Notes. The form and terms of
the Exchange Notes are identical in all material respects to the form and terms
of the 1998 Privately Placed Senior Notes except that (i) the Exchange Notes
have been registered under the Securities Act of 1933 (the "Securities Act")
and (ii) holders of the Exchange Notes are not entitled to certain rights under
a registration agreement relating to the 1998 Privately Placed Senior Notes.
Interest on the 1998 Senior Notes will be payable in cash semi-annually in
arrears on March 15 and September 15 of each year at a rate of 8 3/8% per annum,
commencing September 15, 1998. The 1998 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 June 30, 1998, the Company had
no outstanding subordinated indebtedness and had $568.9 million outstanding
indebtedness that would rank pari passu with the 1998 Senior Notes. The 1998
Senior Notes will mature on March 15, 2008. The 1998 Senior Notes will be
redeemable at the option of the Company, in whole or in part, at any time on or
after March 15, 2003 at 104.188% of their principal amount at maturity, plus
accrued and unpaid interest, declining to 100.000% of their principal amount at
maturity, plus accrued and unpaid interest, on or after March 15, 2006. In the
event of certain equity investments in the Company by certain strategic
investors on or before March 15, 2001, 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 1998 Senior Notes at a redemption
price equal to 108.375% of the principal amount of the 1998 Senior 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 1998
Senior 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 dated as of March 16, 1998 between the Company and the United States
Trust Company of New York as trustee, governing the 1998 Senior Notes (the "1998
Senior Note Indenture")) of the Company, each holder of 1998 Senior Notes shall
have the right to require the Company to repurchase all or any part of such
holder's 1998 Senior Notes at a purchase price equal to 101% of the principal
amount of the 1998 Senior Notes tendered by such holder plus accrued and unpaid
interest, if any, to any Change of Control Payment Date (as defined in the 1998
Senior Note Indenture).
The 1998 Senior Note Indenture imposes operating and financial restrictions
on the Company and its subsidiaries. These restrictions affect, and in certain
cases significantly limit or prohibit, among other things, the ability of the
Company and its subsidiaries to incur additional indebtedness, pay dividends or
make distributions in respect of the Company's or such subsidiaries' capital
stock, make other restricted payments, enter into sale and leaseback
transactions, create liens upon assets, enter into transactions with affiliates
or related persons, sell assets, or consolidate, merge or sell all or
substantially all of their assets. There can be no assurance that such
covenants will not adversely affect the Company's ability to finance its future
operations or capital needs or to engage in other business activities that may
be in the interest of the Company.
16
As of June 30, 1998, the Company estimates that its aggregate capital
requirements for the remainder of 1998, 1999 and 2000 will be approximately $780
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 $291.9 million in net proceeds from the Company's offering of the
1998 Senior Notes in March 1998, the approximately $239.7 million in net
proceeds remaining from the Company's debt offerings in 1997, additional debt
and equity issuances 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.
YEAR 2000 DATE CONVERSION
The Company is currently working to verify system readiness for the
processing of date-sensitive information by the Company's computerized
information systems. The Year 2000 problem impacts computer programs and
hardware timers using two digits (rather than four) to define the applicable
year. Any of the Company's programs that have time-sensitive functions may
recognize a date using "00" as the year 1900 rather than 2000, which could
result in miscalculations or system failures.
The Company is conducting a review of its computer systems and programs to
determine which, if any, systems and programs are not capable of recognizing the
Year 2000 and to verify system readiness for the millennium date. The review
includes consideration of the following areas: (1) Awareness and Communication,
(2) Inventory of Systems Hardware, Software and Data Interfaces and Confirmation
with Key Vendors of Year 2000 Readiness, (3) Identification of Mission-Critical
Components for both Internal Systems and Vendor Relations, (4) Estimated Costs
for Remediation, (5) Estimated Dates of Compliance, (6) Correction/Remediation,
(7) Replacement Activities, (8) Testing and Verification, and (9)
Implementation. The Company is considering these areas for each of its major
operating business units. As of July 31, 1998 the Company had completed more
than 70% of the activities required for review of the Awareness and
Communication area and more than 50% of the activities required for the review
of the Inventory of Systems Hardware, Software and Data Interfaces and
Confirmation with Key Vendors of Year 2000 Readiness area. The Company has begun
the activities required for review of all of the remaining areas and such
activities are in the initial stages.
The total cost of addressing potential problems, which will be expensed as
incurred, are not known as of the date hereof. Based on preliminary
information, however, such costs are not currently expected to have a material
adverse effect on the Company's financial position, results of operations or
cash flows in future periods.
If the Company, its customers or vendors, however, are unable to address
the Year 2000 issues in a timely manner, it could have a material adverse effect
on future operations. The Company is dependent on Regional Bell Operating
Companies for provision of its local and certain of its long distance services.
To the extent Ameritech Corporation ("Ameritech") or U S WEST Communications,
Inc. ("U S WEST") face Year 2000 issues which might interfere with the ability
of those companies to fulfill their obligations to the Company, such
interference could have a material adverse effect on future operations.
17
While the Company's efforts are designed to be successful, because of the
complexity of the Year 2000 issues and the interdependence of organizations
using computer systems, there can be no assurance that the Company's efforts or
those of a third party with which the Company interacts will be satisfactorily
completed in a timely fashion.
EFFECTS OF NEW ACCOUNTING STANDARDS
In June 1997, the FASB issued Statement of Financial Accounting Standards
No. 131, "Disclosures about Segments of an Enterprise and Related Information,"
("SFAS 131"). This pronouncement is effective for calendar year 1998 financial
statements and requires reporting segment information consistent with the way
executive management of an entity disaggregates its operations internally to
assess performance and make decisions regarding resource allocations. Among
information to be disclosed, SFAS 131 requires an entity to report a measure of
segment profit or loss, certain specific revenue and expense items and segment
assets. SFAS 131 also requires reconciliations of total segment revenues, total
segment profit or loss and total segment assets to the corresponding amounts
shown in the entity's consolidated financial statements. The Company is in the
process of identifying reportable segments and has not yet determined the effect
of implementing SFAS 131.
In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133, "Accounting for Derivative Instruments
and Hedging Activities," ("SFAS 133") SFAS 133 establishes accounting and
reporting standards requiring that every derivative instrument (including
certain derivative instruments embedded in other contracts) be recorded in the
balance sheet as either an asset or liability measured at its fair value. SFAS
133 requires that changes in the derivative's fair value be recognized currently
in earnings unless specific hedge accounting criteria are met. Special
accounting for qualifying hedges allows a derivative's gains and losses to
offset related results on the hedged item in the income statement, and requires
that a company must formally document, designate, and assess the effectiveness
of transactions that receive hedge accounting.
18
SFAS 133 is effective for fiscal years beginning after June 15, 1999. A
company may also implement SFAS 133 as of the beginning of any fiscal quarter
after issuance (that is, fiscal quarters beginning June 16, 1998 and
thereafter). SFAS 133 cannot be applied retroactively. SFAS 133 must be
applied to (a) derivative instruments and (b) certain derivative instruments
embedded in hybrid contracts that were issued, acquired, or substantively
modified after December 31, 1997 (and, at the company's election, before January
1, 1998).
The Company does not expect the impact of the adoption of SFAS 133 to be
material on the Company's results of operations as the Company does not
currently hold any derivative instruments or engage in hedging activities.
INFLATION
The Company does not believe that inflation has had a significant impact on
the Company's consolidated operations.
19
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 state
public utilities commissions, as well as before the Federal Communications
Commission ("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, Ameritech and SWBT are the Company's primary 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, as of
the date hereof, efficiently 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, Ameritech or SWBT to deny or substantially limit the
Company's access to partitioned switches would have a material adverse effect on
the Company.
On February 5, 1996, U S WEST filed tariffs and other notices announcing
its intention to limit future Centrex access to its switches by Centrex
customers (including the Company) throughout U S WEST's fourteen-state service
region, effective February 5, 1996 (the "U S WEST Centrex Action"). Although U
S WEST stated that it would "grandfather" existing Centrex agreements with the
Company and permit the Company to continue to use U S WEST's central office
switches through April 29, 2005, it also indicated that it would not permit the
Company to expand to new cities and would severely limit the number of new lines
it would permit the Company to partition onto U S WEST's portion of the switches
in cities served by the Company.
The Company has challenged, or is challenging, the U S WEST Centrex Action
before the public utilities commissions in certain of the states served by U S
WEST where the Company is doing business or plans to do business. The Company's
challenges to the U S WEST Centrex Action have as of the date hereof been
successful in Iowa, Minnesota, South Dakota, North Dakota and Colorado. In
Wyoming, state regulators rejected U S WEST's action, but the matter remains
pending on appeal. The Company has, however, been unsuccessful in its
challenges to the U S WEST Centrex Action in Nebraska and Idaho. In Nebraska,
the Company and other parties have appealed the order of the Nebraska Public
Service Commission rejecting complaints objecting to the U S WEST Centrex
Action. As of the date hereof, the appeal remains pending before the Nebraska
Supreme Court. The Company has also requested that the FCC, under the terms of
the Telecommunications Act of 1996 (the "Telecommunications Act"), preempt the
Nebraska Commission's decision. In Utah, the Company has requested that the
Utah Public Utilities Commission reconsider its order imposing temporary
restrictions on Centrex resale. As of the date hereof, the Company's request
remains pending before the Utah Public Utilities Commission.
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. For example, 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 and various state public utilities commissions.
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
20
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 continue to pursue 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.
LEGAL CHALLENGES TO THE INTERCONNECTION DECISION. 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 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. Although the decisions vacating the Interconnection Decision do not
prevent the Company from negotiating interconnection agreements with local
exchange carriers, they do create uncertainty about the rules governing pricing,
terms and conditions of interconnection agreements, and could make negotiating
such agreements more difficult and protracted. The U.S. Supreme Court has
granted certiorari in this matter and is scheduled to review the decisions of
the U.S. Eighth Circuit Court of Appeals during the 1998 term. There can be no
assurance that the Company will be able to obtain interconnection agreements on
terms acceptable to the Company, or that the pending Supreme Court appeal will
be resolved on terms that promote local exchange competition as originally
contemplated by the FCC.
WIRELINE COMPETITION. In May 1998, each of U S WEST and Ameritech
announced that it had entered into a marketing arrangement with Qwest
Communications International Inc. ("Qwest"). The Company believes that each of
these arrangements constitutes the provision of long distance services by U S
WEST or Ameritech, respectively, in contravention of the Telecommunications Act.
The Company, along with other competitive local service providers and
interexchange carriers, is a party to federal court proceedings challenging the
arrangement between U S WEST and Qwest. The court has stayed the proceedings
before it. As of the date hereof, there are also proceedings pending before the
FCC regarding these arrangements, and the Company, along with other competitive
local service providers and interexchange carriers, is a party to these
proceedings. The FCC has issued a standstill order which currently prohibits US
WEST and Ameritech from marketing, promoting or entering into agreements with
customers under the marketing arrangements. The ability of U S WEST, Ameritech
or other competitors of the Company to enter into and operate such arrangements
could put the Company at a significant disadvantage.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
During the period from April 1, 1998 through June 30, 1998, the Company has
issued and sold the following equity securities:
(1) On April 24, 1998, the Company issued to the shareholders of NewCom
70,508 shares of Class A common stock and paid approximately $1 million cash for
all of the outstanding shares of NewCom, in a transaction accounted for using
the purchase method of accounting. The total purchase price was approximately
$4.2 million based on the average closing market price of the Class A common
stock at the time of the acquisition.
(2) On June 29, 1998, the Company issued to CCC 151,019 shares of Class A
common stock to acquire certain of the assets of CCC. The total purchase price
was approximately $6 million based on the average closing market price of the
Class A common stock at the time of the acquisition and including $78,000 of
cash acquisition costs.
Each issuance of securities described above was made in reliance on the
exemption from registration provided by Section 4(2) or Regulation D of the
Securities Act as a transaction by an issuer not involving any public offering.
The recipients of securities in each such transaction represented their
intention to acquire the securities for investment only and not with a view to
or for sale in connection with
21
any distribution thereof and appropriate legends were affixed to the share
certificates issued in such transactions.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The Annual Meeting of Stockholders of the Company was held on May 27, 1998.
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.
Proposal 1 -- Election of Directors
Term
Expires Votes For Votes Withheld
------- ------------------ ----------------
Elected Director
Richard A. Lumpkin 2001 58,597,862 Class A 207,126 Class A
Thomas M. Collins 2001 58,591,180 Class A 213,808 Class A
Ronald W. Stepien 2001 58,610,872 Class A 194,116 Class A
Robert J. Currey 1999 58,597,412 Class A 207,576 Class A
Continuing Directors
Clark E. McLeod 2000
Blake O. Fisher, Jr. 2000
Lee Liu 2000
Stephen C. Gray 1999
Paul D. Rhines 1999
Proposal 2 -- Ratification of the Appointment of the Company's Independent Public Accountants
Votes For 58,786,480 Class A
Votes Against 6,768 Class A
Votes Withheld 11,740 Class A
Broker Non-Votes 0
22
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 29, 1998.
(b) Reports on Form 8-K
None.
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: August 12, 1998 By: /s/ Stephen C. Gray
-------------------------------------
Stephen C. Gray
President and Chief Operating Officer
Date: August 12, 1998 By: /s/ Blake O. Fisher, Jr.
----------------------------------------
Blake O. Fisher, Jr.
Chief Financial and Administrative Officer
and Treasurer
24
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 29, 1998.