- --------------------------------------------------------------------------------
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, 1999
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 August 3, 1999:
Common Stock Class A: ($.01 par value)............... 150,556,142 shares
Common Stock Class B: ($.01 par value)............................. None
-------------------------------------------------------------------------------
INDEX
Page
----
PART I. Financial Information
- ------- ---------------------
Item 1. Financial Statements.................................................................... 3
Consolidated Balance Sheets, June 30, 1999 (unaudited) and December 31, 1998............ 3
Unaudited Consolidated Statements of Operations and Comprehensive Income
for the three and six months ended June 30, 1999 and 1998.............................. 4
Unaudited Consolidated Statements of Cash Flows for the six months ended
June 30, 1999 and 1998................................................................. 5
Notes to Consolidated Financial Statements (unaudited).................................. 6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations... 12
PART II. Other Information
- -------- -----------------
Item 1. Legal Proceedings....................................................................... 21
Item 2. Changes in Securities and Use of Proceeds............................................... 21
Item 4. Submission of Matters to a Vote of Security Holders..................................... 21
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 millions, except shares)
June 30, December 31,
1999 1998
------------- -----------
(Unaudited)
ASSETS
Current Assets
Cash and cash equivalents................................................. $ 250.5 $ 455.1
Investment in available-for-sale securities............................... 272.5 136.6
Trade receivables, net.................................................... 175.1 116.4
Inventory................................................................. 29.1 12.8
Deferred expenses......................................................... 35.1 26.7
Prepaid expenses and other................................................ 56.1 45.6
-------- --------
TOTAL CURRENT ASSETS..................................................... 818.4 793.2
-------- --------
Property and Equipment
Land and building......................................................... 66.2 60.3
Telecommunications networks............................................... 490.1 307.3
Furniture, fixtures and equipment......................................... 197.5 138.3
Networks in progress...................................................... 284.0 185.5
Building in progress...................................................... 19.3 12.6
-------- --------
1,057.1 704.0
Less accumulated depreciation............................................. 115.3 74.3
-------- --------
941.8 629.7
-------- --------
Investments, Intangible and Other Assets
Other investments........................................................ 39.7 35.9
Goodwill, net............................................................ 725.7 289.6
Other intangibles, net................................................... 238.2 112.4
Other.................................................................... 76.3 64.4
-------- --------
1,079.9 502.3
-------- --------
$2,840.1 $1,925.2
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities
Current maturities of long-term debt...................................... $ 13.9 $ 8.2
Contracts and notes payable............................................... 0.2 4.5
Accounts payable.......................................................... 110.1 62.0
Accrued payroll and payroll related expenses.............................. 27.7 13.6
Other accrued liabilities................................................. 76.7 63.8
Deferred revenue, current portion......................................... 15.0 11.0
Customer deposits......................................................... 27.9 16.8
-------- --------
TOTAL CURRENT LIABILITIES................................................ 271.5 179.9
-------- --------
Long-term Debt, less current maturities.................................... 1,792.4 1,245.2
-------- --------
Deferred Revenue, less current portion..................................... 16.2 16.8
-------- --------
Other long-term liabilities................................................ 19.2 20.5
-------- --------
Stockholders' Equity
Capital Stock:
Common, Class A, $.01 par value; authorized 250,000,000 shares;
issued and outstanding 1999 150,417,738 shares; 1998 127,358,350
shares.................................................................. 1.5 1.3
Common, Class B, convertible, $.01 par value; authorized 22,000,000
shares; issued and outstanding 1999 and 1998 none....................... --- ---
Additional paid-in capital................................................ 1,086.2 716.5
Accumulated deficit....................................................... (362.2) (253.3)
Accumulated other comprehensive income (loss)............................. 15.3 (1.7)
-------- --------
740.8 462.8
-------- --------
$2,840.1 $1,925.2
======== ========
* Class A common stock and accumulated deficit are presented after giving effect for the two-for-one stock
split effected in the form of a stock dividend as described in Note 6.
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 millions, except per share data)
Three Months Ended Six Months Ended
June 30, June 30,
-------------------- -------------------
1999 1998 1999 1998
--------- --------- --------- --------
Revenues:
Telecommunications:
Local and long distance........................................ $106.4 $ 64.5 $ 187.4 $126.8
Local exchange services........................................ 19.8 16.6 37.4 32.5
Private line and data.......................................... 19.3 9.8 34.4 18.5
Network maintenance and equipment.............................. 8.4 7.6 16.5 15.1
Other telecommunications....................................... 8.3 6.9 14.2 13.8
------ ------ ------- ------
Total telecommunications revenue.............................. 162.2 105.4 289.9 206.7
Directory....................................................... 55.7 45.5 105.3 73.5
Telemarketing................................................... 4.8 4.8 8.6 9.8
------ ------ ------- ------
TOTAL REVENUES................................................. 222.7 155.7 403.8 290.0
Operating expenses:
Cost of service................................................. 113.1 83.1 205.5 158.1
Selling, general and administrative............................. 98.5 67.0 178.4 125.7
Depreciation and amortization................................... 43.6 21.0 78.7 40.5
Other........................................................... --- 1.9 --- 3.8
------ ------ ------- ------
TOTAL OPERATING EXPENSES....................................... 255.2 173.0 462.6 328.1
------ ------ ------- ------
OPERATING LOSS................................................. (32.5) (17.3) (58.8) (38.1)
Nonoperating income (expense):
Interest income................................................. 6.7 7.8 15.0 12.4
Interest (expense).............................................. (36.2) (20.4) (65.7) (35.2)
Other income.................................................... 0.6 0.1 0.6 0.8
------ ------ ------- ------
TOTAL NONOPERATING INCOME (EXPENSE)............................ (28.9) (12.5) (50.1) (22.0)
------ ------ ------- ------
LOSS BEFORE INCOME TAXES....................................... (61.4) (29.8) (108.9) (60.1)
Income taxes..................................................... --- --- --- ---
------ ------ ------- ------
NET LOSS....................................................... $(61.4) $(29.8) $(108.9) $(60.1)
====== ====== ======= ======
Loss per common share............................................ $(0.41) $(0.24) $ (0.77) $(0.48)
====== ====== ======= ======
Weighted average common shares outstanding....................... 149.8 125.3 141.1 124.9
====== ====== ======= ======
Other comprehensive income (loss), net of tax:
Unrealized gains on securities:
Unrealized holding gains (losses) arising during the
period........................................................ 9.5 (4.6) 17.7 2.3
Less: reclassification adjustment for gains included in
net income.................................................... (0.6) (0.2) (0.7) (1.0)
------ ------ ------- ------
TOTAL OTHER COMPREHENSIVE INCOME (LOSS)........................ 8.9 4.8 17.0 1.3
------ ------ ------- ------
COMPREHENSIVE LOSS............................................. $(52.5) $(34.6) $ (91.9) $(58.8)
====== ====== ======= ======
* Loss per common share and weighted average common shares outstanding are presented after giving effect for
the two-for-one stock split effected in the form of a dividend as described in Note 6.
The accompanying notes are an integral part of these consolidated financial statements
4
MCLEODUSA INCORPORATED AND SUBSIDIARIES
UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in millions)
Six Months Ended
June 30,
---------------------------------------
1999 1998
---------------- ----------------
Cash flows from operating activities
Net Loss............................................................................... $(108.9) $ (60.1)
Adjustments to reconcile net loss to net cash provided by (used in) operating
activities:
Depreciation.......................................................................... 41.8 23.6
Amortization.......................................................................... 36.9 16.9
Accretion of interest on senior discount notes........................................ 19.0 17.1
Changes in assets and liabilities, net of effects of acquisitions:
(Increase) in trade receivables....................................................... (22.6) (8.5)
(Increase) in inventory............................................................... (14.4) (0.1)
Decrease in deferred expenses......................................................... 0.2 2.7
Decrease (increase) in prepaid expenses and other..................................... 6.2 (2.2)
(Decrease) in deferred line installation costs........................................ (6.2) (6.9)
Increase (decrease) in accounts payable and accrued expenses.......................... (3.1) 18.1
Increase in deferred revenue.......................................................... 2.2 0.6
(Decrease) increase in customer deposits.............................................. 7.0 (0.3)
------- -------
NET CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES.................................. (41.9) 0.9
------- -------
Cash Flows from Investing Activities
Purchases of property and equipment.................................................... (220.7) (110.7)
Available-for-sale securities:
Purchases............................................................................. (348.6) (476.7)
Sales................................................................................. 79.5 202.1
Maturities............................................................................ 150.3 29.7
Acquisitions........................................................................... (170.3) (7.5)
Other.................................................................................. (8.4) (3.8)
------- -------
NET CASH (USED IN) INVESTING ACTIVITIES (518.2) (366.7)
------- -------
Cash Flows from Financing Activities
Payments on contracts and notes payable................................................ (12.9) (3.2)
Net proceeds from long-term debt....................................................... 486.4 291.8
Payments on long-term debt............................................................. (121.6) (6.0)
Net proceeds from issuance of common stock............................................. 3.6 2.0
------- -------
NET CASH PROVIDED BY FINANCING ACTIVITIES............................................ 355.5 284.6
------- -------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS................................. (204.6) (81.2)
Cash and cash equivalents:
Beginning.............................................................................. 455.1 331.9
------- -------
Ending................................................................................. $ 250.5 $ 250.7
======= =======
Supplemental Disclosure of Cash Flow Information:
Cash payment for interest, net of interest capitalized 1999 $9.6 million;
1998 $3.5 million..................................................................... $ 40.2 $ 9.0
======= ======
Supplemental Schedule of Noncash Investing and Financing Activities
Capital leases incurred for the acquisition of property and equipment.................. $ 3.0 $ 5.6
======= ======
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, 1999 and 1998 is Unaudited)
Note 1: Basis of Presentation
Interim Financial Information (unaudited): The financial statements
and notes related thereto as of June 30, 1999, and for the three and six month
periods ended June 30, 1999 and 1998, 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, 1998, filed with the SEC on March 24, 1999.
Reclassifications: Certain items in the unaudited statement of
operations for the three and six month periods ended June 30, 1998 have been
reclassified to be consistent with the presentation in the June 30, 1999
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,
1999 1998
----------------------- --------------------
(in millions)
Trade Receivables:
Billed........................................................... $153.1 $110.6
Unbilled......................................................... 57.7 21.3
------ ------
210.8 131.9
Allowance for doubtful accounts and discounts..................... (35.7) (15.5)
------ ------
$175.1 $116.4
====== ======
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 $29.3 million and $16.4 million, at June 30, 1999 and
December 31, 1998, 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 $40.4 million and $25.1 million at June 30, 1999 and
December 31, 1998, respectively.
Note 3: Long-Term Debt
On February 22, 1999, the Company completed a private offering of $500
million aggregate principal amount of 8 1/8% Senior Notes due February 15, 2009
(the "Senior Notes"). The Company received net proceeds of approximately $487.8
million from the Senior Notes offering. Interest on the Senior Notes will be
payable in cash semi-annually in arrears on August 15 and February 15 of each
year at a rate of 8 1/8% per annum, commencing August 15, 1999. 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 June 30,
1999, the Company had no outstanding subordinated indebtedness and had $1.2
billion outstanding indebtedness that would rank pari passu with the Senior
Notes. The indenture related to the Senior Notes contains certain covenants
which, among other things, restrict the ability of the Company to incur
additional indebtedness, pay dividends or make distributions of the Company's or
its subsidiaries' stock, make other restricted payments, enter into sale and
leaseback transactions, create liens, enter into transactions with affiliates or
related persons, or consolidate, merge or sell all or substantially all of its
assets.
Note 4: Acquisitions
F.D.S.D. Rapid City Directories, Inc. (F.D.S.D): on March 17, 1998,
McLeodUSA Media Group acquired a telephone directory published by F.D.S.D. for a
cash purchase price of approximately $2.2 million.
Bi-Rite Directories, Inc. (Bi-Rite): On March 20, 1998, McLeodUSA Media
Group acquired a telephone directory published by Bi-Rite for a cash purchase
price of approximately $3.7 million.
Smart Pages, Inc. and Yellow Pages Publishers, Inc. (Smart Pages and
Yellow Pages): On April 8, 1998, McLeodUSA Media Group acquired a telephone
directory published by Smart Pages and Yellow Pages 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 141,016 shares of Class A common stock, after
giving effect for the two-for-one stock split described in Note 6, 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 302,038 shares of Class A common stock, after giving effect for
the two-for-one stock split described in Note 6, to acquire certain 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.
Frontier Directory Co. of Nebraska, Inc.(Frontier): On January 14, 1999,
McLeodUSA Media Group acquired a telephone directory published by Frontier for a
cash purchase price of approximately $6.8 million
Talking Directories, Inc. (Talking Directories) and Info America Phone
Books, Inc. (Info America): On February 10, 1999, the Company acquired Talking
Directories in exchange for 5.2 million shares of its Class A common stock,
after giving effect for the two-for-one stock split described in Note 6. In a
7
related and concurrent transaction, on February 10, 1999, the Company acquired
Info America in exchange for 2.4 million shares of its Class A common stock.
The Company also paid outstanding obligations of Talking Directories and Info
America of approximately $27 million.
Dakota Telecommunications Group, Inc. (DTG): On March 5, 1999, the Company
acquired DTG in exchange for approximately two million shares of its Class A
common stock, after giving effect for the two-for-one stock split described in
Note 6, and the assumption of approximately $31 million in DTG debt.
Ovation Communications, Inc. (Ovation): On March 31, 1999, pursuant to the
terms and conditions of an Agreement and Plan of Merger dated January 6, 1999
(the "Merger Agreement"), the Company issued approximately 11.2 million shares
of its Class A common stock, after giving effect for the two-for-one stock split
described in Note 6, and paid approximately $121.3 million cash to the
stockholders of Ovation in exchange for all of the outstanding capital stock of
Ovation. The total purchase price was approximately $310.2 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 Company also assumed approximately
$105.6 million in Ovation debt.
Smart Pages, Inc. and Yellow Pages Publishers, Inc. (Smart Pages and Yellow
Pages): On April 2, 1999, McLeodUSA Media Group acquired two telephone
directories published by Smart Pages and Yellow Pages for a cash purchase price
of approximately $0.7 million.
Ludington Daily News, Inc. d/b/a WMD Phone Guides (WMD): On April 27,
1999, McLeodUSA Media Group purchased three directories published by WMD for a
cash purchase price of $3.3 million.
Fronteer Directory Co.of Minnesota, Inc. (Fronteer): On April 30, 1999,
McLeodUSA Media Group paid $19.8 million in cash for all the outstanding shares
of Fronteer.
Noverr Publishing, Inc. (Noverr): On May 29, 1999, McLeodUSA Media Group
purchased four directories and certain assets of Noverr for a total purchase
price of $22.3 million, which consisted of 79,825 shares of Class A common
stock, after giving effect for the two-for-one stock split described in Note 6,
$19.4 million in cash and note payable and an option to purchase 100,000 shares
of Class A common stock, after effect of two-for-one stock split described in
Note 6. The distribution of the stock, the grant date of the options and the
note payable of $4.4 million will occur in January, 2000.
Millennium Group Telemanagement, LLC (Millennium): On June 8, 1999, the
Company purchased certain assets of Millennium and assumed certain liabilities
of Millennium for a total purchase price of $7.0 million. The purchase price
consisted of $3.5 million in cash and the issuance or commitment to issue
128,530 shares of Class A common stock, after giving effect for the two-for-one
stock split described in Note 6.
8
The following table summarizes the purchase price allocations for the
Company's business acquisitions incurred in the six months ended June 30, 1999
and 1998 (in millions):
Transaction Year: 1999 1998
- ----------------- ---------------- -------------
Cash purchase price $ 170.2 $ 7.4
Acquisition costs 0.1 0.1
Promissory notes 6.7 0.8
Stock issued 349.0 9.2
Option agreements 0.9 --
Note receivable (1.7) --
------- -----
$ 525.2 $17.5
======= =====
Working capital acquired, net $ (21.3) $(0.1)
Fair value of other assets acquired 127.3 1.9
Intangibles 575.4 18.1
Liabilities assumed (156.2) (2.4)
------- -----
$ 525.2 $17.5
======= =====
These acquisitions have been accounted for as purchases and the results of
operations are included in the consolidated financial statements since the dates
of acquisition. All 1999 purchase price allocations are preliminary and subject
to revisions.
The unaudited consolidated results of operations for the six months ended
June 30, 1999 on a pro forma basis as though the above entities had been
acquired as of the beginning of the period is as follows (in millions, except
per share data):
1999
----------------
Revenue.................................................................................................. $ 431.6
Net loss................................................................................................. (115.0)
Loss per common share.................................................................................... (0.77)
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 5: Information by Business Segment
The Company operates predominantly in the business of providing local, long
distance and related communications services to end users and the sale of
advertising space in telephone directories. The two business segments have
separate management teams and infrastructures that offer different products and
services. The principal elements of these segments are to provide integrated
communications services, provide outstanding customer service, expand fiber
optic network, expand intra-city fiber network build, and publish and distribute
directories to local area subscribers.
The Company evaluates the performance of its operating segments based on
earnings before interest, taxes, depreciation and amortization, excluding
general corporate expenses ("EBITDA"). The accounting policies of the
reportable segments are the same as those described in Note 1 of Notes to
Consolidated Financial Statements. Intersegment transfers are accounted for on
an arm's length pricing basis.
Identifiable assets (excluding intersegment receivables) are the Company's
assets that are identified in each business segment. Corporate assets primarily
include cash and cash equivalents, investments in available-for-sale securities,
administrative headquarters and goodwill recorded primarily as a result of the
acquisition of Consolidated Communications, Inc. 1997 and the acquisition of DTG
and Ovation in 1999.
In the three months and six months ended June 30, 1999 and 1998, no single
customer or group under common control represented 10% or more of the Company's
sales.
9
Segment information for the three and six months ended June 30, 1999 and 1998
was as follows (in thousands):
Telecommunications Media Corporate Total
------------------- -------- ---------- ---------
Three months ended June 30, 1999
Revenues $ 166.9 $ 55.8 $ -- $ 222.7
=====================================================
EBITDA 8.6 8.2 (5.7) 11.1
Depreciation and amortization (25.6) (7.6) (10.4) (43.6)
Interest Revenue 0.4 -- 6.3 6.7
Interest Expense (1.6) -- (34.6) (36.2)
Taxes and Other 0.7 (0.1) -- 0.6
-----------------------------------------------------
Net Income (Loss) (17.5) (0.5) (44.4) (61.4)
=====================================================
Six months ended June 30, 1999
Revenues $ 298.2 $ 105.6 $ -- $ 403.8
=====================================================
EBITDA 14.4 17.4 (11.9) 19.9
Depreciation and amortization (45.1) (17.2) (16.4) (78.7)
Interest Revenue 0.8 -- 14.2 15.0
Interest Expense (3.0) -- (62.7) (65.7)
Taxes and Other 0.9 (0.1) (0.2) 0.6
-----------------------------------------------------
Net Income (Loss) (32.0) 0.1 (77.0) (108.9)
=====================================================
As of June 30, 1999
Total assets 1,156.6 434.0 1,249.5 2,840.1
Capital expenditures 339.8 195.4 189.5 724.7
- ------------------------------------------------------------------------------------------------
- ------------------------------------------------------------------------------------------------
Telecommunications Media Corporate Total
------------------ ------- --------- --------
Three months ended June 30, 1998
Revenues $ 110.2 $ 45.5 $ -- $ 155.7
=====================================================
EBITDA 1.6 6.7 (2.7) 5.6
Depreciation and amortization (12.9) (2.5) (5.6) (21.0)
Interest Revenue 0.2 -- 7.6 7.8
Interest Expense (1.3) -- (19.1) (20.4)
Taxes and Other 0.1 -- (1.9) (1.8)
-----------------------------------------------------
Net Income (Loss) (12.3) 4.2 (21.7) (29.8)
=====================================================
Six months ended June 30, 1998
Revenues $ 216.5 $ 73.5 $ -- $ 290.0
=====================================================
EBITDA 2.3 9.0 (5.1) 6.2
Depreciation and amortization (24.6) (4.7) (11.2) (40.5)
Interest Revenue 0.4 -- 12.0 12.4
Interest Expense (2.6) -- (32.6) (35.2)
Taxes and Other 0.8 -- (3.8) (3.0)
-----------------------------------------------------
Net Income (Loss) (23.7) 4.3 (40.7) (60.1)
=====================================================
As of June 30, 1998
Total assets 471.2 182.7 983.1 1,637.0
Capital expenditures 99.5 12.1 24.0 135.6
- ------------------------------------------------------------------------------------------------
Note 6: Subsequent Events
On August 13, 1999, pursuant to the terms and conditions of an Agreement
and Plan of Merger dated June 1, 1999 with Access Communications Holding, Inc.
(Access), a Utah corporation, and certain of the stockholders of Access, the
Company issued 1,939,864 shares of its Class A common stock, after giving effect
to the two-for-one stock split described below, and paid $23.3 million in cash
to the stockholders of Access in exchange for all the outstanding capital stock
of Access. The Company also assumed approximately $48.3 million in Access debt.
In a related transaction, on August 13, 1999, pursuant to the terms and
conditions of an Agreement and Plan of Merger dated June 1, 1999 with S.J.
Investments Holdings, Inc. (SJIH), a Utah corporation, and certain of the
stockholders of SJIH, the Company issued 1,939,864 shares of its Class A common
stock, after giving effect to the two-for-one stock split described below, and
paid
10
$25 million in cash to the stockholders of Access in exchange for all the
outstanding capital stock of SJIH. The Company also assumed approximately $48.3
million in SJIH debt
On June 30, 1999, the Company announced a two-for-one stock split in the
form of a stock dividend on the Company's Class A common stock. The record date
for the stock split was July 12, 1999 and the distribution of the additional
shares took place on July 26, 1999. All share data in the consolidated financial
statements and notes to the financial statements have been adjusted to reflect
the stock split.
McLeodUSA Media Group announced the acquisition of six directories from
J-Mar Publishing of Indian River, Michigan, on July 16, 1999.
On August 11, 1999, the Company issued 1,000,000 shares of 6.75% Series A
Cumulative Convertible Preferred Stock. The net proceeds from this issuance
totaled $241.5 million.
11
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, 1998, filed with the Commission on March 24, 1999
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.
All share data in the consolidated financial statements and notes to the
financial statements have been adjusted to reflect the July 26, 1999 two-for-one
stock split of our Class A common stock.
Overview
We derive our revenue from:
. our core business of providing local, long distance and related
communications services to end users, typically in a bundled package
. the sale of advertising space in telephone directories
. traditional local telephone company services in east central Illinois
and southeast South Dakota
. special access, private line and data services
. communications network maintenance services and telephone equipment
sales, leasing, service and installation
. telemarketing services
. other communications services, including video, computer networking,
cellular, operator, payphone, mobile radio and paging services
We began providing traditional local telephone company services and other
communications services as a result of our acquisition of Consolidated
Communications, Inc. in September 1997, telephone directory advertising as a
result of our acquisition of TelecomUSA Publishing in September 1996, and
telemarketing services as a result of our acquisition of Ruffalo Cody in July
1996. The table set forth below summarizes our percentage of revenues from
these sources:
Quarter Ended June 30,
----------------------------------
1999 1998
---------------- ----------------
Local and long distance communications services............... 48% 41%
Telephone directory advertising............................... 25 29
Traditional local telephone company services.................. 9 11
Special access, private line and data services................ 9 6
Network maintenance and equipment services.................... 4 5
Telemarketing services........................................ 2 3
Other communications services................................. 3 5
---- ----
100% 100%
==== ====
We began offering local and long distance services to business customers in
January 1994. At the end of 1995, we began offering, on a test basis, long
distance services to residential customers. In June 1996, we began marketing
and providing to residential customers in Cedar Rapids, Iowa and Iowa City, Iowa
12
an integrated package of communications services that includes local and long
distance service, voice mail, Internet access and travel card services. Since
June 1996, we have expanded the states in which we offer service to business
customers to include Iowa, Illinois, Indiana, Michigan, Minnesota, Nebraska,
Wisconsin, North Dakota, South Dakota, Colorado, Missouri and Wyoming. We also
expanded our residential service to additional cities in Iowa and Illinois and
began offering the service to customers in North Dakota, South Dakota,
Wisconsin, Wyoming, Colorado, Missouri and Michigan. We plan to continue our
efforts to market and provide local, long distance and other communications
services to business customers and market our service to residential customers.
Our 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 our customers
through long distance carriers, costs of printing and distributing telephone
directories and costs associated with maintaining the Iowa Communications
Network. The Iowa Communications Network is a fiber optic communications
network that links many of the State of Iowa's schools, libraries and other
public buildings. SG&A consists of sales and marketing, customer service and
administrative expenses, including the costs associated with operating our
communications network. Depreciation and amortization include depreciation of
our telecommunications network and equipment; amortization of goodwill and other
intangibles related to our acquisitions, amortization expense related to the
excess of estimated fair market value in aggregate of options over the aggregate
exercise price of such options granted to some of our 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 our local telecommunications service.
As we expand into new markets, both cost of service and SG&A will increase.
We expect to incur cost of service and SG&A expenses before 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 us to build a customer
base large enough to generate sufficient revenue to offset such fixed costs and
marketing expenses.
In January and February 1996, we granted options to purchase an aggregate
of 1,930,332 and 1,377,004 shares of our Class A common stock, respectively, at
an exercise price of $1.335 per share, to some of our 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,
we granted options to purchase an aggregate of 2,937,890 shares of our Class A
common stock at an exercise price of $12.25 to some 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.
We have experienced operating losses since our inception as a result of
efforts to build our customer base, develop and construct our communications
network infrastructure, build our internal staffing, develop our systems and
expand into new markets. We expect to continue to focus on increasing our
customer base and geographic coverage and bringing our customer base onto our
communications network. Accordingly, we expect that our cost of service, SG&A
and capital expenditures will continue to increase significantly, all of which
may have a negative impact on operating results.
In addition, our projected increases in capital expenditures will continue
to generate negative cash flows from construction activities during the next
several years while we install and expand our fiber optic communications network
and develop wireless services. We may also be forced to change our pricing
policies to respond to a changing competitive environment, and we cannot assure
you that we will be able to maintain our operating margin. We cannot assure you
that growth in our revenue or customer base will continue or that we will be
able to achieve or sustain profitability or positive cash flows.
We have generated net operating losses since our inception and,
accordingly, have incurred no income tax expense. We have 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 carry forwards. We 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.
13
Three Months Ended June 30, 1999 Compared with Three Months Ended June 30, 1998
Total revenue increased from $155.7 million for the three months ended June
30, 1998 to $222.7 million for the three months ended June 30, 1999,
representing an increase of $67 million or 43%. Revenue from the sale of local
and long distance telecommunications services accounted for $41.9 million of the
increase. Local exchange services generated $3.2 million in additional revenues
over the same period in 1998. Private line and data revenues accounted for $9.5
million of increased revenues over 1998. Network maintenance and equipment
revenue increased $0.8 million over 1998. Other telecommunications revenue
increased $1.4 million when compared to the same period in 1998. Directory
revenues increased $10.2 million from the second quarter of 1998 to the second
quarter of 1999 due to revenues from new directories acquired in the last two-
quarters of 1998 and the first two-quarters of 1999. Telemarketing revenues in
the second quarter of 1999 were consistent with the telemarketing revenues in
the second quarter of 1998.
Cost of service increased from $83.1 million for the three months ended
June 30, 1998, to $113.1 million for the three months ended June 30, 1999,
representing an increase of $30 million or 36%. This increase in cost of
service was due primarily to the growth in the Company's local and long distance
telecommunications. Cost of service as a percentage of revenue decreased from
53% for the three months ended June 30, 1998 to 51% for the three months ended
June 30, 1999, 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 60% of customer
long distance traffic to the our fiber optic communications network.
SG&A increased from $67 million for the three months ended June 30, 1998 to
$98.5 million for the three months ended June 30, 1999, an increase of $31.5
million or 47%. The acquisitions of Talking Directories Inc. and Info America
Phone Books, Inc. (collectively, "Talking Directories"), Dakota
Telecommunications Group, Inc. ("DTG") and Ovation Communications, Inc.
("Ovation") contributed an aggregate of $17.7 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 administrative
activities to support our growth.
Depreciation and amortization expenses increased from $21 million for the
three months ended June 30, 1998 to $43.6 million for the three months ended
June 30, 1999, representing an increase of $22.6 million or 108%. This increase
consisted of $12.4 million related to the acquisitions of Talking Directories,
DTG and Ovation and $10.2 million due primarily to the growth of the Company's
network.
Interest income decreased from $7.8 million for the three-month period
ended June 30, 1998, to $6.7 million for the same period in 1999. This decrease
resulted from reduction in annualized yield on investments.
Gross interest expense increased from $22.2 million for the second quarter
of 1998 to $41.6 million for the second quarter of 1999. This increase was
primarily a result of an increase in the accretion of interest on our 10 1/2%
senior discount notes of $0.9 million and an increase of interest of $17.3
million primarily as the result of the issuance of our 8 3/8% senior notes, 9
1/2% senior notes and 8 1/8% senior notes. Interest expense of approximately
$5.4 and $1.8 million was capitalized as part of the Company's construction of
fiber optic network during the second quarter of 1999 and 1998, respectively.
Net loss increased from $29.8 million for the three months ended June 30,
1998 to $61.4 million for the three months ended June 30, 1999, an increase of
$31.6 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, 1999 Compared with Six Months Ended June 30, 1998
Total revenue increased from $290 million for the six months ended June 30,
1998 to $403.8 million for the six months ended June 30, 1999, representing an
increase of $113.8 million or 39%. Revenue from the sale of local and long
distance telecommunications services accounted for $60.6 million of this
increase. Local exchange services generated $4.9 million additional revenues
over the same period in 1998. Private line and data revenues accounted for
$15.9 million of increased revenues over 1998. Network maintenance and
14
equipment revenue increased $1.4 million over 1998. Other telecommunications
revenue increased $0.4 million when compared to the same period in 1998.
Directory revenues increased $31.8 million from the first six months of 1998 to
the first six months of 1999 due to revenues from new directories acquired in
the last two-quarters of 1998 and the first two-quarters in 1999. Telemarketing
revenues decreased $1.2 million for the six months ended June 30, 1999 when
compared to the six months ended June 30, 1998.
Cost of service increased from $158.1 million for the six months ended June
30, 1998, to $205.5 million for the six months ended June 30, 1999, representing
an increase of $47.4 million or 30%. This increase in cost of service was due
primarily to the growth in the Company's local and long distance
telecommunications. Cost of service as a percentage of revenue decreased from
55% for the six months ended June 30, 1998 to 51% for the six months ended June
30, 1999, 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 60% of customer
long distance traffic to the Company's fiber optic network.
SG&A increased from $125.7 million for the six months ended June 30, 1998
to $178.4 million for the six months ended June 30, 1999, an increase of $52.7
million or 42%. The acquisitions of Talking Directories, DTG and Ovation
contributed an aggregate of $25.1 million to the increase. Also contributing to
this increase were increased costs of $27.6 million primarily related to
expansion of selling, customer support and administration activities to support
the Company's growth.
Depreciation and amortization expenses increased from $40.5 million for the
six months ended June 30, 1998 to $78.7 million for the six months ended June
30, 1999, representing an increase of $38.2 million or 94%. This increase
consisted of $19.3 million related to the acquisitions of Talking Directories,
DTG and Ovation, and $18.9 million due primarily to the growth of the Company's
network.
Interest income increased from $12.4 million for the six-month period ended
June 30, 1998, to $15 million for the same period in 1998. This increase
resulted from increased earnings on investments made with the remaining proceeds
from our debt offerings in March and October 1998 and the proceeds from our
offering of $500 million aggregate principal amount of our 8 1/8% senior notes
in February 1999.
Gross interest expense increased from $38.6 million for the first six
months of 1998 to $75.3 million for the first six months of 1999. This increase
was primarily a result of an increase in the accretion of interest on our 10
1/2% senior discount notes of $1.8 million and an increase of interest of $34.9
million primarily as the result of the issuance of our 8 3/8% senior notes, 9
1/2% senior notes and 8 1/8% senior notes. Interest expense of approximately
$9.6 and $3.5 million was capitalized as part of the Company's construction of
fiber optic network during the second quarter of 1999 and 1998, respectively.
Net loss increased from $60.1 million for the six months ended June 30,
1998 to $108.9 million for the six months ended June 30, 1999, an increase of
$48.8 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 $1.9 billion at December 31, 1998
to $2.8 billion at June 30, 1999, primarily due to the net proceeds of
approximately $487.8 million from our offering of the 8 1/8% senior notes in
February 1999 and to the net assets of approximately $475.2 million acquired
from Talking Directories, DTG and Ovation. At June 30, 1999, the Company's
current assets of $818.4 million exceeded its current liabilities of $271.5
million, providing working capital of $546.9 million, which represents a
decrease of $66.3 million compared to December 31, 1998. At December 31, 1998,
the Company's current assets of $793.2 million exceeded current liabilities of
$180.0 million, providing working capital of $613.2 million.
The net cash used in operating activities totaled $41.9 million for the six
months ended June 30, 1999 and net cash provided by operating activities totaled
$0.9 million for the six months ended June 30, 1998. During the six months
ended June 30, 1999, cash used in operating activities was used primarily to
15
fund the Company's net loss of $108.9 million for such period. As a result of
the expansion of our local and long distance communications services, we also
required cash to fund:
. growth in trade receivables of $22.6 million
. growth in inventory of $14.4 million
. deferred line installation costs of $6.2 million
. decreases in accounts payable and accrued expenses of $3.1 million
These amounts were partially offset by:
. decreases in prepaid and other expenses of $6.2 million
. decreases in deferred expenses of $0.2 million
. increases in deferred revenue of $2.2 million
. increases in customer deposits of $7.0 million
. cumulative non-cash expenses of $97.7 million
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.
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.
The Company's investing activities used cash of $518.2 million during the
six months ended June 30, 1999 and $366.7 million during the six months ended
June 30, 1998. 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 $220.7 million and $110.7 million during the six
months ended June 30, 1999 and 1998, respectively. The Company also used cash
of $348.6 million and $476.7 million to acquire available-for-sale securities
during the first six months of 1999 and 1998, respectively, offset by proceeds
from sales and maturities of available-for-sale securities of $229.8 million and
$231.8 million, respectively, during those periods.
During the six months ended June 30, 1999, we used an aggregate of $170.3
million cash to acquire:
. directories from Frontier Directory Co. of Nebraska, Inc. in
January 1999
. the capital stock of Talking Directories in February 1999
. the capital stock of DTG in March 1999
. the capital stock of Ovation in March 1999
. certain directories from Yellow Pages and Smart Pages in April 1999
. the capital stock of Fronteer Directory Co. of Minnesota, Inc.,
in April 1999
. directories from Noverr Publishing Inc., in May 1999
. certain directories from Ludington Daily News, Inc., in April 1999
. certain assets of Millennium Group Telemanagement, LLC in June 1999
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.
Net cash received from financing activities was $355.5 million during the
six months ended June 30, 1999, primarily as a result of our offering of our
8 1/8% senior notes in February 1999. Net cash received from financing
activities during the six months ended June 30, 1998 was $284.6 million and
was primarily obtained from the Company's private offering of our 8 3/8% senior
notes in March 1998.
On February 22, 1999, we completed an offering of $500 million aggregate
principal amount of our 8 1/8% senior notes in which we received net proceeds of
approximately $487.8 million. Interest on the 8 1/8% senior notes accrues at the
rate of 8 1/8% per annum and is payable in cash semi-annually in
16
arrears on February 15 and August 15, starting August 15, 1999.
Our 10 1/2% senior discount notes, 9 1/4% senior notes, 8 3/8% senior
notes, 9 1/2% senior notes and 8 1/8% senior notes are senior unsecured
obligations of McLeodUSA ranking pari passu in right of payment with all other
existing and future senior unsecured obligations of McLeodUSA and senior to
all existing and future subordinated debt of McLeodUSA. The 10 1/2% senior
discount notes, 9 1/4% senior notes, 8 3/8% senior notes, 9 1/2% senior notes
and 8 1/8% senior notes are effectively subordinated to all existing and
future secured indebtedness of McLeodUSA and our subsidiaries to the extent of
the value of the assets securing such indebtedness. The 10 1/2% senior
discount notes, 9 1/4% senior notes, 8 3/8% senior notes, 9 1/2% senior notes
and 8 1/8% senior notes also are effectively subordinated to all existing and
future third-party indebtedness and other liabilities of our subsidiaries.
The indentures governing our 10 1/2% senior discount notes, 9 1/4% senior
notes, 8 3/8% senior notes, 9 1/2% senior notes and 8 1/8% senior notes impose
operating and financial restrictions on us and our subsidiaries. These
restrictions affect, and in many cases significantly limit or prohibit, among
other things, our and our subsidiaries' ability to:
. incur additional indebtedness
. pay dividends or make distributions in respect of our or our
subsidiaries' capital stock
. redeem 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
. consolidate, merge or sell all or substantially all of our assets
We cannot assure you that such covenants will not adversely affect our ability
to finance our future operations or capital needs or to engage in other business
activities that may be in our interests.
As of June 30, 1999 based on our business plan, capital requirements and
growth projections as of that date, we estimated that we would require
approximately $1.4 billion through 2001. Our estimated aggregate capital
requirements include the projected costs of:
. building our fiber optic communications network, including intra-city
fiber optic networks
. expanding operations in existing and new markets
. developing wireless services
. funding general corporate expenses
. integrating acquisitions
. constructing, acquiring, developing or improving telecommunications
assets
The estimated costs and incremental capital needs associated with the
acquisitions of Talking Directories, DTG, Ovation, and Millennium are included
in our estimated aggregate capital requirements.
17
We expect to use the following to address our capital needs:
. approximately $523 million of cash and investments on hand at
June 30, 1999
. additional issuances of debt or equity securities
. projected operating cash flow
Our estimate of future capital requirements is a forward-looking statement
within the meaning of the safe harbor provisions of the Private Securities
Litigation Reform Act of 1995. The actual amount and timing of our future
capital requirements may differ substantially from our estimate due to factors
such as:
. strategic acquisition costs and effects of acquisitions on our
business plan, capital requirements and growth projections
. unforeseen delays
. cost overruns
. engineering design changes
. changes in demand for our services
. regulatory, technological or competitive developments
. new opportunities
We also expect to evaluate potential acquisitions, joint ventures and
strategic alliances on an ongoing basis. We may require additional financing if
we pursue any of these opportunities. Accordingly, we may need additional
capital to continue to expand our markets, operations, facilities, network and
services.
We may meet any additional capital needs by issuing additional debt or
equity securities or borrowing funds from one or more lenders. We cannot assure
you that we will have timely access to additional financing sources on
acceptable terms.
Failure to generate or raise sufficient funds may require us to delay or
abandon some of our expansion plans or expenditures, which could have a material
adverse effect on our business, results of operations or financial condition.
See "Business--Risk Factors--Failure to Raise Necessary Capital Could Restrict
Our Ability to Develop Our Network and Services and Engage in Strategic
Acquisitions" in the Company's Annual Report on Form 10-K.
Market Risk
At June 30, 1999, we recorded the marketable equity securities that we hold
at a fair value of $47.8 million. These securities have exposure to price risk.
A hypothetical ten percent adverse change in quoted market prices would amount
to a decrease in the recorded value of investments of approximately $5 million.
We believe our exposure to market price fluctuations on all other investments is
nominal due to the short-term nature of our investment portfolio.
We have no material future earnings or cash flow exposures from changes in
interest rates on our long-term debt obligations, as substantially all of our
long-term debt obligations are fixed rate obligations.
Year 2000 Date Conversion
We are currently verifying system readiness for the processing of date-
sensitive information by our computerized information systems. The Year 2000
problem impacts computer programs and hardware timers using two digits (rather
than four) to define the applicable year. Some of our programs and timers 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.
We are reviewing our IT and non-IT computer systems and programs to
determine which are not capable of recognizing the Year 2000 and to verify
system readiness for the millennium date. The review covers all of our
operations and is centrally managed. The review includes:
1. increasing employee awareness and communication of Year 2000 issues
18
2. inventorying hardware, software and data interfaces and confirming
Year 2000 readiness of key vendors
3. identifying mission-critical components for internal systems, vendor
relations and other third parties
4. estimating costs for remediation
5. estimating completion dates
6. testing and verifying systems
7. remediating any identified problems by correcting or replacing
systems or components
8. implementing the remediation plan
9. developing contingency plans
10. training for contingency plans
We have completed approximately 100% of the activities required for the
first five of these steps, more than 95% of the activities required for the
sixth, seventh and eighth steps and approximately 75% of the activities
required for the ninth step. We are in the initial stages of performing the
activities required to complete the remaining step and are developing
contingency plans to handle our most reasonably likely worst case Year 2000
scenarios. The completion percentages do not include information for pending or
recently completed acquisitions. The review and related Year 2000 activities
have not caused us to defer or forego, to any material degree, any other
critical IT project.
We estimate that our Year 2000 readiness costs will not exceed $7.0
million. We generally expense these costs as incurred. As of July 31, 1999, we
had incurred costs of $4.6 million in connection with our Year 2000 readiness
activities.
Our estimate of our Year 2000 readiness costs is a forward-looking
statement within the meaning of the safe harbor provisions of the Private
Securities Litigation Reform Act of 1995. Costs, results, performance and
effects of Year 2000 activities described in those forward-looking statements
may differ materially from actual costs, results, performance and effects in the
future due to the interrelationship and interdependence of our computer systems
and those of our vendors, material service providers, customers and other third
parties.
We have not yet fully identified our most reasonably likely worst case Year
2000 scenarios. We continue to contact our vendors, suppliers and third parties
with which we have material relationships, regarding their state of readiness.
This activity is focused primarily on mission critical systems and key business
suppliers. U S WEST, Ameritech and Southwestern Bell are our primary suppliers
of local central office switching and local lines. Until we have received and
analyzed substantial responses from them we will have difficulty determining our
worst case scenarios.
We have begun to develop contingency plans to handle worst case scenarios,
to the extent they can be identified fully. We intend to complete our
contingency planning after completing our determination of worst case scenarios.
Completion of these activities depends upon the responses to the inquiries we
have made of our major vendors, material service providers and third parties
with which we have material relationships. We have also begun work on
contingency plans for some systems identified as critical to our operations.
If we, our major vendors, our material service providers or our customers
fail to address Year 2000 issues in a timely manner, such failure could have a
material adverse effect on our business, results of operations and financial
condition. We depend on local exchange carriers, primarily the regional Bell
operating companies, to provide most of our local and some of our long distance
services. To the extent U S WEST, Ameritech or Southwestern Bell fail to address
Year 2000 issues which might interfere with their ability to fulfill their
obligations to us, such interference could have a material adverse effect on our
future operations. If other telecommunications carriers are unable to resolve
Year 2000 issues, it is likely that we will be affected to a similar degree as
others in the telecommunications industry.
Effects of New Accounting Standards
In June 1998, the FASB 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
19
every derivative instrument (including 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.
SFAS 133 is effective for fiscal years beginning after June 15, 2000. 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) 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).
We do not expect the impact of the adoption of SFAS 133 to be material to
our results of operations as we do 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.
20
PART II
OTHER INFORMATION
Item 1. Legal Proceedings
We are not aware of any material litigation against McLeodUSA. We are involved
in numerous regulatory proceedings before various public utility commissions and
the FCC, particularly in connection with actions by the regional Bell operating
companies. For example, on February 5, 1996, U S WEST filed tariffs and other
notices with the public utility commissions in its fourteen-state service region
to limit future Centrex access to its switches. Under the terms of these
tariffs and other notices, U S WEST would permit us to use its central office
switches until April 2005, but would not allow us to expand to new cities and
would severely limit the number of new lines we could partition onto U S WEST's
switches in cities we serve.
We have challenged, or are challenging, this action by U S WEST in many of
the states where we do business or plan to do business. We have succeeded in
blocking this action in Iowa, Minnesota, South Dakota, North Dakota and
Colorado, although U S WEST could take further legal action in some of these
states. In Montana, Nebraska and Idaho, however, similar challenges to this
action have not succeeded. In Wyoming and Utah, challenges to this action remain
pending.
U S WEST has introduced other measures that may make it more difficult or
expensive for us to use Centrex service. In January 1997, U S WEST proposed
interconnection surcharges in several of the states in its service region. In
February 1997, we joined other parties in filing a petition with the FCC
objecting to this proposal based on our belief that it violates several
provisions of the Telecommunications Act of 1996. The matter remains pending
before the FCC and various state public utility commissions.
We anticipate that U S WEST will also pursue legislation in states within
our target market area to reduce state regulatory oversight over its rates and
operations. If adopted, these initiatives could make it more difficult for us to
challenge U S WEST's actions in the future.
We cannot assure you we will succeed in our challenges to these or other
actions by U S WEST that would prevent or deter us from using U S WEST's Centrex
service or network elements. If U S WEST successfully withdraws or limits our
access to Centrex services in any jurisdiction, we may not be able to offer
integrated communications services in that jurisdiction, which could have a
material adverse effect on our business, results of operations and financial
condition. See "Business--Risk Factors--Our Dependence on Regional Bell
Operating Companies to Provide Most of Our Communications Services Could Make it
Harder for Us to Offer Our Services at a Profit" and "Business--Risk Factors--
Actions by U S WEST May Make it More Difficult for Us to Offer Our
Communications Services" in the Company's Annual Report on Form 10-K.
Item 2. Changes in Securities and Use of Proceeds
During the period from April 1, 1999 through June 30, 1999, the Company has
issued and sold the following equity securities:
(1) On June 8, 1999, we acquired certain assets of Millennium in exchange
for 69,406 shares of our Class A common stock.
(2) On May 29, 1999, we purchased four directories and certain assets of
Noverr for a total purchase price of $22.3 million, which consisted of 79,825
shares of Class A common stock, after giving effect for the two-for-one stock
split described in Note 6 to the financial statements, $19.4 million in cash and
note payable and an option to purchase 100,000 shares of Class A common stock,
after giving effect for the two-for-one stock split described in Note 6 to
the financial statements. The distribution of the Class A common stock, the
grant date of the options and the note payable of $4.4 million will occur in
January, 2000.
The issuances of securities described above were made in reliance upon the
exemption from registration provided by Section 4(2) of the Securities Act or
Regulation D promulgated thereunder for transactions by an issuer not involving
any public offering. The recipients of securities in each such transaction
represented their intention to acquire the securities for investment only and
not with a view to or for distribution in connection with such transactions.
All recipients had adequate access to information about us through their
relationship with us or through information about us made available to them.
Item 4. Submission of Matters to a Vote of Security Holders
The Annual Meeting of Stockholders of the Company was held on June 2, 1999.
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.
21
Proposal 1 -- Election of Directors
Term
Expires Votes For Votes Withheld
------------------ ---------- --------------
Elected Director
Stephen C. Gray 2002 67,506,121 34,089
Paul D. Rhines 2002 67,506,309 33,901
Roy A. Wilkens 2002 67,506,510 33,700
Peter H.O. Claudy 2001 67,506,399 33,811
Robert J. Currey 2000 67,506,449 33,761
Continuing Directors
Clark E. McLeod 2000
Blake O. Fisher, Jr. 2000
Lee Liu 2000
Richard A. Lumpkin 2001
Thomas M. Collins 2001
Proposal 2 --Approve the Second Amended and Restated Directors Stock Option Plan
Votes For 50,974,545
Votes Against 16,537,467
Votes Withheld 28,198
Broker Non-Votes 0
Proposal 3 -- Ratification of the Appointment of the Company's Independent
Public Accountants
Votes For 67,517,546
Votes Against 7,780
Votes Withheld 14,884
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.
(b) Reports on Form 8-K
On April 15, 1999, we filed a Current Report on Form 8-K to report the
March 31, 1999, acquisition by merger of Ovation Communications, Inc.
On April 16, 1999, we filed a Current Report on Form 8-K to report our
plans to offer high-speed digital access and data services as part of its
integrated communications product package using DSL (Digital Subscriber Line)
and other technologies. We also announced our plans to file a registration
statement in connection with a proposed underwritten secondary offering of up
to nine million shares of our Class A common stock by several of its
stockholders.
On May 5, 1999, we filed a Current Report on Form 8-K to report results for
the first quarter 1999.
On June 17, 1999, we filed a Current Report on Form 8-K announcing we
entered into an Agreement and Plan of Merger with Access Communications
Holdings, Inc., a Utah corporation.
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 16, 1999 By: /s/ Stephen C. Gray
---------------------------------------
Stephen C. Gray
President and Chief Operating Officer
Date: August 16, 1999 By: /s/ J. Lyle Patrick
---------------------------------------
J. Lyle Patrick
Chief Financial Officer
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.
25