UNITED STATES
SECURITIES AND EXCHANGE COMMISISION
Washington, D.C. 20549
_____________________________
FORM 10-K
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the fiscal year ended August 31, 1997
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from..................to..................
333-24881
(Commission file number)
____________________________
OPTEL, INC.
(Exact name of Registrant as specified in its charter)
_____________________________
Delaware OpTel, Inc. 95 - 4495524
1111 W. MOCKINGBIRD LANE
DALLAS, TEXAS 75247
(214) 634-3800
(State or other (Name, address, (I.R.S. Employer
jurisdiction of including Zip code Identification No.)
incorporation or of principal executive offices)
organization)
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.......
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
contained by reference in Part lll of this Form 10-K or any amendment to this
Form 10-K.
Yes...X.. No.......
COMMON STOCK AS OF OCTOBER 30, 1997
Common Stock Authorized Issued and Outstanding
Class A common stock, $.01 par 8,000,000 -
VALUE
Class B common stock, $.01 par 6,000,000 2,353,498
value
Class C common stock, $.01 par 300,000 225,000
value
DOCUMENTS INCORPORATED BY REFERENCE
- - --------------------------------------------------------------------------------
The following documents are incorporated into this Form 10-K by reference:
None
2
PART I.......................................................................4
Item 1: Business.............................................................4
Overview...................................................................4
Recent Developments - Consummation of Phonoscope Acquisition; Launch of
Houston Central Office Switch; Change in minor Shareholder; Bank Financing
Commitment.................................................................5
Industry...................................................................6
Markets....................................................................6
Strategy...................................................................9
Sales, Marketing and Customer Service......................................9
Networks..................................................................10
Services..................................................................12
Competition...............................................................15
Regulation................................................................18
Item 2: Properties..........................................................27
Item 3: Legal Proceedings...................................................28
Item 4: Submission of Matters to a Vote of Security Holders.................28
Item 4a: Executive Officers of Registrant...................................28
PART II.....................................................................31
Item 5: Market for the Registrant's Common Equity and Related Stockholder
Matters...................................................................31
Item 6: Selected Financial Data.............................................31
Item 7: Management's Discussion and Analysis of Financial Condition and
Results of Operations.....................................................33
Fiscal year ended August 31, 1997 compared to fiscal year ended August 31,
1996......................................................................35
Fiscal year ended August 31, 1996 compared with eight months ended August
31, 1995..................................................................37
Eight Months Ended August 31, 1995........................................38
Liquidity and Capital Resources...........................................38
Recently Issued Accounting Principles.....................................40
Private Litigation Securities Reform Act of 1995..........................41
Item 8: Financial Statements and Supplementary Data.........................41
Item 9: Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure......................................................41
Item 10: Directors and Executive Officers of the Registrant.................41
Item 11: Executive Compensation.............................................41
(1) Prior to Fiscal 1997, there were no other options granted.............43
Item 12: Security Ownership of Certain Beneficial Owners and Management.....43
Item 13: Certain Relationships and Related Transactions.....................44
PART IV.....................................................................49
Item 14: Exhibits, Financial Statement Schedules and Reports on Form 8-K....49
SIGNATURES..................................................................53
3
PART I
ITEM 1: BUSINESS
OVERVIEW
OpTel, Inc, together with its subsidaries, ("OpTel" or "the Company") is the
largest provider of private cable television services to residents of multiple
dwelling unit developments ("MDUs") in the United States and is expanding the
telecommunications services it offers to MDU residents. The Company provides
cable television and, where currently offered, telecommunications services to
MDU residents principally under long-term contracts ("Rights of Entry") with
owners of MDUs. The Company's Rights of Entry are generally for a term of ten to
fifteen years (five years for Rights of Entry with condominium associations).
The weighted average unexpired term of the Company's cable television Rights of
Entry was approximately eight years as of August 31, 1997. The Company currently
provides cable television services in the metropolitan areas of Houston, Dallas-
Fort Worth, San Diego, Phoenix, Chicago, Denver, San Francisco, Los Angeles,
Miami-Ft. Lauderdale, Tampa and Austin. The Company also provides
telecommunications services in Houston, Dallas-Fort Worth, Austin, Chicago,
Denver and Miami-Ft. Lauderdale. As of August 31, 1997, the Company had 132,556
cable television subscribers and 6,825 telecommunications subscribers with 8,190
telephone lines.
For regulatory purposes, the Company is considered to be a private cable
television operator in most of the markets it serves. Private cable television
operators deliver services to consumers without hard-wire crossings of public
rights of way. Consequently, private cable television operators are not required
to obtain cable television franchises and are subject to significantly less
regulatory oversight than are traditional franchise cable television operators.
As a result, they have significant latitude in terms of system coverage, pricing
and customized delivery of services to selected properties. The Company has no
universal service obligations and generally does not incur capital costs to
build its networks until it has entered into Rights of Entry from which it
reasonably expects to build an appropriate customer base. In certain other
markets, such as Houston, the Company delivers cable television services
pursuant to franchises the terms of which are significantly more relaxed than
traditional cable television franchises.
The Company offers a full range of multichannel video programming (including
basic and premium services) which the Company believes is competitive in both
content and pricing with the programming packages offered by its major
competitors. The Company currently provides its telecommunications services as a
shared tenant services ("STS") operator through private branch exchange ("PBX")
switches. The Company offers customers access to services comparable in scope
and price to those provided by the incumbent local exchange carrier ("LEC") and
long distance carrier. The Company's telecommunications strategy includes
replacing its PBX switches with networked central office switches.
The Company invests in networks because it believes that networks provide the
optimal mechanism for delivering bundled cable television and telecommunications
services. The Company's networks use technologies that are capable of bi-
directional transmission. The Company provides its video programming to MDUs
through 18-Gigahertz microwave ("18GHz") and fiber optic networks and non-
networked satellite master antenna television ("SMATV") systems. As of August
31, 1997, approximately 165,000 of the 254,032 units passed for cable television
are served by the Company's networks. These networks generally provide up to 72
channels of video programming. The Company's networks will also facilitate
delivery of voice signal from each MDU to the central office switches to be
deployed or leased by the Company in its markets.
4
The Company intends to license additional spectrum, which it currently
anticipates principally will be in the 23-Gigahertz ("23GHz") band, which it
will use to provide bi-directional voice transmission. The Company intends to
convert substantially all of its SMATV systems to 18GHz or fiber optic networks
by the end of fiscal 1999 and PBX switches to central office switches by the end
of fiscal 2002. The Company believes that there are several benefits to
converting its SMATV systems to cable networks and PBX switches to central
office switches. These include lower per unit maintenance costs, increased
system reliability through better monitoring and redundancy, greater channel
capacity, the opportunity to bundle services, integration of video, voice and
data and improved operating margins.
OpTel was incorporated in the State of Delaware in July 1994, as the successor
to a Delaware corporation that was founded in April 1993. The Company's
principal offices are located at 1111 W. Mockingbird Lane, Dallas, Texas 75247,
and its telephone number is (214) 634-3800.
RECENT DEVELOPMENTS - CONSUMMATION OF PHONOSCOPE ACQUISITION; LAUNCH OF HOUSTON
CENTRAL OFFICE SWITCH; CHANGE IN MINORITY SHAREHOLDER; BANK FINANCING COMMITMENT
On October 27, 1997 the Company acquired the Phonoscope residential cable
television and associated fiber optic network in the greater Houston
metropolitan area for $36.5 million. Phonoscope provides its services over a
fiber optic and coaxial cable distribution system. The Company will use its
existing franchise with the City of Houston to serve Phonoscope subscribers
within the City of Houston, and has received or will seek assignment of the
appropriate municipal franchises to service MDUs in other municipalities. The
acquired Phonoscope Rights of Entry or subscriber agreements cover approximately
60,000 units (principally at MDUs, but including certain single family units
within the footprint of its network) and approximately 34,000 subscribers and
the weighted average unexpired term of the acquired Rights of Entry was
approximately 5 years.
Phonoscope's network and the Company's existing Houston network are in close
proximity with each other, but do not overlap in any material respect. The
Company intends to expand the acquired fiber optic network and, over time,
interconnect the acquired network with the Company's existing Houston network.
The Company recently commenced operating a central office telephone switch in
Houston through which it provides local and long distance services as a
Competitive Local Exchange Carrier ("CLEC"). The Company intends to migrate its
properties currently served through PBX switches in Houston to the central
office switch over the coming months.
In August 1997 Capital Communications CDPQ Inc ("CDPQ"), a direct subsidiary
of Caisse de depot et Placement du Quebec ("Caisse"), a Quebec financial
institution and shareholder of the Company's majority shareholder, Le Groupe
Videotron Ltee ("GVL") purchased the minority interest in the Company from
Vanguard Communications LLP ("Vanguard"). Vanguard also transferred to CDPQ an
existing option to purchase additional shares in the Company which CDPQ promptly
exercised. As of August 31, 1997 GVL held, indirectly, 74.6% of the common
equity of the Company, 16.7% was held by CDPQ and 8.7% by various purchasers of
the Company's Senior Discount Notes due 2005, or their transferees.
In October 1997, the Company received a commitment from a bank to provide a
$150 million senior secured credit facility (the "Senior Facility") which will
be used to provide capital to fund future development. The Senior Facility will
consist of a term loan and a revolving credit commitment both of which will bear
interest at interest rates customary for this type of transaction and the credit
position of the Company. The Senior Facility will be secured by a first fixed
and floating lien on substantially all of the assets of the Company.
Availability under the Senior Facility will be subject to the Company meeting
certain performance criteria. Management expects that funds will become
available under the Senior Facility in December 1997. The commitment to close
the Senior Facility is subject to conditions and terminates December 15, 1997,
if not closed.
5
INDUSTRY
The private cable television industry has undergone significant changes and
consolidation in recent years as a result of changes in cable television and
telecommunications laws and regulations.
Until February 1991, the primary technology available to private cable
television operators was SMATV, whereby the operator received and processed
satellite signals directly at an MDU or other private property with an on-site
headend facility consisting of receivers, processors and modulators, and
distributed the programming to individual units through an internal hard-wire
system in the building. SMATV operators spread the relatively high fixed costs
of operations (headend equipment, management, customer service, billing,
installation and maintenance) over a small subscriber base (frequently the
residents of a single MDU). This high cost structure reduced the incentives for
SMATV operators to invest in technology and overhead, resulting in inferior
channel capacity (usually 33 to 45 channels) and a lesser resource commitment to
customer service, which produced lower penetration rates. In February 1991,
regulatory changes made 18GHz technology, which had been in use for more than 25
years in commercial and military applications, available for use by private
cable television operators for the point-to-point delivery of video programming
services.
The present structure of the U.S. telecommunications market resulted largely
from the break-up of the "Bell System" in 1984 which created two distinct
telecommunications industries: local exchange and interexchange or "long
distance". The long distance industry was immediately opened to direct
competition; however, until recently, the local exchange industry has been
virtually closed to competition. Efforts to open the local exchange market to
competition began in the late 1980's on a state by state basis when competitive
access providers ("CAPs") began offering dedicated private line transmission and
access services which account for less than 10% of the local exchange market. In
the summer of 1995, several states began opening their markets to local exchange
competition. In February 1996, the Telecommunications Act was signed into law.
The Telecommunications Act provides a framework by which all states must allow
competition for local exchange services. Specifically, the Telecommunications
Act (i) requires the incumbent LEC to (a) allow competitors to interconnect to
the LEC's network at any technically feasible point and (b) allow competitors
access to components of the LECs network selectively and (ii) establishes a
framework for reciprocal compensation between the LEC and a CLEC for use of each
other's network.
MARKETS
MDUs comprise a wide variety of high density residential complexes, including
high- and low-rise apartment buildings, condominiums, cooperatives, townhouses
and mobile home communities. According to 1990 U.S. Census Bureau data, there
are more than 13.2 million MDU units in MDUs with greater than 10 MDU units in
the United States, of which approximately 4.0 million are within the Company's
existing geographic markets. The Company estimates that approximately 2.5
million of the MDU units within its existing markets are within MDUs which meet
the Company's preference for MDUs of 150 or more units. Industry sources
estimate that in 1995 the total revenues for cable television in the United
States were $25 billion and total revenues from telecommunications services in
the United States were $168 billion, of which approximately $96 billion
represented revenues from local exchange services.
The Company selected its current markets based upon their growth
characteristics, competitive conditions, MDU concentrations, topographical and
climatic conditions, favorable demographics and, to a lesser extent, favorable
regulatory environments.
6
OpTel operated in the following geographic markets as of August 31, 1997:
Units passed for
Units passed for cable Cable television telecommunications Telecommunications lines
LOCATION (1) subscribers (1)
- - --------------------------------------------------------------------------------------------------------------------
Houston 77,387 31,356 5,270 1,985
Dallas/Fort Worth 34,933 17,787 6,296 2,070
Southern California (Los
Angeles, San Diego) 32,842 20,139 768 199
Phoenix 24,047 9,374 - -
Chicago 28,796 17,006 110 23
Denver 15,178 7,997 1,069 358
San Francisco 23,016 16,069 - -
Miami 14,305 10,969 338 105
Other markets (Austin &
Tampa) 3,528 1,860 2,721 3,450
- - --------------------------------------------------------------------------------------------------------------------
Total 254,032 132,556 16,572 8,190
(1) Units passed represents the number of units with respect to which the
Company has connected and activated its cable television and
telecommunication systems, respectively.
The Company's strategy has been to enter markets either through the
acquisition of a private cable television operator serving the target market or
by entering into Rights of Entry with a major MDU owner in the market. The
Company has entered substantially all of its markets through acquisitions. Upon
acquisition of an operator, the Company historically has begun the process of
upgrading the acquired systems by converting MDUs from SMATV technology to the
Company's 18GHz or, in Houston, fiber optic networks, adding additional
programming and improving customer service. In addition, the Company has been
able to achieve cost efficiencies by consolidating acquired operations into its
existing organization. As acquired operations generally have not offered
telecommunications services, the Company is in the process of adding such
services to its acquired systems.
HOUSTON
The Company entered the Houston market in January 1995 through an acquisition.
The Houston market includes the Company's operations in Bryan/College Station.
The Company has a cable franchise for the Houston market and utilizes a fiber
optic/coaxial cable network to service approximately 83% of its units passed for
cable television with the remainder serviced via SMATV systems. The Company
installed its first central office switch in the Houston market in October 1997.
DALLAS-FORT WORTH
The Company entered the Dallas-Fort Worth market in September 1994 by entering
into Rights of Entry with a significant property owner. Since that date the
Company has increased its market share by acquisition and by entering into
additional Rights of Entry. The Company's corporate headquarters and
centralized customer call center for all of its markets is located in Dallas-
Fort Worth. The Company intends to install a central office switch in the
Dallas-Fort Worth market in the early part of calendar year 1998.
CHICAGO
The Company entered the Chicago market in August 1995 through the acquisition
of a private cable operator whose properties were mainly in Chicago's suburbs.
The Company intends to commence full scale marketing of a competitive local
exchange carrier ("CLEC") telecommunications service in the Chicago market by
the end of fiscal 1999 using its own telecommunication switch, or sooner if
suitable switching capacity can be leased from a CLEC. In March 1997, the
Company consummated an acquisition of a small private cable operator in the
downtown Chicago market.
7
PHOENIX
The Company entered the Phoenix market in December 1994 through an
acquisition. Since that date the Company has increased its market share by
entering into additional Rights of Entry. The Company intends to commence full
scale marketing of CLEC based telecommunications service in the Phoenix market
by the end of fiscal 1999 using its own telecommunication switch, or sooner if
suitable switching capacity can be leased from a CLEC.
SAN DIEGO/LOS ANGELES
The Company entered the San Diego market in December 1994 through an
acquisition. The San Diego market includes parts of Orange County, San
Bernadino County, Riverside County and North County. Since that date, the
Company has increased its market share by entering into additional Rights of
Entry.
The Company entered the Los Angeles market in May 1994 by entering into
certain Rights of Entry. Since that date the Company has increased its market
share by entering into additional Rights of Entry.
The Company operates its systems in San Diego and Los Angeles under one
General Manager and intends to share switching capacity between the two cities.
The Company intends to commence full scale marketing of a CLEC based
telecommunications service in the Southern California market by the end of
fiscal 1999 using its own telecommunication switch, or sooner if suitable
switching capacity can be leased from a CLEC.
SAN FRANCISCO
The Company entered the San Francisco market in August 1996 through an
acquisition and completed another acquisition in November 1996. In the San
Francisco market, the Company currently services all of its units passed for
cable television via SMATV systems but intends to convert substantially all of
these SMATV systems to 18GHz networks by the end of fiscal 1999. The Company
intends to commence full scale marketing of a CLEC based telecommunications
service in the San Francisco market by the end of fiscal 1999 using its own
telecommunication switch, or sooner if suitable switching capacity can be leased
from a CLEC.
DENVER
The Company entered the Denver market in July 1995 through an acquisition.
Since that date the Company has increased its market share by entering into
additional Rights of Entry. The Company intends to commence full scale
marketing of a CLEC based telecommunications service in the Denver market by the
end of fiscal 1999 using its own telecommunication switch, or sooner if suitable
switching capacity can be leased from a CLEC.
MIAMI - FORT LAUDERDALE
The Company entered the Miami-Fort Lauderdale market in June 1995 through an
acquisition. Since that date the Company has increased its market share by
entering into additional Rights of Entry. The Company intends to commence full
scale marketing of a CLEC based telecommunications service in the Miami-Fort
Lauderdale market by the end of fiscal 1999 using its own telecommunication
switch, or sooner if suitable switching capacity can be leased from a CLEC.
TAMPA
The Company entered the Tampa market in August 1996 through an acquisition.
The Company currently services all of its units passed for cable television in
the Tampa market via either SMATV or coaxial cable systems. The Company intends
to dispose of its operations in Tampa during the course of fiscal 1998, either
through a sale of the system or by exchanging these properties for private cable
networks in its other existing markets.
8
AUSTIN
The Company entered the Austin market in July 1994 by entering into certain
Rights of Entry. Since that date the Company has increased its market share by
entering into additional Rights of Entry. The Company currently services all of
its units passed for cable television in the Austin market via SMATV systems.
The Company intends to dispose of its operations in Austin during the course of
fiscal 1998, either through a sale of the system or by exchanging these
properties for private cable networks in its other existing markets.
STRATEGY
The Company intends to grow its business and increase its market concentration
by attracting MDUs currently served by other providers, providing services to
newly-constructed MDUs and, as appropriate, acquiring existing private cable
operators and entering new markets. A critical aspect of the Company's growth
strategy is the development of strategic relationships with owners of portfolios
of MDUs. These relationships encourage the MDU owner to promote and sell the
Company's cable television and telecommunications services to MDU residents.
Many Rights of Entry provide incentives to the MDU owner, principally long-
term revenue sharing, and, in certain cases, payment of "key money" on Rights of
Entry execution. In addition, the Company believes that its ability to deliver
special services tailored to MDU owners and residents enhances the MDU owners
marketing of unit rentals and sales.
The Company's goal is to distinguish itself from its competitors by becoming a
leading provider of a comprehensive set of both cable television and
telecommunications services to MDUs.
The Company's customer marketing strategy is to offer a complete package of
cable television and telecommunications services backed by a high level of
customer service. The Company believes that, given comparable level of product
offerings, MDU residents prefer the simplicity and pricing benefits of dealing
with one supplier for all of their cable television and telecommunications
services. The Company also believes that prompt response to service requests and
customer inquiries is important to MDU residents. The Company affords customers
the opportunity to subscribe for Company services at the time the unit lease is
signed and believes that this added convenience is important to its marketing
efforts. The Company also plans to supplement its cable television and
telecommunications services by providing customers with access to additional
services, including Internet access, intrusion alarm, utility monitoring, and
PCS, cellular and paging services.
The Company is expanding the telecommunications component of its business both
by increasing the number of MDUs to which it provides telecommunications
services and by expanding the number of services offered. As part of its
ongoing telecommunications roll out and coincident with the conversion of its
SMATV systems to networks, the Company intends to replace its PBX switches
located at MDUs with networked central office switches. The Company deployed its
first central office switch in the Houston market in October 1997 and intends to
install central office switches in substantially all of its markets by the end
of fiscal 2002.
SALES, MARKETING AND CUSTOMER SERVICE
Consistent with its business strategy, the Company's marketing goals are to
(i) increase market share in existing markets by entering into additional Rights
of Entry, (ii) increase penetration at each MDU served by the Company, (iii) add
telephone services to existing cable-only properties and (iv) market additional
services, such as premium cable services, Pay-Per-View, Internet access,
intrusion alarm, utility monitoring and PCS, cellular and paging services, to
its subscribers. The Company focuses its marketing efforts on large MDUs located
in clusters within its markets and then attempts to obtain Rights of Entry for
additional MDUs within the coverage of its existing networks.
9
The Company tailors its marketing efforts to two different constituencies: (i)
owners of MDUs who may enter into Rights of Entry and (ii) actual and potential
cable television and telecommunications subscribers at MDUs for which the
Company has entered into Rights of Entry. Each constituency is served by
separate sales and marketing teams that promote the Company's advantages over
its competitors in the marketplace.
The Company is committed to providing excellent customer service to MDU owners
and subscribers in the home, in the field and on the telephone. The Company
believes the most effective means of attracting and retaining MDU owners and
subscribers is by providing high quality subscriber service, including: (i) 24-
hour-a-day, seven-day-a-week subscriber telephone support; (ii) direct lines to
facilitate rapid response to calls initiated by MDU owners and managers; (iii)
computerized tracking of all incoming calls to minimize waiting times; (iv)
service calls generally made the same day the subscriber indicates a service
problem; (v) flexible, seven-day-a-week installation and service appointments;
(vi) follow-up calls and on-site inspections to verify subscriber satisfaction;
and (vii) 80% of installations completed within 3 business days of receiving the
initial installation request, often within 24 hours. The Company also uses focus
groups and subscriber surveys to monitor subscriber satisfaction.
NETWORKS
CABLE TELEVISION ARCHITECTURE
An integral part of the Company's strategy is to link properties to master
headends through microwave and fiber optic networks, to the maximum extent
practicable. In substantially all markets except Houston, the Company transports
video programming to MDUs in one of two ways: (i) by transmitting video
programming from a master earth station and headend to the MDU using point-to-
point microwave conveyance, generally in the 18GHz frequency range; or (ii) by
receiving video programming at a self-contained SMATV headend located at the
MDU. In Houston, video programming reaches a majority of the MDUs served by the
Company through a fiber optic network that the Company operates pursuant to a
franchise from the City of Houston. In certain limited geographic areas, video
programming reaches MDUs through a combination of coaxial cable and microwave
transmission. 18GHz microwave conveyance requires the operator to install small
microwave dishes at each MDU. These dishes receive video programming from a
centrally located master headend which must be within the line of sight of the
receiving dish. The FCC licenses paths between two points at specific frequency
ranges. The video programming may, within limits, be retransmitted at repeater
sites. To insure a high quality picture, the Company generally limits the number
of repeater sites. For the same reason, the Company generally limits the radius
of each microwave link to between three and eight miles, depending on
topographic and climatic conditions.
The Company intends to convert substantially all of its SMATV systems to 18GHz
or fiber optic networks by the end of fiscal 1999. As of August 31, 1997, the
Company had 35 18GHz networks and one fiber optic network in service in 11
metropolitan areas and, on average, 54% of the units passed by the Company were
served by such networks.
Within the MDUs it serves the Company distributes video programming via
conventional coaxial cable. In markets where it offers Pay-Per-View channels,
the Company uses a combination of traps (electronic filtering devices) and
addressable decoder-converter boxes. Where it does not offer Pay-Per-View, the
Company uses traps.
10
The Company has recently completed field testing interdiction devices and has
begun deploying them in several of its current systems. Interdiction devices
will permit the Company to activate and deactivate services or specific channels
by remote command from its central office. When implemented, these devices will
afford quicker activation and disconnection, eliminate or significantly reduce
the need for traps and for decoder-converter boxes in the home, eliminate or
significantly reduce service calls and provide better picture quality. The
Company believes that these devices will also result in better collection
experience, higher levels of penetration and premium service buy-in and greater
customer satisfaction.
TELECOMMUNICATIONS ARCHITECTURE
In metropolitan areas where the Company currently offers telecommunications
services, the Company uses conventional twisted copper wire pairs to distribute
telephone services within an MDU. A PBX switch is installed at the MDU and local
traffic from the MDU is transported via leased trunk lines to the LEC central
office. From the LEC's central office, local calls are routed through the LEC's
network. Long distance traffic is routed via leased trunk lines from the PBX
switch to the Company's chosen long distance carrier (currently AT&T). The
regulations under which the Company's PBX-based services are provided generally
prohibit the aggregation of local telephone traffic between noncontiguous MDUs,
and in certain states there are limits or prohibitions on resale of intrastate
long distance and local service at a profit. These restrictions adversely effect
the profitability of the Company's STS operations. The Company intends to seek
certification as a CLEC in each of the states in which it operates. As a CLEC,
the Company will be relieved of these limits and prohibitions. The Company has
already been granted CLEC certification in Texas, Florida, Illinois and
California and has applications pending in Arizona and Colorado. The Company
believes CLEC certification will be available in a timely manner in these
markets. However, if certification were not granted the Company would be
restricted to providing STS services in that market.
The Company plans to interconnect MDUs to an owned or leased central office
switch using its owned fiber optic network and microwave networks and the
network facilities of other service providers. The Company intends to
interconnect its central office switch to several long distance carriers'
points-of-presence and to the public switched telephone network via the LEC's
network.
The implementation of the Company's telecommunications roll out plans will
depend in some measure on the speed and manner in which states implement (i) the
liberalized competition provisions of the Telecommunications Act and (ii) the
establishment of the interconnection and tariff requirements that the
Telecommunications Act imposes on the incumbent LEC.
The Company intends to contract for other ancillary elements of service from
the incumbent LEC in each market or from other available carriers. These
ancillary services include (i) operator service, (ii) directory listings, (iii)
emergency 911 service, and (iv) conveyance where the Company does not have a
network.
The Company intends to modify its existing networks (currently used to provide
video programming) to accommodate two-way digital telecommunications traffic so
as to connect the MDUs to its planned central office switches in each of its
markets. The Company intends to use its existing network configuration if
feasible and to supplement its microwave plant if necessary, including through
the use of other available radio spectrum for telecommunications services.
However, other than in Dallas, the Company has not yet commenced frequency
coordination and there can be no assurance that the Company will be able to
obtain licenses for these frequencies on the paths it desires.
It is also possible that the Company will augment its microwave networks in
many markets with fiber optic links between microwave hubs and from hubs to its
central switch locations. Particular network architecture in any market will be
dependent on, among other factors, bandwith requirements and equipment costs,
which are not yet determinable.
11
The Company will use its networks to aggregate MDU long distance and local
traffic at its or its selected partners' telecommunications switch. From there,
traffic will be delivered to the point of presence of the connecting carrier
either through the Company's microwave or fiber networks, or where appropriate,
other available means of transport, including those of the interconnecting
carriers.
SERVICES
CABLE TELEVISION SERVICES
OpTel offers its subscribers a full range of popular cable television
programming at competitive prices. The Company's 18GHz networks are capable of
delivering up to 72 uncompressed analog channels of programming at each MDU. In
addition, the programming selections available at an MDU can be tailored to the
demographics of each MDU and, unlike franchise cable television operators which
may be required to carry all local broadcast channels and public access
channels, the Company can utilize all of its available channels to provide
popular entertainment, news and information programming.
The Company offers various programming packages to its cable television
subscribers. The Company's basic programming package offered to MDUs served by
its 18GHz and fiber optic networks typically includes 60-72 channels and is
generally priced below the rate charged by the incumbent franchise cable
television operator for a comparable package. The Company also offers premium
television services. These often feature uninterrupted, full-length motion
pictures, sporting events, concerts and other entertainment programming.
Premium services are offered individually or in discounted packages with basic
or other services. Certain of the Company's systems are capable of offering
movies, sporting events, concerts and other special events on a Pay-Per-View
basis.
The Company purchases copyrighted programming from program suppliers, pursuant
to private, negotiated multi-year license agreements. The average term of such
contracts is four years and such contracts are typically renewed upon
expiration. Generally, the Company pays its programming suppliers a fixed
monthly fee per subscriber, subject to volume discounts and reduced rates for
MDUs where the Company's services are supplied to all units on a bulk basis.
The programming fees average 31% of basic cable revenue and between 60% and 70%
of premium and pay per view revenue. The Company is not subject to any material
minimum subscriber requirements under its programming license agreements.
The video programming broadcast on local television broadcast stations is
subject to compulsory copyright license requirements from the copyright owners.
The Company is required to obtain retransmission consents from off-air
broadcasters but has had little difficulty in obtaining retransmission consent
agreements. Non-broadcast programming, often referred to as cable programming,
is not subject to the compulsory copyright license. However, federal
regulations prohibit (i) cable television operators, satellite cable programming
vendors in which a cable television operator has an attributable interest, and
satellite broadcast programming vendors from charging unfair, unreasonable or
discriminatory prices for programming and (ii) most exclusive dealing
arrangements whereby cable systems have procured programming that is unavailable
to their competition. The prohibition on exclusive distribution arrangements is
scheduled to expire on October 5, 2002, unless the FCC finds, during a
proceeding to be conducted in 2001, that the prohibition continues to be
necessary.
12
An integral part of the Company's strategy is to link properties to master
headends through microwave and fiber optic networks, to the maximum extent
practicable. In substantially all markets except Houston, the Company
transports video programming to MDUs in one of two ways: (i) by transmitting
video programming from a master earth station and headend to the MDU using
point-to-point microwave conveyance, generally in the 18GHz frequency range; or
(ii) by receiving video programming at a self-contained SMATV headend located at
the MDU. In Houston, video programming reaches a majority of the MDUs served by
the Company through a fiber optic network that the Company operates pursuant to
a franchise from the City of Houston. In certain limited geographic areas,
video programming reaches MDUs through a combination of coaxial cable and
microwave transmission.
18GHz microwave conveyance requires the operator to install microwave dishes
at each MDU. These dishes receive video programming from a centrally located
master headend which must be within the line of sight of the receiving dish. The
FCC licenses paths between two points at specific frequency ranges. The video
programming may, within limits, be retransmitted at repeater sites. To insure a
high quality picture, the Company generally limits the number of repeater sites.
For the same reason, the Company generally limits the radius of each microwave
link to between three and eight miles, depending on the topographic and climatic
conditions of the market.
The Company intends to convert substantially all of its SMATV systems to 18GHz
or fiber optic networks by the end of 1999. As of August 31, 1997, the Company
operated 18GHz networks in each of its 9 major metropolitan areas except Houston
which is served by a fiber-optic network and San Francisco which is served by
SMATV systems and is currently in the process of being converted to an 18GHz
networks. On average, 60% of the units passed by the Company are currently
served by networks (approximately 67% pro forma for the Phonoscope acquisition).
OpTel's network design is digital capable and many of its components are
hybrid digital-analog. This will facilitate upgrading to digital compression
when economical and required by the marketplace. The use of networks
facilitates the upgrade to digital because networked systems have fewer headends
to upgrade than SMATV systems where it would not be economically viable to
update headends serving individual properties.
The Company's cable contracts include MDUs which subscribe on a "retail"
basis, where each resident of an MDU can independently opt to be a cable
subscriber and is separately billed, and MDUs which are under "bulk" contracts,
in which the property owner buys cable services from OpTel for 100% of the
apartments in the complex and includes basic cable in the services offered to
building residents. Residents of MDUs served under bulk contracts contract
separately with OpTel for premium services. Currently, approximately two-thirds
of OpTel's contracts are retail contracts. While bulk contracts have lower
revenues per customer than retail arrangements and generally have a lower gross
margin, the increase in penetration helps to offset this and certain program
providers grant discounts for bulk subscribers. In addition, bulk contracts
have lower servicing costs (billing, bad debt) than retail contracts. The
Company will sign bulk contracts where required but generally anticipates that
bulk contracts will decrease as a proportion of the total contract base over the
next few years as a greater proportion of new contracts are being signed for
the provision of retail service. An increase in the number of retail contracts
as a proportion of the total contract base is expected to contribute to an
increase in revenue per customer.
TELECOMMUNICATIONS SERVICES
The Company currently provides telephone service under two regulatory
frameworks. In Houston, Dallas, Miami, Chicago, San Diego and Denver, it
operates as an STS provider. To date, OpTel has restrained the growth of STS
telephony because of the marginal economics of that business. In Houston, it
also operates as a CLEC. The Company intends to convert to CLEC operation in
all of its markets over the next two to three years.
13
OpTel's telephone contracts provide that OpTel will be the exclusive provider
of local telephone services to MDU residents, subject to the legal rights of the
incumbent local exchange carrier ("ILEC") and other providers to offer service.
Pursuant to the telephone ROE contracts, the building owners receive revenue
sharing payments and may receive an initial payment. In return building owners
are required to promote OpTel's service and refrain from promoting other
telecommunications providers' service to MDU residents.
While the telephone product currently provides only minor revenue streams for
OpTel, Management believes it represents an attractive and potentially lucrative
business opportunity for several reasons. First, OpTel has already achieved
penetration (in terms of lines) of approximately 48% in those properties which
it currently offers telephone services as an STS provider. Even allowing for the
distortion of the Austin market where telephone penetration is very high, this
figure is above 34%. This penetration level has been achieved with virtually no
marketing effort. Secondly, OpTel will be serving as an MDU residential-oriented
CLEC, and should benefit from the recognized demand for CLEC services in the
residential sector. Management knows of no other CLEC with as directed a
residential strategy as OpTel. Thirdly, the revenue sharing structure, together
with the "one stop shopping" aspects of cable and telephony ROE contracts,
should create incentives for property owners to promote the telephone product.
In metropolitan areas where the Company currently offers telecommunications
services, the Company uses conventional twisted copper wire pairs to distribute
telephone services within an MDU. Under the STS model, a PBX switch is
installed at the MDU and local traffic from the MDU is transported using the
ILEC's commercial transport either to the ILEC central office switch or to the
central office switch of an long distance operator ("IXC"). From the ILEC's
central office, local calls and long distance calls are routed through the
ILEC's network or using the IXC's long distance network if the PBX is also
interconnected with the IXC's switch. Where there is no such direct
interconnection, long distance traffic is routed from the ILEC's switch to the
Company's chosen long distance carrier (currently AT&T). Using its own central
office switches the Company believes it will have much greater control over
quality of its product offering and interconnect relationships (and hence
price). As a result, the Company intends to seek certification as a CLEC in
each of the states in which it operates and currently has CLEC status in Texas,
California, Florida and Illinois.
The Company is currently in the process of converting to the CLEC telephone
model of operation. This involves interconnecting MDUs to an owned central
office switch or leased capacity on the central office switch of another CLEC
using OpTel's own fiber optic network and microwave networks and the network
facilities of other service providers. Local traffic is then routed from the
OpTel switch to the ILEC switch using dedicated transport. OpTel intends to
interconnect its central office switch to several long distance carriers'
points-of-presence and to the public switched telephone network via the ILEC's
network. The switch in Houston is now fully operational and direct
interconnection with a preferred long distance provider is expected to be
completed in the near future.
OpTel plans to contract for other ancillary services from the ILEC and other
service providers. These services include operator service, directory listings
and emergency 911 service and, in certain markets, transport.
14
The Company intends to modify portions of the existing networks, currently
used to provide video programming, to accommodate two-way digital
telecommunications traffic. The Company expects to use 23GHz as its principal
frequency to carry telecommunications traffic. The Company believes that using
23GHz will enable it to utilize proven equipment manufactured by several
vendors. The Company will transmit and receive 23 GHz signals generally using
certain modifications to its existing 18GHz dishes and has achieved satisfactory
results in technology field trials. The Company will use its networks to
aggregate MDU long distance and local traffic at its telecommunication switch.
In certain markets the Company is currently exploring the possibility of
initially leasing telecommunication switch capacity from other CLECs in order to
speed up the roll out of telephone services. From these switches, traffic will
be delivered to the point of presence of the connecting carrier either through
the Company's microwave or fiber networks, or where appropriate, other available
means of transport, including those of interconnecting carriers.
Competition
The multichannel television and telecommunications industries are highly
competitive. The Company presently competes with companies that specialize in
the provision of multichannel television or telecommunication services and,
increasingly, with companies that offer bundled multichannel television and
telecommunications services. Many of these competitors are larger companies with
greater access to capital, technology and other competitive resources. The
Company's private cable television service competes with traditional franchise
cable television operators as well as wireless cable television operators, other
private cable television operators, direct broadcast satellite ("DBS")
operators, stand-alone satellite service providers and, to a lesser extent, off-
air broadcasters. The Company's telecommunications services compete with other
STS providers, LECs, CLECs and CAPs and will compete with long distance
telephone companies and franchise cable television operators as they begin to
enter the local telephone business. The Company's long distance service competes
with established interexchange carriers and resellers. In addition, recent
telecommunications offerings, including PCS, and future offerings may increase
competition in the telecommunications industry. Recent and future legislative,
regulatory and technological developments will likely result in additional
competition, as telecommunications companies enter the cable television market
and as franchise cable television operators and interexchange carriers begin to
enter the local telephone market. Similarly, mergers, joint ventures and
alliances among franchise, wireless or private cable television operators and
Regional Bell Operating Companies ("RBOCs") may result in providers capable of
offering bundled cable television and telecommunications services in direct
competition with the Company.
The Company competes with multichannel television operators and
telecommunications service providers to obtain Rights of Entry. In most markets
serviced by the Company, franchise cable television operators now offer revenue
sharing and access fee arrangements to MDU owners. There can be no assurance
that these payments will not increase in the future as competition increases for
access to the higher quality MDUs. Another basis of competition is the breadth
of programming and range of services offered. Although the Company as a matter
of course investigates new sources of programming and technologies that may
increase its range of services, other larger and more diversified competitors
may attract the targeted MDUs based on their increased menu of services.
Consequently, the Company may be compelled to reduce its prices and improve its
range of services under its existing Rights of Entry which generally require the
Company to remain competitive with the market in general. At present, the
Company believes that its existing Rights of Entry give it a competitive
advantage within its present markets; however, these advantages may deteriorate
with changes in regulations, the types of competitors and with technological
advances. There can be no assurance that the Company will be able to compete
successfully with existing competitors or new entrants in the market for such
services. Competition may also be enhanced by technological developments that
allow competitors of the Company to bypass property owners altogether and market
their services directly to the tenants of MDUs. Although the Company's Rights of
Entry prohibit tenants from installing receiving equipment on the exterior of
the building, these provisions are not always enforced. The Rights of Entry do
not prevent a resident from
15
using cellular telephone service, for example, offered by another provider.
While the Company believes that the exclusivity provisions of its Rights of
Entry provide it with competitive advantages, such advantages may be
significantly diminished by technological and other developments beyond the
control of the Company. Such developments may impact the Company's strategies
and may require it to expend funds beyond the levels currently contemplated.
Certain of the Company's current and potential competitors are described
below.
Traditional Franchise Cable Systems. The Company's major competition for
Rights of Entry in each market comes from the traditional franchise cable
television operator. The Company competes with such operators by (i) focusing
exclusively on MDUs, (ii) sharing profits with MDU owners, (iii) offering
customized programming, and (iv) charging lower rates to subscribers.
Multipoint Multichannel Distribution Systems. MMDS systems are similar to the
Company's 18GHz networks in that they use microwave transmitting and receiving
equipment. MMDS differs from 18GHz in that (i) it "broadcasts" its video
programming direct to individual subscribers and generally not to an MDU's
receiver and (ii) its systems transmit in an omni-directional manner, while
18GHz systems are point-to-point. As a result, MMDS wireless cable can provide
service to all households within a wireless operator's "line-of-sight." The
2.5GHz spectrum utilized by MMDS wireless cable was initially allocated by the
FCC to applicants other than MMDS operators within a given market, with 20 of
the available channels generally allocated to educational institutions. As a
result, MMDS wireless operators have had difficulty acquiring or leasing the
critical mass of channels required to offer a diverse programming lineup.
Moreover, absent digital compression technology, channel capacity is limited to
33 analog channels.
Local Multipoint Distribution Service. The FCC has recently issued rules
reallocating the 28GHz band to create a new video programming delivery service
referred to as local multipoint distribution service ("LMDS"). The FCC also has
issued a license for the New York City market for one operator that is
developing a system to utilize the 28GHz frequency for pay television. As
currently proposed, LMDS would provide a single licensee up to 1000 MHz of
spectrum for the distribution of programming in each prescribed geographic area.
LMDS systems, like MMDS, will use point-to-multipoint microwave distribution for
wireless cable services. Unlike MMDS, however, LMDS systems, using the proposed
allocation in the 28 GHz band will be able to provide channel capacity equal or
greater to that of most cable systems, including the Company's. In addition,
LMDS systems that would allow subscriber-to-hub transmissions to facilitate the
provision of interactive services and telecommunications have been proposed.
SMATV Systems. The largest number of private cable companies are operators of
SMATV systems. Like the Company, these systems offer a multichannel television
service pursuant to rights of entry with MDU owners. Where the Company has
introduced or will introduce 18GHz systems, the Company competes with SMATV
systems on the basis of (i) larger channel offerings (typically SMATV offers 33
to 45 channels), (ii) the quality of its video programming delivery, (iii)
customer service, and (iv) the perceived high price of SMATV relative to the
programming package provided. The Company may acquire additional SMATV
operations with a view to converting them, where feasible, to 18GHz technology,
adding channels and upgrading customer and field service.
Direct Broadcast Satellite. DBS systems involve the transmission of encoded
video programming direct from a satellite to the home user without any
intermediate processing or retransmission by a terrestrial operator. Although
prices have been decreasing, DBS service typically requires the purchase of
equipment and installation fees which are a significant cost to the subscriber.
In addition, subscribers generally pay a monthly programming fee to receive DBS
service. Some of these fees are lower than those charged by the Company before
consideration of the equipment costs. However, the Company believes that it can
effectively compete with DBS systems in the MDU marketplace for the following
reasons. First, DBS line-of-sight problems are significant (unless an entire
MDU is connected to the service) because a DBS antenna must be pointed in the
proper direction to receive video programming from the satellite. In
16
addition, most MDU owners prohibit the placement of individual antennas on their
property by MDU residents. Perhaps more importantly, other than in so-called
"white areas" of the country (generally rural locations without either cable
television service or good reception of over-the-air broadcast programming), DBS
operators are presently not permitted to retransmit network or local
broadcasting programming. Certain DBS operators have announced "MDU programs"
which generally consist of either (i) paying commissions to a local satellite
dish dealer who has, at its own expense, overbuilt an MDU or (ii) billing MDU
owners for the service on a bulk basis. The Company's Rights of Entry currently
prohibit an MDU owner from allowing a DBS system to be installed at the MDU.
OpTel does not view DBS as a major threat as, because of the frequencies that
they use, they are generally not amenable to MDU installation in properties of
over 100 units. However, OpTel would consider offering this service, using its
own technology, to supplement its channel lineup if there was overwhelming
demand for the product and it was a commercially viable source of programming.
Telephone Companies. The Telecommunications Act repealed the
telecommunications-cable television cross-ownership restriction, which
prohibited telecommunications companies from providing video programming
directly to subscribers in their telecommunications service areas. Several of
the RBOCs have acquired MMDS or other private cable television operators in an
effort to begin providing cable television services and several other LECs have
indicated their intent to enter the cable television market. Similarly, the
Telecommunications Act will in all likelihood result in a significant increase
in the number of companies, including CLECs, long distance carriers and wireless
telephone operators, offering local telephone service.
Many of the Company's telecommunications services compete directly with
services offered by the ILECs which currently dominate their local
telecommunications markets. These companies all have long-standing relationships
with their subscribers and have financial, personnel and technical resources
substantially greater than the Company. The Company expects to compete in this
market by (i) establishing strategic relationships with MDU owners so as to
allow the Company to market effectively to MDU residents, (ii) providing value
added, enhanced services to MDU residents, (iii) bundling its telecommunications
and cable television services, (iv) providing a high level of customer service
and responsiveness, and (v) competitively pricing its products.
Wireless Telecommunications. The Company's telecommunications services will
also compete with current and future wireless telecommunications offerings,
including those of cellular and PCS providers. Wireless telecommunications can
be sold to MDU residents without violating the Company's Rights of Entry since
wireless telecommunications do not require the use of the Company's network or
the MDUs internal wiring. The Company intends to offer all or certain of these
services, on a resale basis, directly to its subscribers and to bundle wireless
communications with the Company's other offerings.
Video Stores. Retail stores rent video cassette recorders ("VCRs") and/or
video tapes, and are a major participant in the entertainment video program
delivery industry. Videocassette rentals do not compete with cable television
operators' news, information, education and public affairs programming. Although
management does not believe that video rentals and sales have a material
competitive impact on the basic services provided by franchise, private or
wireless cable systems, the availability of movies and other programming on
videocassette has a competitive impact on the penetration rates for the
Company's premium channels and Pay-Per-View programming. The Pay-Per-View window
(i.e., the time period after which a theatrical film is released in the Pay-Per-
View market) is generally later than the corresponding home video window.
Management believes that until this Pay-Per-View window is shortened to coincide
with or precede the home video window, any rise in Pay-Per-View penetration
rates would be unlikely to come for studio produced feature films. Rather, it
would more likely come from sporting events, concerts and cable-exclusive movies
not released through theaters.
17
Off-Air Local Broadcasts. Off-air local broadcasts (e.g., ABC, NBC, CBS, Fox
and PBS affiliates and independent local stations) provide a free programming
alternative to the public. This programming generally offers MDU residents less
variety and does not include the specialized entertainment and news programming
available only on cable television. Customers who choose it over cable
television usually do so on the basis of cost. The Company currently retransmits
off-air local broadcasts to its private cable television subscribers, but its
ability to do so in the future is generally dependent upon receipt of
retransmission consents.
REGULATION
The multichannel television and telecommunication industries are subject to
extensive regulation at the federal, state and local levels. The following
summary does not purport to describe all present and proposed federal, state and
local regulations and legislation relating to the multichannel television and
telecommunications industry. Legislative and regulatory proposals under
consideration from time to time by Congress and various federal agencies, as
well as state and local franchise requirements, have in the past, and may in the
future, materially affect the Company and the multichannel television and
telecommunications industries. Additionally, many aspects of regulation at the
federal, state and local levels currently are subject to judicial review or are
the subject of administrative or legislative proposals to modify, repeal or
adopt new laws and administrative regulations and policies. Neither the outcome
of these proceedings nor their impact on the Company can be predicted at this
time. The Company believes that it is in compliance in all material respects
with all federal, state and local regulations applicable to it. In some
instances, the Company has acquired businesses that do not comply with all
regulations applicable to them and it undertakes to remediate such matters as
soon as practicable and in a manner that does not materially adversely impact
it.
TELECOMMUNICATIONS ACT OF 1996
On February 8, 1996, the President signed into law the Telecommunications Act
of 1996, (the "Telecommunications Act") which amended the Communications Act of
1934 (the "Communications Act"). The Telecommunications Act has altered, and
will continue to alter, federal, state and local laws and regulations regarding
telecommunications providers and services. The law is intended, in part, to
promote substantial competition in the marketplace for local telephone service
and in the delivery of video and other services. Although the Company believes
that certain provisions of the Telecommunications Act will help the Company
compete with ILECs, it is premature to predict the effect of the
Telecommunications Act on the multichannel television and telecommunications
industries in general or the Company in particular. In large part, the impact
of the Telecommunications Act will depend upon the outcome of various FCC rule
making proceedings to interpret and implement the Telecommunications Act,
including the FCC's First Report and Order regarding the interconnection
obligations of telecommunications carriers and litigation concerning the FCC's
implementation of the Telecommunications Act.
18
REGULATION OF CABLE TELEVISION
Certain of the Company's networks are, for regulatory purposes, deemed to be
"Cable Systems". To constitute a Cable System, a multichannel television system
must use hard-wire or fiber optic cable that makes a tangible physical crossing
or use of a public right-of-way. As a result, all Cable Systems are required to
obtain a local franchise and are subject to state and local regulation as well
as federal Cable System regulation. The Company's 18GHz networks and SMATV
systems are not considered Cable Systems and thus are not subject to local
franchising requirements and are free from most Cable System regulation. The
Company's Houston, Texas system, a portion of its Fort Worth, Texas system and
certain other small systems are regulated as Cable Systems. However, the
Company's Houston, Fort Worth and other small franchise cable television systems
are exempt from federal rate regulation and the universal service obligation,
even though they are Cable Systems, because they are subject to "effective
competition" as discussed in greater detail below.
Set forth below is a discussion of the principal laws and regulations
governing the Company's private and franchise cable television operations.
Federal Cable System Regulation
-------------------------------
The Communications Act, as amended, governs the regulation of Cable Systems.
The regulations imposed on Cable Systems include requirements to (i) obtain a
local franchise (which may require the franchisee to pay franchise fees to local
governments of up to 5% of yearly gross revenues), (ii) delete certain programs
from cablecasts, (iii) comply with certain customer service standards, (iv)
retransmit certain broadcast television programming, (v) in most circumstances,
conform subscriber service and equipment rates to applicable federal
regulations, (vi) comply with FCC equal employment opportunity ("EEO") rules and
policies, (vii) make available channels for leased-access programmers at rates
that are to be calculated on a formula established by the FCC, and (viii) offer
customer service to all buildings passed by its network. In addition, rates for
basic cable service on Cable Systems not subject to "effective competition" are
regulated by local franchising authorities. Rates for upper tier or "cable
programming services" on such systems are regulated by the FCC. The
Telecommunications Act eliminates cable programming service tier rate regulation
effective March 31, 1999, for all Cable System operators. The Company's
networks that are Cable Systems are subject to these requirements, which impose
regulatory costs and reduce the speed and flexibility with which the Company and
its Cable System competitors can respond to competitive challenges from other
video distribution technologies. The Company's Cable Systems, however, are
exempt from rate regulation because they are, the Company believes, subject to
"effective competition."
Prior to the enactment of the Telecommunications Act, Cable Systems were
deemed to be subject to "effective competition" if either: (1) fewer than 30% of
the households in the franchise area subscribe to the service of the Cable
System; (2) the area is served by at least two unaffiliated multichannel
television operators, both of which are able to provide service to at least 50%
of the households in the franchise area, and the number of households actually
subscribing to all but the largest multichannel television operator exceeds 15%;
or (3) the local franchising authority itself offers multichannel television to
at least 50% of the households in the franchise area. The Telecommunications
Act expanded the definition of "effective competition" to include situations in
which a LEC or its affiliate offers multichannel television directly to
subscribers by any means (other than direct-to-home satellite services) in the
franchise area. It is expected that this change will provide franchise cable
television operators with increased pricing flexibility as LECs begin to provide
multichannel television services. No assurance can be given that the Company
does not, or will not in the future, constitute "effective competition" to any
franchise cable television operator with which it competes.
19
Copyright Licensing. Cable Systems and private cable television systems are
entitled to federal compulsory copyright licensing privileges. In order to
obtain a compulsory copyright, such systems must make semi-annual payments to a
copyright royalty pool administered by the Library of Congress. A compulsory
copyright provides a blanket license to retransmit the programming carried on
television broadcast stations. Non-broadcast programming, often referred to as
cable channel programming, is not subject to the compulsory copyright license.
The Company purchases this copyrighted programming from program suppliers (e.g.,
ESPN), which in turn obtain rights to the programming directly from the program
copyright owner pursuant to a private negotiated agreement. Bills have been
introduced in Congress over the past several years that would eliminate or
modify the cable compulsory license. The need to negotiate with the copyright
owners for each program carried on each broadcast station in the channel lineup
could increase the cost of carrying broadcast signals or could impair the
Company's ability to obtain programming.
Must-Carry and Retransmission Consent. The Communications Act grants local
television stations the right to elect to either force local Cable Systems to
"carry" the television station free of charge (a "must carry" right) or to
prohibit Cable Systems and private cable television systems from carrying the
local television station (a "retransmission consent" right). Under the must-
carry rules, a Cable System, subject to certain restrictions, generally must
carry, upon request by the station and depending on the number of usable
activated channels on the system, all commercial television stations with
adequate signals that are licensed to the same market as the Cable System. Under
the retransmission consent rules, Cable Systems and private cable television
systems are precluded from carrying commercial broadcast stations that choose
not to exercise their must-carry rights, all "distant" commercial broadcast
stations (except for "superstations", i.e., commercial satellite-delivered
independent stations such as WTBS), commercial radio stations and certain low-
powered television stations, without obtaining those stations' explicit written
consent for the retransmission of their programming. Retransmission consent
agreements do not obviate a copyright license for the programming carried on the
broadcaster's signal. However, Cable Systems and private cable television
systems may obtain a compulsory copyright license for broadcast programming as
described above. To date, the "must carry/retransmission consent" regulations
have not had a significant impact on either the operations or profitability of
the Company. The Company has had little difficulty obtaining retransmission
consent agreements with local broadcasters. Nonetheless, there can be no
assurance that broadcasters, in some circumstances, will not withhold
retransmission consent, require excessive compensation for that consent or
impose onerous conditions thereon. Recent changes in federal law and regulation
will likely affect the conduct of the Company's private and franchise cable
television business.
Changes in the Definition of a "Cable System." Formerly, to avoid being
classified as a Cable System, private cable television systems were limited to
linking with hard wire only commonly owned or managed MDUs without crossing a
public right-of-way. The Telecommunications Act amended the definition of Cable
System such that systems which make no use of public streets or public rights-
of-way no longer are deemed to be Cable Systems, regardless of the type or
ownership of properties served by the system. Thus, for example, the Company's
private cable television systems now may serve mobile home parks and private
communities without a local franchise and free of most federal Cable System
regulations.
20
Elimination of the Telco-Cable Cross-Ownership Restriction. The
Telecommunications Act repealed the LEC cable television cross-ownership
restriction, which prohibited LECs from providing multichannel television
directly to subscribers in their telephone service areas. This change may
increase the level of competition in the multichannel television market. LECs
now have several options for entering and competing in the multichannel
television marketplace. LECs now may: (i) provide video programming to
subscribers through radio communications under Title III of the Communications
Act; (ii) provide transmission of video programming on a common carrier basis
under Title II of the Communications Act (i.e., provide a common carrier video
platform); (iii) provide video programming as a Cable System under Title VI of
the Communications Act (franchise cable); or (iv) provide video programming by
means of an "open video system." Open video systems are not required to comply
with the full panoply of federal Cable System regulation, but they are subject
to certain additional programming selection limitations. It is unclear at this
time the extent to which any of these market entry options will be used by LECs.
Rate Relief for Small Cable Operators. The Telecommunications Act
deregulated the rates charged for cable programming services in any Cable System
operated by a "small cable operator" that serves 50,000 or fewer subscribers.
The law defines a "small cable operator" as one which, in the aggregate, serves
fewer than one percent of all subscribers in the United States and which is not
affiliated with any entity with gross annual revenues in excess of $250 million.
This provision may provide increased pricing flexibility for certain of the
Company's competitors who qualify as "small cable operators."
The Uniform Rate Requirement. Prior to enactment of the Telecommunications
Act, the Communications Act generally provided that Cable Systems were required
to have a rate structure for the provision of cable service that was uniform
throughout its geographic area. The Telecommunications Act provides that this
requirement is applicable only where "effective competition" is absent. Further
the Telecommunications Act exempts from the uniform rate requirement non-
predatory bulk discounts offered to MDUs. Consequently, the franchise cable
television operators with which the Company competes now have increased pricing
flexibility with respect to MDU bulk discounts.
Program Access. The program access provisions of the Communications Act were
intended to eliminate unfair competitive practices and facilitate competition by
providing competitive access to certain defined categories of programming.
Generally, these restrictions are applicable to Cable System operators,
satellite cable programming vendors in which a Cable System operator has an
attributable interest and satellite broadcast programming vendors. The
programming access provisions prohibit these entities from charging unfair,
unreasonable or discriminatory prices for programming. Further, the programming
access provisions prohibit most exclusive dealing arrangements pursuant to which
Cable Systems obtain the exclusive right to distribute the subject programming
within their franchise areas. Such exclusive distribution arrangements have been
found to inhibit the ability of new entrants to compete in the multichannel
television market. The prohibition on exclusive contracts, however, is scheduled
to expire on October 5, 2002 unless the FCC determines, during a proceeding that
is to be conducted in 2001, that the prohibition continues to be necessary to
promote competition in the multichannel television market. The
Telecommunications Act amended the program access provisions by adding that the
provisions shall also apply to common carriers and their affiliates. Thus,
telecommunications companies entering the market will find it more difficult to
limit their competitors' access to programming.
21
Subscriber Access. The FCC has initiated a review of the rights of various
multichannel television service providers to obtain access to MDUs and other
private property. The FCC has indicated that it seeks to ensure a level
competitive playing field in the emerging multichannel television market. One
possibility raised by the FCC is the establishment of a federal mandatory access
requirement or a limit on the duration of exclusive service agreements between
MDU owners and video programming providers. In another proceeding, the FCC is
contemplating an order preempting state, local and private restrictions on over-
the-air reception antennas placed on rental properties or properties not within
the exclusive control of the viewer. Although it is open to question whether
the FCC has statutory and constitutional authority to compel mandatory access,
restrict exclusive agreements or preempt private restrictions on antennas
located on property owned or controlled by others, there can be no assurance
that it will not attempt to do so. Either such action would tend to undermine
the exclusivity provisions of the Company's Rights of Entry with MDU owners.
State and Local Cable System Regulation
---------------------------------------
Because Cable Systems use public rights-of-way, they are subject to state and
local regulation, typically imposed through the franchising process. State
and/or local officials often are involved in the franchisee selection, system
design and construction, safety, consumer relations, billing, and community-
related programming and services among other matters. Cable Systems generally
are operated pursuant to nonexclusive franchises, permits, or licenses granted
by a municipality or other state or local government entity. Franchises
generally are granted for fixed terms and in many cases are terminable if the
franchise operator fails to comply with material provisions of the franchise.
Franchising authorities are immune from monetary damage awards arising out of
regulation of Cable Systems or decisions made on franchise grants, renewals,
transfers and amendments.
Cable franchises typically contain provisions governing fees to be paid to
the franchising authority, length of the franchise term, renewal, sale or
transfer of the franchise, territory of the franchise, design and technical
performance of the system, use and occupancy of public rights-of-way and types
of cable services provided.
Although federal law contains certain procedural safeguards to protect
incumbent Cable Systems from arbitrary denials of franchise renewal, the renewal
of a cable franchise cannot be assured unless the franchisee has met certain
statutory standards. Moreover, even if a franchise is renewed, a franchising
authority may impose new requirements, such as the upgrading of facilities and
equipment or higher franchise fees. At least two states, Massachusetts and
Connecticut, have adopted legislation subjecting Cable Systems to regulation by
a centralized state government agency. There can be no assurance that other
states will not similarly adopt state level regulation.
The Company's Houston cable television franchise and its other limited cable
television franchises are subject to state and local franchise laws. Moreover,
although 18GHz private cable systems are not subject to local franchise laws,
state and local property tax and environmental laws are applicable to the
Company's business. For example, the Company has to comply with local zoning
laws and applicable covenants, conditions and restrictions when installing its
antennae and other microwave equipment.
In addition, a number of states have enacted mandatory access laws. Although
such laws differ in some respects from state to state, state mandatory access
laws generally require that, in exchange for just compensation (typically set by
statute or regulation to be as low as $1.00), the owners of rental apartments
(and, in some instances, the owners of condominiums and manufactured housing
parks) must allow the local franchise cable television operator to have access
to the property to install its equipment and provide cable service to residents
of the MDU. Such state mandatory access laws effectively eliminate the ability
of the property owner to enter into an exclusive Rights of Entry agreement with
a provider of cable or other video programming services. To the best of the
Company's knowledge, states that have enacted cable mandatory access statutes in
some form are: Connecticut, Delaware, Illinois, Kansas, Maine, Minnesota,
22
Nevada, New Jersey, New York, Pennsylvania, Rhode Island and Wisconsin. The
District of Columbia and the cities of Scottsdale and Glendale, Arizona, and
Lewisville, Texas also have adopted municipal ordinances requiring mandatory
access. However, the Company believes that the enforceability of such ordinances
is doubtful under existing judicial precedent. Florida currently has a mandatory
access statute for condominiums, but the validity of that statute has been
called into question because an identical provision of Florida law that applied
to rental properties has been held to be unconstitutional. Virginia has an anti-
compensation statute that forbids an owner of an MDU from accepting compensation
from whomever the owner permits to provide cable or other video programming
services to the property. Such a statute severely limits the ability of a cable
or other video programming provider to enter into an exclusive Right of Entry
agreement with an owner of an MDU because an owner usually is induced to enter
an exclusive agreement through financial incentives. These statutes have been
and are being challenged on constitutional grounds in various states.
The Company does not operate in any mandatory access state other than Florida
(with respect to condominiums) and Illinois. The Company has recently entered
into Rights of Entry in Nevada which is also a mandatory access state. When
operating in Illinois, the Company generally enters into bulk sales agreements
with MDU owners, whereby the MDU owner agrees to purchase cable television, at a
discount, for each unit in the MDU and provides the service to the MDU resident
as one of the amenities included in their rent.
18GHz and Private Cable Regulation
----------------------------------
In February of 1991, the FCC made 18GHz frequencies available for the point-
to-point delivery of multichannel television. The FCC exercises jurisdiction
over 18GHz microwave and other transport technologies using the radio frequency
spectrum pursuant to Title III of the Communications Act, which vests authority
in the FCC to regulate radio transmissions and to issue licenses for radio
stations. The scope, content, and meaning of existing laws, rules and
regulations governing 18GHz technology are subject to legislative, judicial and
administrative changes.
The Company's 18GHz networks must comply with the FCC's licensing procedures
and rules governing a licensee's operations. Application to use 18GHz microwave
"paths" and frequencies is made to the FCC and is subject to certain technical
requirements and eligibility qualifications. After 18GHz paths are licensed to
an applicant, the facilities must be constructed and fully operational within 18
months of the grant. The facilities must be built in strict accordance with the
terms of the granted application. Most of the Company's licenses are valid for a
period of five years from the grant date, however, new licenses are valid for
ten years from the date of grant, after which the licensee must apply to the FCC
for license renewal. License renewal is not an automatic right, although it is
routinely granted if the licensee is in substantial compliance with the FCC
rules.
Licensing procedures include (i) obtaining an engineering report confirming
that the proposed path does not interfere with existing paths and (ii) filing
FCC Form 402 which includes a statement of eligibility and use, a system diagram
and a statement regarding compliance with the frequency coordination
requirement. The entire licensing procedure requires approximately 120 days.
23
The Company does not "own" the paths and frequencies granted by the FCC.
Rather, the Company is merely licensed or permitted to "use" the frequencies.
Moreover, the rights granted to the Company to use 18GHz frequencies are not to
the complete exclusion of other potential licensees. First, the Company's rights
only extend to the 18GHz paths identified in its application as connecting the
various points in its video distribution system. Other 18GHz microwave users are
permitted to file applications and serve the same buildings as the Company (in
so far as the 18GHz licensing is concerned), but they may not interfere with an
incumbent user's licensed microwave paths. Second, the Company has no right to
the airspace over which the programming is transmitted. Obstructions could be
constructed in the line-of-sight of the microwave paths, precluding connection
of the satellite earth station with the various reception points to be served.
The 18GHz band also is authorized for use by other kinds of users, including
non-video, point-to-point microwave, mobile communications and satellite down-
link transmissions. Although sharing these frequencies is technically feasible,
it is possible that the Company will be unable to obtain licenses for these
frequencies on the paths it desires, or that it will be able to use only a
portion of the frequencies at certain locations because of pre-existing users.
Although private cable television operators are not subject to the full range
of regulation applicable to Cable Systems, they are subject to the following
federal regulations. First, private cable television operators are entitled to
the compulsory copyright license described above. Second, private cable
television operators benefit from the federal laws and regulations that require
certain programming providers to make cable programming available to all
multichannel video programming distributors on fair, reasonable and
nondiscriminatory terms. Third, as noted above, private cable television
operators are required to obtain retransmission consent from local broadcasters
in order to retransmit their signals. Finally, private cable television systems
are required to comply with the FCC's EEO rules and policies. The FCC's EEO
rules and policies require multichannel television operators to establish and
disseminate an EEO program that includes the use of recruiting sources that
serve minorities and women, and to evaluate its hiring and promotion practices
in comparison to the local labor pool. In addition, the FCC requires systems
with six or more full time employees to file an annual EEO report detailing the
system's EEO performance.
Because they are subject to minimal federal regulation, 18GHz private cable
television operators have significantly more competitive flexibility than do the
franchised Cable Systems with which they compete. 18GHz private cable television
operators have fewer programming restrictions, greater pricing freedom, and they
are not required to serve any customer whom they do not choose to serve. In
addition, with the exception of local zoning laws and regulations, state and
local authorities generally have no jurisdiction over private cable television
operators. The Company believes that these advantages help to make its private
cable television systems competitive with larger franchised Cable Systems.
23GHz Microwave Regulation
--------------------------
The Company anticipates that in the future it will use 23GHz microwave
frequencies, which are available for both private or common carrier
communications, to provide bi-directional telecommunications services. The
application and licensing procedures for authorizations to use the 23GHz
frequencies are substantially the same as those applicable at 18GHz. Although
the Company expects that 23GHz frequencies will be available on its current
paths and to meet its future needs, the Company has not commenced frequency
coordination and there can be no assurance that the Company will be able to
obtain licenses for these frequencies on the paths it desires.
24
TELECOMMUNICATIONS REGULATION
The telecommunications services provided by the Company are subject to
regulation by federal, state and local government agencies. As the Company
implements its telecommunications strategy, which includes replacing many of its
current PBX switches with networked central office switches, the Company will
increasingly become regulated as a CLEC. The FCC has jurisdiction over
interstate services, and state regulatory commissions exercise jurisdiction over
intrastate services. Additionally, local authorities may regulate limited
aspects of the Company's business, such as the use of public rights-of-way. The
following subsections summarize the local, state and federal regulations that
pertain to the Company's current and projected telecommunications services.
Shared Tenant Services
----------------------
The Company currently offers telecommunications services as an STS operator
to subscribers in Houston, Dallas-Ft. Worth, Austin, Denver and Miami-Ft.
Lauderdale. The Company offers STS services to residents of MDUs using
conventional twisted copper wire pairs to distribute telephone services within
an MDU. A PBX switch is installed at the MDU and traffic from the MDU is
transported via leased trunk lines to the LEC central office. From the LEC's
central office, local calls are routed through the LEC's network and long
distance traffic is routed to the Company's chosen long distance carrier
(currently AT&T). By providing MDU tenants with interconnection in this manner,
the STS provider (rather than the tenant) subscribes to local exchange service
from the telecommunications company, then "resells" service to the MDU tenant.
The resale of STS is subject to the terms and conditions in the tariffs of the
telecommunications company whose services it resells and to regulation by the
states in which the Company resells such services. Historically, virtually all
such telecommunications company tariffs flatly prohibited resale of local
exchange service. However, in recent years several state legislatures and Public
Utility Commissions ("PUCs") determined that resale of local exchange service is
in the public interest and have directed telecommunications companies within
their jurisdictions to allow for resale of local exchange service, opening the
way for STS operations. Moreover, the Telecommunications Act requires such
resale pursuant to interconnection agreements with the incumbent LEC. In some
states, PUCs have issued detailed regulations governing the provision of STS and
other resale services. In other jurisdictions where no formal requirements have
been adopted, most telecommunications companies have nonetheless modified their
tariffs to provide for resale of local exchange services.
The precise terms and conditions under which such resale services may be
provided varies from state to state, and from LEC to LEC, and may include
significant restrictions and limitations. These include: (i) a requirement to be
certified by the state PUC; (ii) restrictions with respect to the location and
ownership of MDUs to which STS service may be provided and the crossing of
public rights-of-way by STS operator facilities; (iii) regulations allowing
telecommunications companies to apply different local service rate structures
(e.g., measured use vs. flat rate) to STS providers and other subscribers, in
some cases lessening or even eliminating efficiencies which might otherwise be
realized through the use of the LECs' trunking facilities; (iv) regulations
providing for LEC access or rights-of-way to directly service individual
customers within an MDU; and (v) in certain states, limits or prohibitions on
resale of intrastate long distance and local service at a profit.
Of the six states in which the Company operates, none has adopted regulations
governing the provision of STS services. The California PUC has, however,
adopted informal STS "guidelines." In addition, Florida requires providers of
STS services to be certified to resell local exchange services. The Company has
applied for such certification. Other than the California "guidelines" and
Florida's certification requirement, the Company may provide STS services in
each of these six states, subject only to individual telecommunications company
tariff provisions. The tariffs of all major LECs serving these jurisdictions
provide for resale of local exchange service pursuant to varying terms and
conditions. Provision of STS service in these states in the future will be
subject to any regulations that ultimately may be adopted by state authorities,
and to changes in telephone company tariffs.
25
Competitive Local Exchange Carrier Regulation
---------------------------------------------
Recent and impending changes in federal law and regulation likely will affect
the conduct of the Company's telecommunication service business. The FCC
historically has left the regulation of the intrastate aspects of local exchange
service to the states. It has, however, exercised its jurisdiction over
interstate matters and jurisdictionally mixed matters respecting local telephone
service. The Telecommunications Act expands the FCC's authority to regulate
local exchange service and there can be no assurance that the FCC will not
exercise this authority aggressively.
State regulation of local exchange service traditionally has favored the
ILECs (principally the RBOCs and GTE). The state laws have, with the exception
of STS, generally prohibited competition in the local exchange. The
Telecommunications Act expressly preempts such prohibitions. The
Telecommunication Act declares that no state or local laws or regulations may
prohibit or have the effect of prohibiting the ability of any entity to provide
any interstate or intrastate telecommunications service. States may, however,
impose "competitively neutral" requirements regarding universal service, public
safety and welfare, service quality and consumer protection. Local authorities
may also require reasonable, competitively neutral compensation for use of the
public rights-of-way.
The Company currently offers telecommunications services in Houston as a
CLEC, but has not yet converted many of its telephone properties from STS to
CLEC services. The Company anticipates that it will, in the future,
increasingly compete in other telecommunications markets as a CLEC. For purposes
of the Telecommunications Act, CLECs and ILECs are subject to the same basic set
of requirements. However, certain additional obligations are imposed on ILECs,
but not on CLECs. Although the Company does not believe that the regulatory
burdens applicable to CLECs will have a material effect on its business, no
assurance can be given at this time regarding the extent or impact of such
regulation.
The Telecommunications Act requires all carriers, both CLECs and ILECs, to
interconnect, resell their services, provide number portability, provide dialing
parity, afford access to their poles, ducts, conduits and rights-of-way, and to
establish reciprocal compensation for the transport and termination of other
LECs' telephone traffic. All providers of telecommunications services are also
subject to the Act's requirements that they contribute to state and federal
universal service funds. ILECs are subject to certain additional requirements,
such as a duty to negotiate interconnection agreements in good faith, to
unbundle elements of their networks, to provide non-discriminatory
interconnection with their networks, to comply with specific resale obligations,
to provide notice of changes to their networks and to allow collocation of other
carriers' equipment on their premises. The Company is not, however, considered
an ILEC in any state, and is instead only subject to the obligations imposed on
CLECs.
The FCC and various state PUCs are in the process of defining the precise
contours of the requirements that will govern local exchange service in the
future. Although the Telecommunications Act sets forth certain standards, it
also authorizes the states to adopt additional regulations provided that such
regulations do not conflict with the federal standards. It is unclear at this
time how the states will respond to the new federal legislation, and what
additional regulations they may adopt. Moreover, the United States Court of
Appeals for the Eighth Circuit overturned portions of the FCC's First Report and
Order that had set forth pricing methodologies for unbundling, resale and
interconnection, and that had also set forth certain technical requirements,
such as obligations relating to quality of service and combination of unbundled
network elements. The FCC has stated that it intends to seek review of this
decision in the Supreme Court, but has not yet done so. It is not possible for
the Company to predict the outcome of these or any other proceedings relating to
the Telecommunications Act. Nonetheless, at this time it is clear that an
increasing number of service providers will be seeking to compete as CLECs in
the local exchange markets and that state and federal regulations will, to some
extent, allow for such market entry. Although
26
jurisdictional lines of authority and basic implementation issues are being
determined by the FCC and the federal courts in accordance with the statutory
provisions outlined above, several states already have begun the process of
opening the local exchange market to competition.
Most states require companies seeking to compete in intrastate
telecommunications services to be certified to provide such services. These
certifications generally require a showing that the carrier has the financial,
managerial and technical resources to offer the proposed services consistent
with the public interest. State regulation of telecommunications services may
impose upon the Company additional regulatory burdens, including quality of
service obligations and universal service contributions.
Long Distance Resale Regulation
-------------------------------
Non-dominant interexchange carriers, such as the Company, are subject to
limited federal regulation. Nonetheless, carriers are required by statute to
offer their services under rates, terms and conditions that are just, reasonable
and not unreasonably discriminatory, and to file tariffs for their international
and interexchange services. The Telecommunications Act grants the FCC explicit
authority to forbear from regulating any telecommunications service provider if
the agency determines that it would be in the public interest to do so. Pursuant
to this authority, the FCC previously determined that it would forbear from
requiring that non-dominant interexchange carriers file tariffs for their
domestic services. The U.S. Court of Appeals for the District of Columbia
Circuit, however, has stayed that decision pending court review.
As a non-dominant carrier, the Company is permitted to make tariff filings on
a single day's notice and without cost support to justify specific rates. The
FCC generally does not exercise direct oversight over cost justification and the
level of charges for service of non-dominant carriers, although it has the
statutory power to do so. The FCC has jurisdiction to act upon complaints
brought by third parties, or on the FCC's own motion, against a carrier for
failure to comply with its statutory obligations.
Foreign Ownership Restrictions
------------------------------
Section 310(b) of the Communications Act prohibits foreign controlled
companies from holding common carrier radio licenses. To allow the Company to
provide common carrier telecommunications services using its networks, in the
event that the Company decides it desires to provide such services, the Company
has assigned substantially all of its frequency licenses (the "Assigned
Licenses") to Transmission Holdings, Inc ("THI"), an entity controlled by United
States citizens. To establish the terms of the Company's continued and
unencumbered use of the Assigned Licenses, the Company has entered into a
license and services agreement pursuant to which THI has agreed to provide to
the Company all the transmission capacity it requires or may in the future
require and the Company has granted THI a non-exclusive license to use all of
the Company's facilities and related equipment, such as microwave transmitting
and receiving equipment, required to provide transmission capacity. The Company
has also obtained an option to acquire the assets or equity of THI, subject to
FCC approval.
ITEM 2: PROPERTIES
The Company's national call center and its executive, administrative and sales
offices are located in Dallas, Texas. The premises lease has a ten year term
expiring November 30, 2005, and, as of August 31, 1997, requires monthly rental
payments of approximately $50,000. The Company, by exercising an option, can
lease additional space at its current location at comparable rates. The Company
leases additional space in the cities in which it operates for its regional
offices and warehouse operations.
In October 1997, the Company purchased a building proximate to its executive
offices in Dallas, Texas. The Company intends to relocate certain
administrative functions and to install a central office switch at the building.
27
The Company owns substantially all of the cable television and
telecommunications equipment essential to its operations. The Company's major
fixed assets are cable television headends, microwave transmitters and
receivers, SMATV receivers, PBX switches and coaxial fiber optic cable. Such
properties do not lend themselves to description by character and location of
principal units. Substantially all of this equipment (other than fiber optic
cable laid under public rights of way) resides on or under the MDUs served by
the Company or in leased facilities in various locations throughout the
metropolitan areas served by the Company.
ITEM 3: LEGAL PROCEEDINGS
Except as set forth below, the Company is not a party to any pending material
legal proceedings except for those arising in the ordinary course of business.
The Company does not believe that these will have a material adverse impact on
the Company's financial condition or results of operations. The Company is
engaged in an administrative proceeding before the United States Patent and
Trademark Office ("PTO") relative to registration of the "OpTel" trademark. The
PTO found the Company's application to be allowable; however, a proceeding in
the PTO was commenced by Octel Communications Corp. ("Octel Communications") on
November 7, 1995 seeking to prevent the Company from registering the "OpTel"
trademark on the grounds that the Company's trademark is confusingly similar to
the mark used by Octel Communications in a related field and claiming that the
Company's application has procedural deficiencies. The PTO proceeding is related
solely to the Company's right to register the mark and does not have a direct
bearing on the Company's continued use of the OpTel trademark. The PTO
proceeding is in its relatively early stages and the Company is vigorously
pursuing its right to register the OpTel trademark. However, there can be no
assurance as to the outcome of the PTO proceeding. In addition, there can be no
assurance that Octel Communications or another third party will not commence an
infringement action against the Company under applicable federal or state law.
Although the Company does not believe that its use of the name "OpTel" infringes
on the trademark rights of any other person, there can be no assurance as to the
outcome of any future infringement action or that any such outcome would not
materially adversely affect the Company.
ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 4A: EXECUTIVE OFFICERS OF REGISTRANT
The following table sets forth certain information regarding the directors and
executive officers of the Company at August 31, 1997:
BOARD OF DIRECTORS
POSITION Age
-------- ---
Claude Chagnon Chairman of the Board and Director 42
Louis Brunel Director; President and CEO 56
Christian Chagnon Director 41
Pierre Fortier Director 42
Alain Michel Vice Chairman of the Board and Director 48
28
EXECUTIVE OFFICERS
POSITION Age Previous Experience
-------- --- -------------------
Louis Brunel President, CEO and Director 56 GVL, VHP
Bertrand Blanchette CFO 40 GVL, VHP
John Czapko VP, Sales 56 Metrocel Cellular
Telephone
Stephen Dube VP, Marketing and Corporate 41 GVL; Laurentian
Development Financial Inc.
Michael E. Katzenstein VP, Legal Affairs and General 38 Kronish, Lieb,
Counsel Weiner and Hellman
LLP
William Shepherd VP, New Business and Product 44 Great Lakes
Development Telecommunications
Thomas Watson VP, Engineering & Information 41 GTE Telephone
Services
Lynn Zera VP, Human Resources 50 Keystone Consulting
Claude Chagnon has served as a Director since August 1996. Since October 1996,
he has been the President and Chief Operating Officer of GVL. From January 1994
to October 1996, Mr. Chagnon was Vice Chairman of GVL. Prior to 1994, Mr.
Chagnon has held various positions at GVL and its subsidiaries including, from
May 1988 to January 1994, President of Videotron Ltee, a Canadian cable
television company and wholly-owned subsidiary of GVL. Mr. Chagnon also serves
as a Director of GVL, Tele-Metropole Inc., a Canadian broadcaster and subsidiary
of GVL, and Provigo Inc., a Canadian food retailer.
Louis Brunel has served as a Director since March 1995 and as President and
Chief Executive Officer since April 1996. Since 1988, Mr. Brunel has held
various positions at GVL and its subsidiaries, including, immediately prior to
joining OpTel, Vice-Chairman and Chief Executive Officer of Videotron Holdings
Plc ("VHP"), a recently divested UK based cable and telephone subsidiary of GVL.
While at VHP, Mr. Brunel was the chief architect of VHP's cable
television/telecommunications business. From 1988 to 1990, he served as Vice
President-Corporate Development of GVL. In addition, he served as President of
Videotron International Ltee ("VIL"), from September 1994 through December 1996.
Christian Chagnon has served as a Director since March 1997 and has been
Senior Vice President, Strategic Planning and Technology of GVL since September
1993. Prior to August 1994, Mr. Chagnon was also President of Videotron
Services Informatiques Lte. Mr. Chagnon also serves as a Director of GVL.
Pierre Fortier has served as a director of OpTel since November 1997. Mr.
Fortier was appointed a director of OpTel, as CDPQ's nominee, pursuant to a
Stockholders Agreement dated as of August 15, 1997, between VPC, the Company and
CDPQ. Since August 1997, Mr. Fortier has served as a vice president of CDPQ.
From 1990 to August 1997, Mr. Fortier served as a Vice President of Capital
d'American, a subsidiary of Caisse, and from 1990 until November 1995 as a Vice
President of Special Projects at Caisse.
Alain Michel has served as a director of OpTel since April 1997. Since July
1992, Mr. Michel has held various management positions at GVL, most recently,
since July 1994, he has been GVL's Senior Vice President and Chief Financial
Officer. Mr. Michel is also a director of Groupe Goyette Inc., a Canadian
public company which provides transportation and storage services.
Bertrand Blanchette was appointed Chief Financial Officer in September 1996.
From September 1995 to December 1996, Mr. Blanchette served as Chief Financial
Officer of VHP. From June 1994 to December 1995, he was Vice President Control
of GVL. From October 1986 to June 1994, Mr. Blanchette was Vice President
Finance of Heroux, Inc., a public manufacturer of airplane parts.
John Czapko was appointed Vice President Sales in March 1997. From September
1993 to February 1997, Mr. Czapko was Director of Indirect Distribution of
Metrocel Cellular Telephone Company ("Metrocel"). From June 1991 to September
1993, he was Director of Direct Distribution of Metrocel. Prior to that, Mr.
Czapko was Director of Spectrum Management of Primeco Personal Communications
where he helped develop and launch their new wireless PCS networks.
29
Stephen Dube served as Vice President Acquisitions and Strategic Planning for
OpTel from July 1995 to May 1997 and since that date as Vice President Marketing
and Corporate Development for OpTel. From July 1995 to March 1997, Mr. Dube
served as a Director of OpTel. From January 1992 to April 1995, Mr. Dube was
Senior Vice President of Laurentian Financial Inc., a financial services
company. From June 1986 to January 1992, he was Vice President of Alexis Nihon
Group, a real estate and venture capital company.
Michael E. Katzenstein was appointed Vice President Legal Affairs, General
Counsel and Secretary in November 1995. Prior to joining OpTel, Mr. Katzenstein
was a partner (and, prior to January 1993, an associate) at Kronish, Lieb,
Weiner and Hellman LLP. Mr. Katzenstein received his J.D. from Boston
University School of Law in 1985.
William Shepherd has been Vice President New Business and Product Development
since June 1996. From September 1994 to December 1995 Mr. Shepherd was Vice
President, Sales and marketing of Great Lakes Telecommunications Corporation
("Great Lakes") and from December 1995 until February 1996 was Chief Operating
Officer of that Company. From January 1992 to September 1994 Mr. Shepherd was
President of Continental Communications Corporation, a provider of
communications consulting and international transmission resale.
Thomas Watson was appointed Vice President Information Services in September
1996. In August 1997 he also assumed the role of Vice President of Engineering.
From January 1992 to September 1996, Mr. Watson held various positions at GTE
Telephone Operations, an ILEC, including, Group Product Manager, Group Manager
Engineering and Senior Program Manager. From June 1990 to January 1992, he was
Group Engineer Manager for GTE Government Systems Corporation, a software
developer.
Lynn Zera was appointed Vice President Human Resources in November 1995. From
July 1994 to October 1995 Ms. Zera was Executive Director of Keystone
Consulting. From July 1993 to July 1994, she was Executive Director of Human
Resources of Intellicall, Inc., a telecommunications company. From March 1978
to January 1993, she held various management and marketing positions with Oryx
Energy, a company involved with the production and exploration of oil and gas.
30
PART II
ITEM 5: MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
OpTel's common equity is privately held, 74.6% by VPC Corporation, an
indirect, wholly owned subsidiary of GVL, 16.7% by CDPQ and 8.7% by various
purchasers of the Company's Senior Discount Notes due 2005, or their
transferees.
The Company's capital stock is not registered or listed on any exchange and
there is no established market for these securities. The Company has not
declared any dividend on its capital stock and does not intend to do so in the
foreseeable future. The terms of the Indenture governing the Senior Discount
Notes prohibit the payment or declaration of dividends in cash. It is expected
that any future working capital financing will also contain similar
restrictions.
ITEM 6: SELECTED FINANCIAL DATA
The selected consolidated financial data presented below as of and for the
periods ended December 31, 1993 and 1994 and August 31, 1995, 1996 and 1997 have
been derived from the consolidated financial statements of the Company, which
consolidated financial statements have been audited by Deloitte & Touche LLP,
independent auditors. In 1995, the Company changed its fiscal year end to
August 31 to match that of its majority stockholder. As a result of the change
in fiscal year and the Company's history of growth through acquisitions the
Company's historical financial results are not directly comparable from period
to period, nor are they indicative of future results of operations in many
respects. The following information should be read in conjunction with
"Management's Discussion and Analysis of Financial Condition and Results of
Operations," "Business" and the Consolidated Financial Statements of the Company
and the notes thereto, appearing elsewhere in this Report on Form 10-K.
31
Consolidated Statements of Operations Data:
Period From
April 20, 1993 Period From
(Date of January 1,
Inception) To Year Ended 1995 To August Year Ended Year Ended
December 31, December 31, 1994 31, 1995 August 31, August 31,
1993 1996 1997
($ thousands)
Revenues:
Cable Television $ 12 $ 240 $ 8,782 $ 25,893 $ 36,915
Telecommunications - 202 788 1,712 2,921
Total Revenues 12 442 9,570 27,605 39,837
Operating Expenses:
Cost of services 6 470 4,557 11,868 19,202
Customer support, general 304 7,733 12,055 19,636 28,925
and administrative
Depreciation and 8 117 2,420 8,676 14,505
amortization
Total Operating Expenses 318 8,320 19,032 40,181 62,633
Loss From Operations (306) (7,878) (9,462) (12,576) (22,796)
Other Income (Expense):
Interest expense on
stockholder note (1) - - (919) (5,342) (15,204)
Other interest expense (1) (1) (76) (349) (657) (16,210)
Interest and other income - 10 100 145 5,675
Loss Before Income Taxes (307) (7,944) (10,630) (18,430) (48,535)
Income Tax Benefit (2) - - 469 - -
Net Loss (307) (7,944) (10,161) (18,430) (48,535)
Loss per share (3) (6.89) (8.30) (19.98)
Cash dividend declared - - - - -
FINANCIAL DATA:
Net cash flows used in
operating activities (183) (3,332) (3,494) (452) (15,935)
Net cash flows used in
investing activities (517) (10,576) (72,144) (72,037) (143,126)
Net cash flows provided by
financing activities 741 18,886 72,655 72,131 244,688
EBITDA (4) (298) (7,761) (7,042) (3,899) (8,291)
Capital Expenditures (5) 517 9,278 22,170 62,121 71,506
(1) Interest expense is reported net of interest capitalized in property, plant
and equipment.
(2) The Company had no taxable income for the periods reported. The Company
reported an income tax benefit in the eight months ended August 31, 1995 due to
the reduction of a deferred tax liability established as the result of an
acquisition.
(3) Loss per share is not presented for the periods the Company was organized
as a partnership.
(4) EBITDA represents earnings before interest expense, income tax benefits,
depreciation and amortization. EBITDA is not intended to represent cash flow
from operations or an alternative to net loss, each as defined by generally
accepted accounting principles. The Company believes that EBITDA is a standard
measure commonly reported and widely used by analysts, investors and other
interested parties in the cable television and telecommunications industries.
Accordingly, this information has been disclosed herein to permit a more
complete comparative analysis of the Company's operating performance relative to
other companies in the industry.
(5) Capital expenditures include expenditures on property, plant and equipment
together with intangible assets excluding acquisitions.
32
Operating and Other Data:
-------------------------
AUGUST 31,
-------------------------------------------------------------
1995 1996 1997
------------------- ------------------- -------------------
Cable
Units under contract (1) 173,324 241,496 295,149
Units passed (2) 170,336 225,433 254,032
Subscribers 75,944 114,163 132,556
Penetration (3) 44.6% 50.6% 52.2%
Pay to Basic ratio (4)
Avg. Monthly Revenue/Subscriber (5) $ 22.8 $ 22.7 $ 24.9
Telephone
Units under contract (1) 10,322 20,945 39,831
Units Passed (2) 9,116 12,364 16,572
Subscribers 2,207 4,080 6,825
Lines (6)
Penetration (7) 24.2% 33.0% 41.2%
Avg. Monthly Revenue/Subscriber (5) -- $ 45.4 $ 44.7
1. Units under contract represent the number of units currently passed and
additional units with respect to which the Company has entered into Rights of
Entry for the provision of cable television and telecommunications services,
respectively, but which the Company has not yet passed and which the Company
expects to pass within the next five years. At this time substantially all
units under contract for telecommunications are also under contract for cable
television.
2. Units passed represents the number of units with respect to which the Company
has connected its cable television and telecommunications systems,
respectively. The difference between units under contract and units passed
represents units for which Rights of Entry have been entered into, but which
are not yet connected and activated for cable television and
telecommunications services, respectively.
3. Basic penetration is calculated by dividing the total number of basic
subscribers at such date by the total number of units passed.
4. Pay-to-basic ratio is calculated by dividing the total number of premium
units subscribed for by the total number of basic subscribers.
5. Represents revenues per average monthly subscriber for the fiscal periods
ended as of the date shown. Information with respect to the
telecommunications business for the period ended August 31, 1995 is not
available.
6. Lines represent the number of telephone lines currently being provided to
telecommunications subscribers. A telecommunications subscriber can subscribe
for more than one line.
7. Penetration is calculated by dividing the total number of telecommunications
subscribers at such date by the total number of units passed.
33
ITEM 7: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Set forth below is a discussion of the financial condition and results of
operations of the Company for the eight month period ended August 31, 1995 and
for the fiscal years ended August 31, 1996 and 1997. This discussion should be
read in conjunction with the Consolidated Financial Statements and notes thereto
appearing elsewhere in this Form 10-K.
Overview
The Company was founded in April 1993 to build, acquire and operate private
cable television systems. Since inception, the Company has experienced
substantial growth. This growth has been achieved through acquisitions of other
operators, many of which were SMATV systems, and the negotiation by the Company
of new Rights of Entry. Since inception, the number of units under contract for
cable television increased to 295,149 at August 31, 1997. In general, the
conduct of the acquired operations prior to acquisition was materially different
than following acquisition. Among the changes made in many of the businesses
after acquisition were (i) the commencement of conversion of SMATV systems to
18GHz or fiber optic networks; (ii) providing customer service from a more
advanced national call center in Dallas; (iii) increasing the number of
programming channels; (iv) improving technical and field service and system
reliability; and (v) in some cases, offering telephone services. Substantially
all of the SMATV systems acquired by the Company are being converted to 18GHz or
fiber optic networks, a process which is expected to be substantially complete
by the end of fiscal 1999. Currently the Company's networks provide cable
television services to over 150,000 units representing approximately 60% of the
units passed for cable television. In addition, the Company is rolling out
telecommunications offerings in its markets and expects to offer
telecommunications services in substantially all of its markets by the end of
calendar 1999. In 1995, the Company changed its fiscal year end to August 31 to
match that of its majority stockholder. As a result, the Company's historical
financial results are not directly comparable from period to period, nor are
they indicative of future results of operations in many respects. All of the
Company's acquisitions have been accounted for by the purchase method of
accounting.
The Company earns substantially all of its cable television revenues from
monthly customer fees for basic, premium and ancillary services. Substantially
all of its telecommunications revenues are earned from monthly fees for line
rental and toll usage.
Through August 31, 1997, the Company had invested approximately $258 million
primarily in its cable television and telecommunications systems. The Company's
revenues have grown from $0.4 million for the year ended December 31, 1994 to
$39.8 million for fiscal 1997. Results of operations for fiscal 1997 include
negative EBITDA of $(8.3) million as compared with $(3.9) fiscal 1996. EBITDA
represents earnings before interest expense, income tax benefits, depreciation
and amortization.
EBITDA is not intended to represent cash flow from operations or an
alternative to net loss, each as defined by generally accepted accounting
principles. The Company believes that EBITDA is a standard measure commonly
reported and widely used by analysts, investors and other interested parties in
the cable television and telecommunications industries. Accordingly, this
information has been disclosed herein to permit a more complete comparative
analysis of the Company's operating performance relative to other companies in
the industry.
34
While pursuing its investment and development strategy, the Company incurred
and continues to incur substantial up-front operating expenses for sales
(including obtaining Rights of Entry), customer operations, administration and
maintenance of facilities, general and administrative expenses and depreciation
and amortization in order to solicit and service customers in advance of
generating significant revenues. As a result of these factors, the Company has
generated operating losses of $22.8 million, $12.6 million, and $9.5 million for
fiscal 1997, fiscal 1996, and the eight months ended August 31, 1995
respectively, as its cable television and telecommunications customer base has
grown. The Company reported negative EBITDA of $(8.3) million, $(3.9) million,
and $(7.0) million for fiscal 1997, fiscal 1996 and the eight months ended
August 31, respectively. The Company expects that the significant expenses to
be incurred as it implements its telecommunications roll out strategy will
adversely effect EBITDA for a significant period of time. Once the buildout of
the telecommunications networks and conversion of SMATV systems is completed,
the Company expects that the incremental costs associated with the addition of
new customers in its existing markets will be principally limited to marketing
and, to a lesser extent, to customer service, and, therefore, that its EBITDA
will improve significantly. Although the Company believes that its investment in
networks will result in operating efficiencies, the Company has accumulated
insufficient post-network conversion operating data to meaningfully compare
pre-and post-conversion costs. There can be no assurance that the Company will
generate positive EBITDA in the future.
The principal operating factors affecting the Company's future results of
operations are expected to include (i) changes in the number of MDUs under
Rights of Entry, (ii) penetration rates for its services, (iii) the terms of its
arrangements with MDU owners, including revenue sharing, (iv) the prices that it
charges its subscribers, (v) normal operating expenses, which in the cable
television business comprise principally programming expenses and in the
telecommunications business comprise principally fees paid to long distance
carriers, the cost of trunking services and other LEC charges, as well as, in
each case, billing and collection costs, technical service and maintenance
expenses and customer support services, and (vi) capital expenditures as the
Company implements its telecommunication roll out strategy and completes its
conversion of SMATV systems. The Company's results of operations may also be
impacted by future acquisitions. The Company has typically acquired businesses
that are private companies owned by entrepreneurs and without the same
regulatory compliance practices and internal accounting controls and procedures
of the Company. Accordingly, the Company frequently is required to take remedial
actions, which may include the expenditure of funds and may take extensive time
to implement. In general, the Company factors the costs associated with these
matters into the terms of its acquisitions, including, where practicable through
indemnification rights. However, there can be no assurance that the Company's
results of operations or liquidity would not be affected by these or other
matters arising from past or future acquisitions.
The Company anticipates that it will continue to have higher churn than is
typical of a franchise cable television operator due to the frequent turnover of
MDU tenants. This churn generally does not result in a reduction in overall
penetration rates since the outgoing subscriber is often quickly replaced by a
new tenant in his or her unit. This may result in average installation revenue
per subscriber that is higher than for a franchise cable television operator.
Although this may also require higher installation expenses per subscriber,
because of the layout of MDUs and the Company's ability to obtain "permission to
enter" from the MDU owner, installations can often be completed when the
subscriber is not home, limiting the expense of installation. Accordingly, the
Company does not believe that churn is as significant an operating statistic as
would be the case for franchise cable television operators.
35
FISCAL YEAR ENDED AUGUST 31, 1997 COMPARED TO FISCAL YEAR ENDED AUGUST 31, 1996
TOTAL REVENUES. Total revenues for the fiscal year ended August 31, 1997
("fiscal 1997") increased by $12.2 million or 44% to $39.8 million compared to
revenues of $27.6 million for the fiscal year ended August 31, 1996 ("fiscal
1996").
CABLE TELEVISION. Compared to fiscal 1996 cable television revenues increased
by $11.0 million, or 42%, to $36.9 million from $25.9 million, reflecting both a
16% increase in the number of customers and a 10% increase in the average
monthly revenue per customer which rose from $22.7 in fiscal 1996 to $24.9 in
fiscal 1997. The increase in revenue per customer resulted from a combination
of rate increases following property upgrades and increased premium revenues as
the Company's pay to basic ratio improved from 53% to 64% over the course of the
year. The Company continued to grow basic penetration which increased by 1.6
percentage points over the year.
TELECOMMUNICATIONS. The Company's strategy is to roll out a residential CLEC
service in each of the major markets in which it operates. Until recently the
Company served certain properties as an STS provider, reselling telephone
service using PBXs situated at the MDU properties. The Company has not
historically promoted such STS service because it was not in line with its
strategy to offer a central office facility to its customers. Despite not
promoting telecommunications services during the year, telecommunications
contributed $2.9 million of revenue compared to $1.7 million in the preceding
year, mainly as a result of an increase in customers (from improved penetration
which rose from 33% to 41% over the year) and a 34% increase in the number of
units where telephone service is offered from 12,364 to 16,572. Average monthly
revenues per customer declined over the period from $45.4 in fiscal 1996 to
$44.7 in fiscal 1997. The decline is largely due to aggressive pricing in the
last quarter of the fiscal year in order to coincide with the launch of its
Houston switch. This aggressive pricing includes certain limited discounted
local calling plans which are intended to be offered for a short time period
only. Accordingly, the Company does not consider the current level of revenue
per customer to be indicative of the level of revenue per customer it expects to
earn following the introduction of its own switches which are rich in enhanced
features and permit much more sophisticated call billing.
COST OF SERVICES. Overall, gross margins decreased over the year from 57.0% to
51.8%, largely due to costs associated with the increase in the number of
customers served by PBX telephone service, to the increase in premium cable
penetration which has lower associated margins and an increase in the proportion
of the Company's portfolio under revenue sharing arrangements with property
owners. The PBX costs represent the costs of interconnecting individual
properties with the switch of the incumbent ILEC and will be removed once the
Company is able to utilize its own networks in order to pass telephone traffic
to its central office switches. Consequently the Company expects gross profit
margins to improve once its central office switches are employed to serve
telephone customers.
EXPENSES. Expenses (customer support, selling, general and administrative
expenses) were $28.9 million for the year compared to $17.3 million in fiscal
1996. The increase in expenses was in line with the Company's budget and was
largely due to an increase in personnel associated with the expansion of the
Company's operations and recruitment for the roll out of the Company's
telecommunications services in advance of the expected revenues. In addition
the Company incurred a one time reorganization charge of $1.4 million associated
with the restructuring of certain senior management positions during the year
which was included in customer support, selling, general and administration
expense in fiscal 1997.
36
EBITDA. The Company's negative EBITDA increased from $(3.9) million to $(8.3)
million over the year, largely due to the reduced gross margins and the
expansion of the Company's operations in anticipation of the roll out of
telecommunications services. The increase in negative EBITDA was largely within
expectations given that the Company increased its personnel in the middle of
fiscal 1997 in anticipation of two significant events that eventually occurred
after the end of the fiscal year due to matters beyond the control of the
Company's management - the launch of the Houston central office switch and the
consummation of the Phonoscope transaction in Houston.
FINANCING. Interest expense (net of interest income and amounts capitalized)
was $(25.7) million for fiscal 1997, an increase of $19.9 million over net
interest expense of $(5.8) million in fiscal 1996, reflecting the increase in
the Company's debt incurred principally to fund the build out of its network.
Notes payable and long-term obligations and convertible notes to shareholders
amounted to $351.2 million at August 31, 1997 compared to $91.9 million at
August 31, 1996.
FISCAL YEAR ENDED AUGUST 31, 1996 COMPARED WITH EIGHT MONTHS ENDED AUGUST 31,
1995
TOTAL REVENUES. Revenues were $27.6 million for fiscal 1996, an increase of
188% over revenues of $9.6 million for the eight months ended August 31, 1995.
Of the revenues generated in fiscal 1996, 93.8% and 6.2% represented revenues
from cable television and telecommunications, respectively, compared to 91.8%
and 8.2%, respectively, for the eight months ended August 31, 1995.
CABLE TELEVISION. Cable television revenues were $25.9 million for fiscal
1996, an increase of 194%, over cable television revenues of $8.8 million for
the eight months ended August 31, 1995. The growth was attributable in part to
an increase in the average number of cable television subscribers, which
accounted for approximately $15.6 million of the increase. Cable television
revenues also grew in part from an increase in the retail price of the Company's
cable television services which accounted for approximately $1.5 million of the
increase.
TELECOMMUNICATIONS. Telecommunications revenues were $1.7 million for fiscal
1996, an increase of 113%, over the eight months ended August 31, 1995. This
growth was largely due to an increase in the average number of
telecommunications subscribers.
COST OF SERVICES. Cost of services were $11.9 million for fiscal 1996, an
increase of 159%, from $4.6 million for the eight months ended August 31, 1995.
The increases in costs were primarily attributable to the growth in the number
of cable television subscribers and telecommunications lines. Gross margins
increased from 52.4% for the eight months ended August 31, 1995 to 57.0% for
fiscal 1996.
EXPENSES. Expenses (customer support, selling, general and administrative
expenses) increased to $17.3 million from $8.2 million, or 111%, over the eight
months ended August 31, 1995. The increase was largely due to an increase in
personnel associated with the expansion of the Company's operations and the
rapid growth in the size of the cable television and telecommunications networks
and the number of subscribers.
The Company incurred $2.3 million for fiscal 1996 and $3.8 million for the
eight months ended August 31, 1995, related to the costs of assimilating the
acquisitions made by the Company and include severance, relocation and
recruitment costs.
EBITDA. Negative EBITDA increased to $(3.9) million for fiscal 1996. The
improvement in negative EBITDA represents an increase of $3.1 million over
negative EBITDA of $(7.0) million for eight months ended August 31, 1995.
Negative EBITDA represented (14.1)% of total revenues for fiscal 1996 compared
to (73.6)% of total revenues for the eight months ended August 31, 1995.
37
EIGHT MONTHS ENDED AUGUST 31, 1995
TOTAL REVENUES. Revenues were $9.6 million for the eight months ended August
31, 1995, an increase of $9.2 million over revenue of $0.4 million for the year
ended December 31, 1994. Of the revenues generated in the eight months ended
August 31, 1995, 91.8% and 8.2% represented revenues from cable television and
telecommunications, respectively, compared to 54.3% and 45.7% respectively, for
the year ended December 31, 1994.
CABLE TELEVISION. Cable television growth was primarily attributable to an
increase in the average number of cable television subscribers.
TELECOMMUNICATIONS. Telecommunications revenue growth was primarily due to an
increase in the average number of telecommunications subscribers.
COST OF SERVICES. Cost of services were $4.6 million for the eight months
ended August 31, 1995, an increase of $4.1 million from $0.5 million for the
year ended December 31, 1994. These expenses represent variable costs of the
Company, including programming, interconnection costs and revenue sharing with
property owners. Their increase was primarily attributable to the growth in the
number of cable television subscribers and telecommunications lines. Gross
margins increased from negative (6.4)% for the year ended December 31, 1994 to
52.4% for the eight months ended August 31, 1995.
EXPENSES. Customer support, selling, general and administrative expenses were
$8.2 million for the eight months ended August 31, 1995, an increase of 6.5%
over the year ended December 31, 1994. The increase was largely due to an
increase in personnel associated with the expansion of the Company's operations
generated primarily by the acquisition of private cable companies in five
markets and the rapid growth in the size of the Company's cable television and
telecommunications networks and the number of subscribers.
The Company incurred reorganization costs of $3.8 million for the eight month
period ended August 31, 1995, related to the costs of assimilating the
acquisitions made by the Company and include severance, relocation and
recruitment costs.
EBITDA. Negative EBITDA increased to ($7.0) million for the eight months
ended August 31, 1995. The improvement in negative EBITDA represents an
increase of $.8 million over negative EBITDA of $(7.8) million for the year
ended December 31, 1994. Negative EBITDA represented (73.6)% of total revenues
for the eight months ended August 31, 1995.
The Company recorded an income tax benefit of $0.5 million for the eight
months ended August 31, 1995 which was the result of the reduction of a deferred
tax liability no longer required due to increased tax losses being available. No
income tax expense was recorded for the year ended December 31, 1994.
LIQUIDITY AND CAPITAL RESOURCES
The Company has generated net losses since its inception, resulting in an
accumulated deficit of $77.3 million as of August 31, 1997. During the past
year, the Company has required external funds to finance capital expenditures
associated with the completion of acquisitions in strategic markets, expansion
of its networks and operating activities. Net cash used in acquisitions and
capital expenditures was $72.1million during the period ended August 31, 1995,
$72.0 million in fiscal 1996 and $78.2 million in fiscal 1997.
38
Since inception, the Company has relied primarily on investments from its
principal stockholder in the form of equity and convertible notes to fund its
expenditures. The Company received net funding from its principal stockholder of
$23.7 million in fiscal 1997, $73.4 million during fiscal 1996, $79.5 million
during the eight months ended August 31, 1995 and $15.0 million during the year
ended December 31, 1994. None of the Company's stockholders or affiliates are
under any contractual obligation to provide additional financing to the Company.
In February 1997 the Company issued $225 million of 13% Senior Notes due 2005
(the "Senior Notes"). Interest on the Senior Notes is payable bi-annually in
February and August of each year. Approximately $79.6 million of the net
proceeds under the Senior Notes was placed into escrow to cover interest
payments for the first six periods. The Senior Notes are unsecured liabilities
of the Company and may be prepaid early subject to early redemption penalties
customary for such offerings. In addition, the Indenture governing the Senior
Notes contains certain customary covenants which, amongst other things, limit
the ability of the Company to raise additional unsecured debt before certain
performance related criteria are achieved and prevent the declaration or
distribution of cash dividends.
In connection with the issuance of the Senior Notes VPC agreed (i) to extend
the maturity of their Convertible Notes until six months following the maturity
or indefeasible payment in full of the Senior Notes and (ii) to subordinate the
Convertible Notes in right of payment to the Senior Notes in the event of a
liquidation, dissolution, reorganization, receivership or winding-up of the
Company and in the event of a Default or Event of Default (each as defined under
the indenture) or when the maturity of the Notes has been accelerated.
On October 13, 1997, the Company received a commitment from a bank to provide
a $150 million senior secured credit facility (the "Senior Facility") which will
be used to provide capital to fund future development. The Senior Facility will
consist of a term loan and a revolving credit commitment both of which will bear
interest at interest rates customary for this type of transaction and the credit
position of the Company. The Senior Facility will be secured by a first fixed
and floating lien on substantially all of the assets of the Company.
Availability under the Senior Facility will be subject to the Company meeting
certain performance criteria. Management expects that funds will become
available under the Senior Facility in December 1997. The funding of the Senior
Facility is subject to customary no material adverse changes clauses and
terminates December 15, 1997, if not closed. Management expect that the Senior
Facility will include customary covenants that will include, amongst others,
limitations on additional indebtedness, limitations on certain payments,
investments and distributions and limitations on liens and certain asset sales.
The Company's future results of operations will be materially impacted by its
ability to finance its planned business strategies. In addition to the Senior
Facility the Company expects it will need an additional $235 million in
financing over the next five years in order to maximize its potential within its
targeted markets in the United States. A considerable proportion of OpTel's
capital expenditure requirements is scaleable dependent upon the number of ROE
contracts that the Company signs. The capital expenditure requirements will be
larger or smaller depending whether OpTel is able to achieve its expected market
share amongst the potential MDUs in its markets. The Company plans to raise
future financings from additional subordinated debt, a public equity offering
and/or private equity infusions. The foregoing estimates are based on certain
assumptions, including the timing of the signing of Rights of Entry, the
conversion of MDUs currently served by SMATV systems to the networks and the
telecommunications roll out, each of which may vary significantly from the
Company's plan. There can be no assurance that the Company will be successful
in obtaining any necessary financing on reasonable terms or at all.
39
In addition, both GVL and Caisse have the power to prevent the Company from
obtaining additional debt or equity financing. GVL is party to an indenture
which limits the aggregate amount of indebtedness which can be incurred by GVL
and its subsidiaries, including the Company taken as a whole (based upon a ratio
of total consolidated indebtedness to consolidated operating cash flow). As a
result, GVL's strategies and the operating results of its subsidiaries other
than the Company may affect the ability of the Company to incur additional
indebtedness. There can be no assurance that GVL will not restrain the Company's
growth or limit the indebtedness incurred by the Company so as to ensure GVL's
compliance with the terms of its debt instruments.
The Company benefits from the fact that it does not require a substantial
capital investment in its cable television and telecommunications networks in
advance of connecting subscribers to its networks since a significant proportion
of the costs comprises the internal wiring and the erection of microwave
transmitting and receiving equipment specific to the MDU. These expenditures
are, to a large extent, "success-based" and will only be incurred when new
properties are brought into service or when existing properties serviced by
SMATV systems are connected to the networks. When a new Right of Entry is signed
it takes approximately four months of construction work to activate signal at
the property. Once the property is activated, penetration rates increase
rapidly. The balance of the budgeted capital expenditures is for infrastructure
assets not related to individual MDUs. These assets include central office
switches, cable television headends, computer hardware and software and
capitalized construction costs. The Company can to some degree control the
timing of the infrastructure capital expenditures by controlling the timing of
the telecommunications roll out and the scope of its expansion.
In order to accelerate the achievement of the Company's strategic goals, the
Company has from time to time held, and continues to hold, preliminary
discussions relating to possible acquisitions by the Company and possible
investments in the Company by strategic investors.
RECENTLY ISSUED ACCOUNTING PRINCIPLES
Statement of Financial Accounting Standards No. 121 ("SFAS No. 121"),
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to
be Disposed Of", requires that long-lived assets and certain identifiable
intangibles to be held and used by an entity be reviewed for impairment whenever
events or changes in circumstances indicate that the carrying value of an asset
may not be recoverable. SFAS No. 121 also requires that long-lived assets and
certain identifiable intangibles to be disposed of be reported at the lower of
carrying amount or fair value less cost to sell. The Company adopted SFAS No.
121 effective September 1, 1996, and the impact of such adoption was not
significant to its financial condition and results of operations.
Statement of Financial Accounting Standards No. 123 ("SFAS No. 123"),
"Accounting for Stock-Based Compensation," issued by the Financial Accounting
Standards Board ("FASB"), requires that an employer's financial statements
include certain disclosures about stock-based employee compensation arrangements
regardless of the method used to account for them. The Company will measure
compensation costs using Accounting Principles Board Opinion No. 25, "Accounting
for Stock Issued to Employees," and will therefore include pro forma disclosures
in the notes to the financial statements for all awards granted after December
31, 1994. The Company was disclosed the pro forma net income and pro forma
earnings per share as if the fair value based accounting methods in SFAS No. 123
had been used to account for stock-based compensation cost in future financial
statement presentations.
40
Statement of Financial Accounting Standards No. 128 ("SFAS No. 128"),
"Earnings Per Share," is effective for earnings per share calculations and
disclosures for periods ending after December 15, 1997, including interim
periods, and requires restatement of all prior period earnings per share data
that is presented. SFAS No. 128 supersedes Accounting Principles Board Opinion
No. 15, "Earnings Per Share," and provides reporting standards for calculating
"Basic" and "Diluted" earnings per share. Management does not believe the impact
of the adoption of SFAS No. 128 will have a material impact on the Company's
earnings per share computations.
The FASB issued, in February 1997, SFAS No. 129, "Disclosure of Information
about Capital Structure," which establishes standards for disclosing information
about an entity's capital structure and is effective for financial statements
for periods ending after December 15, 1997.
In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income,"
which establishes standards for reporting and display of comprehensive income
and its components in the financial statements. SFAS No. 130 is effective for
fiscal years beginning after December 15, 1997.
The FASB also issued, in June 1997, SFAS No. 131, "Disclosures about Segments
of an Enterprise and Related Information," which establishes standards for the
way public companies disclose information about operating segments, products and
services, geographic areas and major customers. SFAS No. 131 is effective for
financial statements for periods beginning after December 15, 1997.
PRIVATE LITIGATION SECURITIES REFORM ACT OF 1995
This report contains forward-looking statements based on current
expectations that involve a number of risks and uncertainties. The forward-
looking statements are made pursuant to safe harbor provisions of the Private
Securities Litigation Reform Act of 1995. The factors that could cause actual
results to differ materially include the following: industry conditions and
competition, interest rates, business mix, availability of additional financing,
and the risks described from time to time in the Company's reports to the
Securities and Exchange Commission.
ITEM 8: FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The information required by Item 8 is set forth on pages F-1 through F-21 of
this Form 10-K. The Company is not required to provide the supplementary
financial information required by Item 302 of Regulation S-K.
ITEM 9: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
ITEM 10: DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information with respect to the directors and executive officers of the
Company is included as Item 4A of Part I of this form 10-K as permitted by
Instruction 3 to Item 401(b) of Regulation S-K.
41
ITEM 11: EXECUTIVE COMPENSATION
The following table sets forth certain information concerning compensation
awarded to or paid to the Company's Chief Executive Officer and the four most
highly compensated executive officers for the fiscal year ended August 31, 1997,
1996 and the period ended August 31, 1995.
Summary Compensation Table
Annual Compensation
----------------------------------------------------
Name and principal position Other Annual All other
Year/Period Salary Bonus Compensation Compensation(17)
Louis Brunel 1997 $269,623(1) $ 39,790(6) $ 26,272(11) $ --
President and Chief 1996 $ 35,095(1) $ -- $ -- $ --
Executive Officer 1995 $ -- $ -- $ -- $ --
Rory Cole (2) 1997 $163,654 $ 43,750 $ 11,240(12) $ 3,629
Vice President and Chief 1996 $175,000 $ 37,505(7) $ 18,389(13) $ 4,750
Operating Officer 1995 $102,980(2) $ 22,405(6) $ -- $ --
Michael Katzenstein 1997 $175,000 $ 57,500 $ 65,196(14) $ 2,820
Vice President Legal 1996 $135,346(3) $133,706(8) $ 10,050(15) $ 3,334
Affairs and General Counsel 1995 $ -- $ -- $ -- $ --
Bertrand Blanchette 1997 $129,702(4) $ 34,161(9) $ 4,800(15) $ --
Vice President and Chief 1996 $ -- $ -- $ -- $ --
Financial Officer 1995 $ -- $ -- $ -- $ --
Stephen Dube 1997 $119,139(5) $ 69,288(10) $ 9,226(16) $ 2,844
Vice President Marketing 1996 $ 36,542(5) $ -- $ -- $ --
and Corporate Development 1995 $ -- $ -- $ -- $ --
William Shepherd 1997 $140,000 $ -- $ -- $ 888
Vice President 1996 $ 35,000 $ -- $ -- $ --
New Product and Business 1995 $ -- $ -- $ -- $ --
Development
1. During fiscal 1996, Mr. Brunel was paid primarily by GVL. Beginning June 1,
1996, a portion of Mr. Brunel's salary was allocated to the Company. Effective
November 1, 1996, Mr. Brunel accepted the position of President and Chief
Executive Officer on a full-time basis at an annual salary of $275,000.
2. Mr. Cole commenced employment with the Company in February 1995, at an
annual salary of $175,000. Mr. Cole is no longer employed by the Company.
3. Mr. Katzenstein commenced employment with the Company in November 1995, at
an annual salary of $170,000.
4. Mr. Bertrand Blanchette commenced employment with the Company as Chief
Financial Officer in September 1996. During the period September 1996 through
December 1996, Mr. Blanchette continued to act as Chief Financial Officer of
Videotron Holdings Plc. ("VHP"), a subsidiary of GVL which was divested in
December 1996. During such period, Mr. Blanchette's salary was paid by VHP and a
portion of such salary was allocated to the Company. Mr. Blanchette commenced
full-time employment with the Company effective January 1, 1997, at an annual
salary of $150,000.
5. During fiscal 1996, Mr. Dube was paid primarily by GVL. Beginning June 1,
1996, a portion of Mr. Dube's salary was allocated to the Company. Effective
January 1, 1997, Mr. Dube accepted the position of Vice President Acquisitions
and Strategic Planning on a full-time basis at an annual salary of $145,000. He
assumed the position of Vice President Marketing and Corporate Development in
June 1997.
6. The entire amount represents relocation payments.
7. $1,005 represents relocation payments.
8. $93,706 represents relocation payments and the remainder represents a
signing bonus.
9. $29,161 represents relocation payments.
42
10. $54,288 represents relocation payments.
11. $21,680 represents an automobile allowance and the remainder represents
reimbursement of benefits paid by GVL. See 1 above.
12. $9,851 represents an automobile allowance and the remainder represents tax
reimbursements resulting from relocation.
13. $10,076 represents an automobile allowance and $8,313 represents tax
reimbursements resulting from relocation.
14. $49,823 represents tax reimbursements resulting from relocation, $10,573
represents an automobile allowance, and $4,800 represents reimbursements under
COBRA.
15. The entire amount represents an automobile allowance.
16. $5,980 represents an automobile allowance and the remainder represents
reimbursement of benefits paid by GVL. See 5 above.
17. Represents 401(k) matching funds.
Option Grants in Last Fiscal Year (1)
- - -------------------------------------------------------------------------------------------------------------------------
Potential Realized Value at Assumed Annual
Individual Grants Rates of Stock Price Appreciation for
Option Term
- - -------------------------------------------------------------------------------------------------------------------------
% of
Total
Number of Options
Securities Granted to
Underlying Options Employees
Granted in Fiscal Exercise Expiration
Name Year Price Date 5% 10%
- - -------------------------------------------------------------------------------------------------------------------------
Louis Brunel 16,034.79 18.40% $85.75 November, 2006 $758,067 $1,867,155
Bertrand
Blanchette 4,373.12 5.02% $85.75 November, 2006 $206,745 $ 509,224
Michael
Katzenstein 9,137.61 10.49% $74.42 November, 2006 $535,522 $1,167,549
Stephen Dube 3,381.88 3.88% $85.75 November, 2006 $159,883 $ 393,800
William Shepherd
3,265.27 3.75% $85.75 November, 2006 $154,370 $ 380,221
(1) Prior to Fiscal 1997, there were no other options granted.
43
ITEM 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table sets forth certain information as of August 31, 1997
regarding the beneficial ownership of OpTel's Common Stock by the owners of 5%
or more of the Common Stock and by all directors and executive officers of the
Company as a group. As of August 31, 1997, securities convertible into, or
exercisable for, approximately 1,891,404 shares of Common Stock were
outstanding, of which 1,801,367 were underlying the Convertible Notes (assuming
the conversion of the Convertible Notes on April 30, 1999 at a formula provided
in the terms of the Convertible Notes if no initial public offering of Common
Stock were to occur by such date).
Name and Address of Beneficial Owner Equity Voting
Number of Shares Percentage Percentage
Le Groupe Videotron ltee 1,923,977 74.6 81.75
300 Avenue Viger Avenue East
Montreal, Quebec, H2X3W4 (1)
Capital Communications CDPQ Inc. 429,521 16.7 18.25
1981, avenue McGill College
Montreal, Quebec, H3A 3C7
Louis Brunel (2) 4,009 0.2 0
1111 W Mockingbird Lane,
Dallas, 75247, Texas
Michael E. Katzenstein (2) 2,284 0.1 0
1111 W Mockingbird Lane,
Dallas, 75247, Texas
Stephen Dube (2) 845 0.0 0
1111 W Mockingbird Lane,
Dallas, 75247, Texas
All directors and officers as a group (12
persons) (2) 7,779 0.3 0
1. Such shares are owned by VPC, an indirect wholly-owned subsidiary of GVL.
VPC has agreed to certain restrictions on its abilities to transfer or otherwise
dispose of such shares. Andre Chagnon, the founder of GVL, indirectly controls
approximately 68% of GVL's outstanding voting rights. Pursuant to the terms of
the Stockholders Agreement between VPC, the Company and CDPQ, Caisse will have
certain rights with respect to the Company. Pursuant to a shareholders
agreement between GVL and Caisse, Caisse will have certain rights with respect
to the Company effective upon termination of the Stockholders Agreement between
VPC and CDPQ and for so long as GVL controls the Company.
2. Represents Class A Common Stock issuable upon exercise of options.
44
ITEM 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
CONVERTIBLE NOTES
The Company has financed a large portion of its capital needs by borrowing
from its majority stockholder, VPC. The Company borrowed approximately $17.8
million, $73.4 million and $23.7 million from VPC in the form of convertible
notes during the eight month period ended August 31, 1995, fiscal 1996 and
fiscal 1997, respectively (collectively, the "Convertible Notes"). As of August
31, 1997, the Company had outstanding $129.6 million of Convertible Notes
(including accrued interest). The Convertible Notes bear interest at a rate of
15% per annum, payable concurrently with the payment of principal. Interest gets
added to principal on an annual basis. In connection with the issuance of the
Senior Notes, the maturity of the Convertible Notes was extended to six months
after the final maturity of the Senior Notes and the Convertible Notes were
subordinated in right of payment to the Senior Notes.
The principal of and interest on the Convertible Notes may be converted, in
whole but not in part, at the election of VPC, into shares of Class B Common,
during the period of (i) 180 days commencing on the IPO Date and (ii) if such
180-day period shall not previously have commenced and expired, the period of 90
days commencing on April 30, 1999 (the "Conversion Date"). Subject to customary
anti-dilution adjustments, the conversion price of the Convertible Notes will be
(1) the price at which Common Stock is first sold to the public in a public
offering, provided that the product of such price and the number of shares of
Common Stock outstanding, on a fully-diluted basis (excluding shares sold in the
offering and shares issuable upon conversion of outstanding Convertible Notes)
equals or exceeds $225.0 million, or (2) if no such sale of Common Stock has
taken place on or before the Conversion Date, a price equal to the quotient of
$225.0 million divided by the number of shares of Common Stock outstanding on
that date, on a fully diluted basis (excluding shares issuable upon conversion
of outstanding Convertible Notes).
The Convertible Notes are not subject to prepayment without the consent of
VPC. Subject to the terms of the Indenture for the Senior Notes, the Convertible
Notes must be prepaid out of proceeds of any sale of debt or equity securities
of OpTel to the extent that VPC, in its sole discretion, shall require.
In the event of a liquidation, dissolution, reorganization, receivership or
winding-up of the Company, the holders of the Notes and the Trustee will be
entitled to the prior payment in full of all obligations owing under the
Indenture for the Senior Notes and the Notes before any payment whatsoever is
made on account of the Convertible Notes. In addition, no payment on account of
the Convertible Notes may be made at a time when (x) any Default or Event of
Default (each as defined under the Indenture for the Senior Notes) has occurred
or is continuing or will occur as a result of such action or (y) the maturity of
the Notes has been accelerated. Accordingly, the prepayment of the Convertible
Notes and the payment of any interest on account of the Convertible Notes will
at all times be subject to the covenants of the Indenture for the Senior Notes.
RICHEY WARRANT
In connection with the acquisition by the Company (as the assignee of
Vanguard) of certain subsidiaries of International Richey Pacific Cablevision,
Ltd. ("Richey"), Vanguard granted to Richey a warrant (the "Richey Warrant") to
purchase certain limited partnership interests in Vanguard at an exercise price
of $1.25 million, subject to adjustment. The Richey Warrant is exercisable, in
whole or in part, at any time prior to December 28, 1997. If the Richey Warrant
is not exercised, Richey may, during the 90 day period commencing on December
28, 1997, require the Company to purchase the Richey Warrant for $1.0 million,
subject to reduction (the "Put Price"). Vanguard may, at its option, repurchase
the Richey Warrant for $4.0 million, subject to adjustment. The Company has
agreed to pay Vanguard, in the event that the Richey Warrant is exercised, or
Richey, in the event that Vanguard opts to repurchase the Richey Warrant, the
Put Price.
45
VANGUARD-RELATED TRANSACTIONS
In August 1996, in connection with a negotiated settlement of certain disputes
between the Company's principal stockholders, the Company granted Vanguard a
non-transferable option (the "Vanguard Option") to purchase 48,937 shares of
Class B Common at an exercise price of $53.55 per share, subject to adjustment.
In August 1997, Vanguard sold the option to Capital Communications CDPQ who
exercised the option at the same time as acquiring the minority interest in the
Company previously held by Vanguard.
In September 1996, the Company entered into a consulting agreement with James
A. Kofalt, a former director of the Company and a limited partner of Vanguard,
pursuant to which the Company agreed to compensate Mr. Kofalt with a one time
payment of $70,000 and a per diem consulting fee of $3,500 (if such consulting
services are requested by the Company). In connection therewith, the Company
also granted Mr. Kofalt a warrant (the "Kofalt Warrant") to purchase up to
24,992 shares of Class A Common at an exercise price of $53.55 per share,
subject to adjustment. The Kofalt Warrant is presently exercisable and expires
on August 31, 1999. In the event that the Kofalt Warrant is exercised prior to
the IPO Date, the shares of Class A Common held by Mr. Kofalt will become
subject to transfer restrictions, rights of first refusal and drag along.
STOCKHOLDERS' AGREEMENT
On August 15, 1997, in connection with the sale by Vanguard of its minority
stock position in the Company to CDPQ, the Company, VPC and CDPQ entered into a
Stockholders' Agreement (the "Stockholders' Agreement"), and the Company and
CDPQ entered into a related Registration Rights Agreement (the "Registration
Rights Agreement"), under which CDPQ has certain rights and obligations relating
to the Company and VPC. CDPQ is a subsidiary of Caisse, which is a significant
minority stockholder of GVL and a party to the GVL Stockholders Agreement
described below.
Designation of Directors. Under the Stockholders' Agreement, VPC and the
Company are required while CDPQ holds at least 5% of the Company's voting stock
to take action so that CDPQ will designate a number of Directors of the Company
and each of its subsidiaries, and each committee of the Board of Directors of
the Company and each of its subsidiaries, which is proportionate (in relation
to the total number of Directors or committee members) to CDPQ's percentage
ownership of the Company's voting stock, but in no event less than one Director
and one committee member. This agreement supersedes the rights to designate a
Director of the Company previously held by Caisse pursuant to the GVL
Stockholders' Agreement, which are subject to reinstatement in the event CDPQ
ceases to be a stockholder of the Company. The following is a summary of
certain provisions of the Stockholders' Agreement and the Registration Rights
Agreement.
Approval of Certain Actions by CDPQ. Pursuant to the Stockholders' Agreement,
until the consummation of a public offering of the Company's voting Common
Stock, CDPQ has the right to approve (i) any amendment to the certificate of
incorporation or bylaws of the Company or any subsidiary; (ii) any change in the
capital stock of the Company or any subsidiary; (iii) the acquisition or
disposition by the Company or any subsidiary of assets or securities in excess
of $10 million in any single transaction or $40 million in the aggregate in any
fiscal year; (iv) the incurrence by the Company or certain subsidiaries of
indebtedness not permitted under the Indenture for the Company's Senior Notes,
including, after indebtedness under the Indenture has been satisfied, the
maintenance of other indebtedness that would violate certain financial covenants
contained in the Indenture.
46
Rights in Connection with Other Financings. Pursuant to the Stockholders'
Agreement, until the consummation of a public offering of the Company's voting
Common Stock (or earlier in certain events), VPC is obligated to cause the
Company to afford CDPQ rights equivalent to those afforded other purchasers of
the Company's capital stock to the extent they are more advantageous than the
rights held by CDPQ. Subject to certain exceptions and to termination at VPC's
request in connection with certain events, the Company is obligated to afford
CDPQ preemptive rights to purchase equity securities which the Company proposes
to sell, in ratio to CDPQ's ownership of the total outstanding equity securities
of the Company prior to the sale.
Tag Along, First Offer and Put Rights. Pursuant to the Stockholders'
Agreement, CDPQ has certain tag along rights in connection with sales by VPC of
outstanding shares of the Company's voting stock. Further, each of VPC and CDPQ
is obligated to afford the other a right of first purchase of any equity
securities of the Company which either of them proposes to sell prior to
consummation of a public offering of the Company's voting Common Stock. If a
public offering of the Company's voting Common Stock has not been consummated
prior to August 15, 2002, CDPQ has the right to sell to VPC all of the Company's
shares then owned by CDPQ, at a price equal to the fair market value of the
shares to be sold.
Registration Rights. Pursuant to the Registration Rights Agreement, after the
consummation of a public offering of the Company's voting Common Stock, CDPQ has
the right, on two occasions, subject to certain conditions, to require the
Company, at its expense, to register under the Securities Act of 1993, as
amended, shares of Common Stock held by CDPQ to permit the public offering of
such shares. In addition, CDPQ has unlimited piggyback rights to include Common
Stock held by it in registration statements filed by the Company for the sale of
its equity securities for cash, subject to certain conditions, including
customary allocation and holdback provisions.
GVL SHAREHOLDERS' AGREEMENT
Caisse, CDPQ, Sojecci Ltee and Sojecci (1995) Ltee, the principal shareholders
of GVL, and Andre Chagnon (the founder of GVL) are parties to the GVL
Shareholders' Agreement, which provides, among other things, that for so long as
GVL controls the Issuer, Caisse will be allowed to select one of GVL's nominees
to the Board of Directors of the Issuer and to have one representative on the
Audit Committee of the Issuer, subject to any prior commitments made by GVL to
other stockholders of the Issuer and certain other conditions. In addition, the
principal shareholders of GVL have agreed they shall not allow the Company to
take certain actions without the consent of Caisse, including the incurrence of
additional indebtedness or any acquisition or merger, each outside the normal
course of business, or the issuance of additional capital stock of the Issuer.
MANAGEMENT FEES
In connection with a negotiated settlement of certain disputes between the
Company's principal stockholders, in August 1996, VPC and Vanguard agreed to
provide, at the specific request of the Board, such reasonable consultant,
advisory and management services as the Company may reasonably require. The
Company is unable to determine if the aggregate fees paid to VPC and Vanguard in
connection with such services are greater than or less than the fees the Company
would be required to pay if it obtained such services from an unaffiliated third
party. The Company accrued a liability of $29,167 payable to each of VPC and
Vanguard for general consulting services, during fiscal 1996. Vanguard was paid
such amounts during fiscal 1997. In fiscal 1997, the Company accrued and paid
Vanguard $350,000 per annum (plus travel expenses) for such services and accrued
$350,000 to VPC for similar services. All such amounts have not yet been paid
to VPC. These arrangements were terminated as of August 15, 1997, the date of
the sale of the minority interest in the Company to CDPQ.
47
LICENSE HOLDING COMPANY
The Company has assigned substantially all of its frequency licenses to THI in
exchange for a $1.0 million principal amount (subject to adjustment as described
below) 8% secured promissory note due on February 14, 2007 (the "License Note").
The License Note contains covenants which restrict THI from, among other things,
incurring indebtedness other than to the Company or in the ordinary course of
business, and merging or consolidating with another entity.
The Communications Act prohibits any corporation of which more than one-fifth
of the capital stock is owned or voted by non-U.S. citizens, or any corporation
directly or indirectly controlled by any other corporation of which more than
one-fourth of the capital stock is owned or voted by non-U.S. citizens, from
holding a common carrier radio station license. GVL, the Company's principal
stockholder, is a Canadian corporation. Consequently, THI was created to permit
the Company to use the Assigned Licenses, modified as necessary, to provide
"common carrier" telecommunications services in the event that the Company
should desire to do so in the future. Russell S. Berman, Henry Goldberg and
Thomas Watson, each U.S. citizens, each own one-third of the outstanding equity
interests in THI. Mr. Watson is the Vice President of Engineering and
Information Services of OpTel. Russell S. Berman is a partner at Kronish, Lieb,
Weiner & Hellman LLP which represents both the Company and THI with respect to
various legal matters. Henry Goldberg is a partner at Goldberg, Godles, Weiner &
Wright which represents both the Company and THI with respect to certain federal
regulatory matters.
To establish the terms of the Company's continued and unencumbered use of the
Assigned Licenses, the Company and THI entered into a license and services
agreement (the "THI Agreement") pursuant to which THI has agreed to provide to
the Company all the transmission capacity it requires or may in the future
require and the Company has granted THI a non-exclusive license to use all of
the Company's facilities and related equipment, such as microwave transmitting
and receiving equipment, required to provide such transmission capacity. THI
will secure future licenses necessary to provide the Company with the
transmission capacity it requires. The THI Agreement provides for payments from
the Company to THI which are expected to approximate the monthly interest due on
the License Note plus an allowance for the anticipated expenses of THI. The
Company may also advance funds to THI to the extent necessary to enable THI to
fulfill its obligations under the THI Agreement. All amounts of such advances
will be added to the principal amount of the License Note. It is not expected
that payments made by the Company to THI will have a material impact on the
Company's cash flows or results of operations.
In connection with the above described transaction, the Company has received
an option from THI (the "THI Option") to purchase all or, in certain
circumstances, some of the assets of THI and a separate option from each
stockholder of THI (each, an "Individual Option") to purchase all of such
person's shares of capital stock of THI. The exercise price of the THI Option is
equal to the current principal amount of, plus the accrued interest on, the
License Note on the closing date, which amount may be paid by tendering the
License Note to THI plus an amount equal to the lesser of (i) book value of the
assets being purchased or (ii) the initial capitalization of THI plus 10%
premium compounded annually. The exercise price of each Individual Option is
equal to the lesser of (x) the book value of the shares being purchased and (y)
the price paid for such shares plus 10% premium compounded annually. The THI
Option and the Individual Options are exercisable at any time prior to February
14, 2007, subject to FCC approval.
48
ACQUISITION OF CERTAIN ASSETS
Effective as of July 31, 1996, the Company purchased certain assets of certain
subsidiaries of Wireless Holdings, Inc. and Videotron (Bay Area) Inc., both of
which are affiliates of VPC for an aggregate purchase price of approximately
$3.9 million. The assets represented approximately 23,000 units passed. The
operations of the acquired assets are located in the San Francisco, California
and Tampa, Florida areas. The amounts paid represented the sellers' historical
costs. At the time of the purchase, the Board of Directors of the Company
received a valuation report which estimated the fair market value of such assets
to be approximately equal to their historical cost.
INSURANCE
The Company purchases certain insurance coverage through GVL, including
directors and officers liability insurance. The Company paid an aggregate of
approximately $478,000 and $434,000 to GVL for this insurance coverage in fiscal
1996 and 1997, respectively.
PART IV
ITEM 14: EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
(a) The following documents are filed as part of this report:
1. Financial Statements. The following consolidated financial statements of
the Company and the report of the independent auditors thereon, are
included in this Form 10-K on pages F-1 through F-18:
Independent Auditor's Report
Consolidated Balance Sheets at August 31, 1997 and 1996
Consolidated Statements of Operations for the years ended August 31,
1997 and 1996, the period from January 1, 1995 to August 31, 1995 and
the year ended December 31, 1994,
Consolidated Statements of Stockholders' Equity for the years ended
August 31, 1997 and 1996, the period from January 1, 1995 to August
31, 1995 and the year ended December 31, 1994,
Consolidated Statements of Cash Flows for the years ended August 31,
1997 and 1996, the period from January 1, 1995 to August 31, 1995 and
the year ended December 31, 1994, Notes to the Consolidated Financial
Statements
49
3. Exhibits
--------
3.1 Restated Certificate of Incorporation of the Registrant, together with
all amendments thereto.*
3.2 Bylaws of the Registrant.*
3.3 Certificate of Amendment to the Restated Certificate of Incorporation
of the Registrant
4.1 Indenture, dated as of February 14, 1997, between the Registrant and
U.S. Trust Company of Texas, N.A., as Trustee.*
4.2 Form of Senior Note (included in Exhibit 4.1).*
4.3 Escrow Agreement, dated as of February 14, 1997, between the Registrant
and U.S. Trust Company of Texas, N.A., as Trustee and as Escrow Agent.
4.4 Registration Agreement, dated as of February 14, 1997, between the
Registrant, Salomon Brothers Inc. and Merrill Lynch, Pierce, Fenner &
Smith.*
4.5 Common Stock Registration Rights Agreement, dated as of February 14,
1997, between the Registrant, VPC, GVL, Salomon Brothers Inc. and
Merrill Lynch, Pierce, Fenner & Smith.*
4.6 Registration Rights Agreement, dated as of August 15, 1997, between the
Registrant and Capital Communications CDPQ Inc.
4.7 Warrant Agreement, dated as of July 11, 1997, between the Registrant
and Rory O. Cole
10.1 Stockholders' Agreement, dated as of December 22, 1994, between VPC,
Vanguard Communications, L.P. ("Vanguard"), Vanguard Communications,
Inc. ("General Partner") and the Registrant.*
10.2 Registration Rights Agreement, dated as of December 22, 1994, between
the Registrant and Vanguard.*
10.3 Settlement Agreement, dated as of August 1, 1996, between Vanguard, the
General Partner, Pacific Capital Group, Inc. ("Pacific"), VPC, the
Registrant and GVL.*
10.4 Amendment, dated as of February 17, 1997, between Vanguard, the
General Partner, Pacific, VPC, GVL and the Registrant.*
10.5 Form of Convertible Note (included as Exhibit B to the Amendment
referenced as Exhibit 10.4 hereto) and a list of the issue dates and
principal amounts of all outstanding Convertible Notes (included as
Schedule 1 to the Amendment referenced as Exhibit 10.4 hereto).*
10.6 Warrant, dated as of December 29, 1994, between International Richey
Pacific Capital Corporation and Vanguard.*
10.7 Lease Agreement dated July 25, 1995 between Space Center Dallas, Inc.
and the Registrant.*
10.8 First Amendment to Lease Agreement dated August 8, 1996 between Space
Center Dallas, Inc. and the Registrant.*
10.9 Restated Incentive Stock Plan of the Registrant.*
10.10 Annual Bonus Plan of the Registrant.*
10.11 Medium Term Performance Plan of the Registrant.*
10.12 Employment Agreement between Louis Brunel and the Registrant dated
November 15, 1996.*
10.13 Employment Agreement between Rory Cole and the Registrant dated
January 3, 1997.*
10.14 Employment Agreement between Michael Katzenstein and the Registrant
dated September 18, 1995.*
50
3. Exhibits (continued)
-------------------
10.15 Separation and Consulting Agreement, dated as of September 1, 1996,
between the Registrant and James A. Kofalt.*
10.16 Warrant Agreement, dated as of September 1, 1997, between the
Registrant and James A. Kofalt.*
10.17 Assignment Agreement, dated as of February 14, 1997, among TVMAX
Telecommunications, Inc. ("TVMAX"), Sunshine Television
Entertainment, Inc., Richey Pacific Cablevision, Inc., IRPC Arizona,
Inc. and Transmissions Holdings, Inc. ("THI").*
10.18 Equipment License and Services Agreement, dated as of February 14,
1997, between TVMAX and THI.*
10.19 Form of Shareholders Option Agreement, dated as of February 14, 1997,
between TVMAX and each of the shareholders of THI, together with a
list of the shareholders of THI.*
10.20 Option Agreement, dated as of February 14, 1997, between TVMAX and
THI.*
10.21 City of Houston, Texas, Ordinance No. 97-285 dated March 19, 1997,
granting TVMAX Communications (Texas), Inc. a temporary permit to
operate a Telecommunications Network.*
10.22 City of Houston, Texas, Ordinance No. 89-338 dated March 29, 1989
granting to PrimeTime Cable Partners I, Ltd. the right to operate for
15 years a Community Antenna Television System, and subsequent
ordinances consenting to assignment of rights to Eaglevision and to
TVMAX Communications (Texas), Inc.*
10.23 City of Houston, Texas, Ordinance No. 97-1088 dated September 3 1997,
extending the TVMAX Communications (Texas), Inc. temporary permit to
operate a Telecommunications Network (originally granted under
Ordinance 97-285).
10.24 Purchase Agreement, dated as of July 23, 1997 among the Registrant,
Phonoscope, Ltd., Phonoscope Management L.C., Lee Cook, Alton Cook
and Lee Cook Family Trust.
10.25 Amendment Number 001 to the Videotron/Lucent Agreement, dated August
28, 1997, among Videotron Telecom Ltee and Lucent Technologies Canada
Inc. and TVMAX Telecommunications Inc and Lucent Technologies Inc.
10.26 Summary of Terms and Conditions of Senior Secured Facilities between
Registrant and Goldman Sachs Credit Partners L.P.
10.27 Interconnection Agreement under Sections 251 and 252 of the
Telecommunications Act of 1996 by and between Southwestern Bell
Telephone Company and OpTel (Texas) Telecom, Inc.
11. Computation of Per Share Earnings
* Filed as an exhibit to the Registrant's registration statement on
Form S-4 filed with Securities and Exchange Commission on April 10, 1997.
(b) Reports on Form 8-K
- - ---- -------------------
A report on Form 8-K related to an event on August 14 has been filed during the
last quarter of the period covered by this report.
51
2. Financial Statements Schedules. The following financial statements schedule
of the Company for the period xx and the years ended August 31, 1996 and
1997 is included in this Form 10-K on page S-1
SCHEDULE NO. DESCRIPTION PAGE NO
----------- ----------- -------
Schedule II Valuation and Qualifying Accounts S-1
All other financial statement schedules have been omitted because they are
inapplicable or the required information is included or incorporated by
reference elsewhere herein.
3. Exhibits. The Company will furnish to any eligible stockholder, upon
written request of such stockholder, a copy of an exhibit listed below upon
payment of a reasonable fee equal to the Company's expenses in furnishing
such exhibit.
52
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.
OPTEL, INC.
-----------
By: /s/ Bertrand Blanchette
--------------------------------------------
(Signature)
BERTRAND BLANCHETTE
Chief Financial Officer
(Duly authorized officer and principal financial officer of the Registrant)
Date: November 23, 1997
53
DELOITTE &
TOUCHE LLP
- - ----------- LOGO [LETTERHEAD OF DELOITTE & TOUCHE LLP]
INDEPENDENT AUDITORS' REPORT
To the Board of Directors of
OpTel, Inc.:
We have audited the accompanying consolidated balance sheets of OpTel, Inc. and
subsidiaries (the "Company") as of August 31, 1997 and 1996 and the related
consolidated statements of operations, stockholders' equity and cash flows for
the years ended August 31, 1997 and 1996, the period from January 1, 1995 to
August 31, 1995, and the year ended December 31, 1994. These consolidated
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audits to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.
In our opinion, such consolidated financial statements present fairly, in all
material respects, the financial position of OpTel, Inc. and subsidiaries as of
August 31, 1997 and 1996 and the results of their operations and their cash
flows for the years ended August 31, 1997 and 1996, the period from January 1,
1995 to August 31, 1995, and the year ended December 31, 1994, in conformity
with generally accepted accounting principles.
/s/ Deloitte & Touche LLP
October 14, 1997
OPTEL, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
- - ---------------------------------------------------------------------------------------------------------------------------
AUGUST 31,
------------------------------
ASSETS 1997 1996
------------- -------------
CASH AND CASH EQUIVALENTS $ 87,305,069 $ 1,677,332
RESTRICTED INVESTMENTS (Notes 6 and 12) 67,206,227 -
ACCOUNTS RECEIVABLE (Net of allowance for doubtful accounts of $1,125,223 and
$542,134, respectively) 4,044,145 3,063,719
PREPAID EXPENSES, DEPOSITS AND OTHER ASSETS 1,835,503 1,561,641
PROPERTY AND EQUIPMENT, NET (Note 4) 160,441,887 103,799,650
INTANGIBLE ASSETS, NET (Note 5) 82,583,272 65,876,003
------------ ------------
TOTAL $403,416,103 $175,978,345
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
ACCOUNTS PAYABLE $ 7,926,879 $ 5,647,024
ACCRUED EXPENSES AND OTHER LIABILITIES 13,969,444 10,506,586
DEFERRED REVENUES AND CUSTOMER DEPOSITS 2,977,872 2,167,253
CONVERTIBLE NOTES PAYABLE TO STOCKHOLDER (Notes 6 and 9) 129,603,875 89,414,364
NOTES PAYABLE AND LONG-TERM OBLIGATIONS (Note 6) 221,652,973 2,443,341
DEFERRED ACQUISITION LIABILITIES (Notes 3 and 6) 6,919,914 6,520,022
------------ ------------
Total liabilities 383,050,957 116,698,590
COMMITMENTS AND CONTINGENCIES (Notes 3 and 7)
STOCKHOLDERS' EQUITY (Notes 9,10 and 13):
Preferred stock, $.01 par value; 1,000,000 shares
authorized; none issued and outstanding - -
Class A common stock, $.01 par value; 8,000,000 shares
authorized; none issued and outstanding - -
Class B common stock, $.01 par value; 6,000,000 shares
authorized; 2,353,498 and 2,304,561 issued and outstanding, respectively 23,535 23,046
Class C common stock, $.01 par value; 300,000 shares 2,250 -
authorized; 225,000 issued and outstanding
Additional paid-in capital 97,683,458 88,065,805
Accumulated deficit (77,344,097) (28,809,096)
------------ ------------
Total stockholders' equity 20,365,146 59,279,755
------------ ------------
TOTAL $403,416,103 $175,978,345
============ ============
See notes to consolidated financial statements.
-2-
OPTEL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
- - --------------------------------------------------------------------------------------------------------------------------------
PERIOD FROM
JANUARY 1, 1995 YEAR ENDED
YEAR ENDED YEAR ENDED TO AUGUST 31, DECEMBER 31,
AUGUST 31, 1997 AUGUST 31, 1996 1995 1994
----------------------------------------------------------------------
REVENUES:
Cable television $ 36,915,504 $ 25,893,401 $ 8,782,610 $ 240,193
Telecommunications 2,921,816 1,711,446 787,788 201,467
------------- ------------- ------------ -----------
Total revenues 39,837,320 27,604,847 9,570,398 441,660
OPERATING EXPENSES:
Cost of services 19,202,306 11,867,960 4,557,609 469,952
Customer support, general and administrative 28,925,629 19,636,273 12,054,671 7,732,610
Depreciation and amortization 14,505,383 8,676,262 2,420,397 117,020
------------- ------------- ------------ -----------
Total operating expenses 62,633,318 40,180,495 19,032,677 8,319,582
------------- ------------- ------------ -----------
LOSS FROM OPERATIONS (22,795,998) (12,575,648) (9,462,279) (7,877,922)
OTHER INCOME (EXPENSE):
Interest expense on convertible notes payable
to stockholder (Notes 4 and 9) (15,204,416) (5,342,208) (918,501) -
Other interest expense (16,209,932) (656,925) (349,297) (76,367)
Interest and other income 5,675,345 144,997 99,936 10,112
------------- ------------- ------------ -----------
LOSS BEFORE INCOME TAXES (48,535,001) (18,429,784) (10,630,141) (7,944,177)
INCOME TAX BENEFIT (Note 8) - - 469,502 -
------------- ------------- ------------ -----------
NET LOSS $(48,535,001) $(18,429,784) $(10,160,639) $(7,944,177)
============= ============= ============ ===========
NET LOSS PER COMMON SHARE (Notes 2 and 10) $(19.98) $(8.30) $(6.89)
============= ============= ============
WEIGHTED AVERAGE NUMBER OF COMMON SHARES
OUTSTANDING (Notes 2 and 10) 2,429,511 2,219,770 1,474,554
============= ============= ============
See notes to consolidated financial statements.
-3-
OPTEL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
- - ----------------------------------------------------------------------------------------------------------------------------------
CLASS B CLASS C
COMMON STOCK COMMON STOCK
----------------------------------------------------
PARTNERSHIP SHARES PAR SHARES PAR
CAPITAL OUTSTANDING VALUE OUTSTANDING VALUE
-------------------------------------------------------------------
BALANCE, JANUARY 1, 1994 $ 688,582 - $ - - $ -
Contributions 10,375,012 - - - -
Net Loss of Partnership - - - - -
Reorganization from partnership (11,063,594) 716,695 7,167 - -
Net loss - - - - -
------------ --------- ------- ------------ ------
BALANCE, DECEMBER 31, 1994 - 716,695 7,167 - -
Issuance of stock upon debt
conversion, net of transaction costs - 1,120,985 11,210 - -
Sale and issuance of stock - 311,652 3,116 - -
Net loss - - - - -
------------ --------- ------- ------------ ------
BALANCE, AUGUST 31, 1995 - 2,149,332 21,493 - -
Issuance of stock upon debt conversion - 171,162 1,712 - -
Contribution and cancellation of shares - (15,933) (159) - -
Net loss - - - - -
------------ --------- ------- ------------ ------
BALANCE, AUGUST 31, 1996 - 2,304,561 23,046 - -
Issuance of stock with senior notes offering - - - 225,000 2,250
Stock options exercised - 48,937 489 - -
Net loss - - - - -
------------ --------- ------- ------------ ------
BALANCE, AUGUST 31, 1997 $ - 2,353,498 $23,535 225,000 $2,250
============ =========== ======= ============= ======
ADDITIONAL
PAID-IN ACCUMULATED
CAPITAL DEFICIT
----------------------------
BALANCE, JANUARY 1, 1994 $ - $ (306,844)
Contributions - -
Net Loss of Partnership - (7,725,504)
Reorganization from partnership 3,024,079 8,032,348
Net loss - (218,673)
----------- ------------
BALANCE, DECEMBER 31, 1994 3,024,079 (218,673)
Issuance of stock upon debt
conversion, net of transaction costs 59,193,763 -
Sale and issuance of stock 16,684,540 -
Net loss - (10,160,639)
----------- ------------
BALANCE, AUGUST 31, 1995 78,902,382 (10,379,312)
Issuance of stock upon debt conversion 9,163,264 -
Contribution and cancellation of shares 159 -
Net loss - (18,429,784)
----------- ------------
BALANCE, AUGUST 31, 1996 88,065,805 (28,809,096)
Issuance of stock with senior notes offering 6,997,750 -
Stock options exercised 2,619,903 -
Net loss - (48,535,001)
----------- ------------
BALANCE, AUGUST 31, 1997 $97,683,458 $(77,344,097)
=========== ============
See notes to consolidated financial statements.
-4-
OPTEL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
- - -----------------------------------------------------------------------------------------------------------------------------------
PERIOD FROM
JANUARY 1, 1995
YEAR ENDED YEAR ENDED TO AUGUST 31, YEAR ENDED
AUGUST 31, 1997 AUGUST 31, 1996 1995 DECEMBER 31, 1994
---------------------------------------------------------------------
OPERATING ACTIVITIES:
Net loss $ (48,535,001) $(18,429,784) $(10,160,639) $ (7,944,177)
Adjustments to reconcile net loss to net
cash flow used in operating activities:
Depreciation and amortization 14,505,383 8,676,262 2,420,397 117,020
Deferred tax benefit - - (488,402) -
Noncash interest expense 15,106,854 5,661,026 1,146,713 -
Noncash interest earned on restricted investments (2,303,258) - - -
Increase(decrease) in cash from changes in
operating assets and liabilities, net of effect
of business combinations:
Accounts receivable (754,403) (1,369,646) (1,004,576) (58,300)
Prepaid expenses, deposits and other assets (785,519) (126,370) 180,363 (1,007,641)
Deferred revenue and other liabilities 640,398 906,413 894,993 164,106
Accounts payable and accrued expenses 6,190,494 4,229,678 3,517,250 5,397,128
------------- ------------ ------------ ------------
Net cash flows used in operating activities (15,935,052) (452,421) (3,493,901) (3,331,864)
------------- ------------ ------------ ------------
INVESTING ACTIVITIES:
Purchases of businesses (6,716,849) (9,916,038) (49,974,397) (1,297,818)
Acquisition of intangible assets (10,112,233) (7,903,979) (608,345) (3,210,994)
Purchases and construction of property and equipment (61,393,547) (54,217,352) (21,561,505) (6,067,215)
Purchases of restricted investments (79,609,219) - - -
Proceeds from maturity of restricted investments 14,706,250 - - -
------------- ------------ ------------ ------------
Net cash flows used in investing activities (143,125,598) (72,037,369) (72,144,247) (10,576,027)
------------- ------------ ------------ ------------
FINANCING ACTIVITIES:
Proceeds from convertible notes payable 33,700,000 73,437,817 62,823,304 15,000,000
Repayments on convertible notes payable (10,000,000) - - -
Proceeds from senior notes payable 218,000,000 - - -
Financing costs of senior notes payable (5,737,641) - - -
Proceeds from issuance of common stock 9,620,393 84 16,687,656 -
Payment on notes payable and long term obligations (894,365) (1,306,759) (6,855,767) (6,488,888)
Contributions received from partners - - - 10,375,012
------------- ------------ ------------ ------------
Net cash flows provided by
financing activities 244,688,387 72,131,142 72,655,193 18,886,124
------------- ------------ ------------ ------------
NET INCREASE (DECREASE) IN CASH
AND CASH EQUIVALENTS 85,627,737 (358,648) (2,982,955) 4,978,233
CASH AND CASH EQUIVALENTS AT
BEGINNING OF PERIOD 1,677,332 2,035,980 5,018,935 40,702
------------- ------------ ------------ ------------
CASH AND CASH EQUIVALENTS AT
END OF PERIOD $ 87,305,069 $ 1,677,332 $ 2,035,980 $ 5,018,935
============= ============ ============ ============
SUPPLEMENTAL DISCLOSURE OF CASH
FLOW INFORMATION (Notes 3 and 9)
Cash paid during the period for:
Interest $ 15,059,205 $ 289,509 $ 119,725 $ 38,836
============ ============ ============ ============
Taxes $ 2,450 $ - $ 18,900 $ -
============ ============ ============ =============
Increase in capital lease obligations $ 1,630,045 $ 878,988 $ - $ -
============ ============ ============ =============
Convertible debt issued for accrued interest $ 16,489,511 $ 6,436,131 $ - $ -
============ ============ ============ =============
Conversion of convertible debt and
partnership capital to common stock:
Partnership capital $ - $ - $ - $ (3,031,246)
============ ============ ============ =============
Convertible debt and accrued interest $ - $ (9,165,805) $(60,792,115) $ -
============ ============ ============ =============
Common stock $ - $ 1,712 $ 11,210 $ 7,167
============ ============ ============ =============
Additional paid-in capital, net of
transaction costs $ - $ 9,163,264 $ 59,193,763 $ 3,024,079
============ ============ ============ =============
See notes to consolidated financial statements.
-5-
OPTEL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- - --------------------------------------------------------------------------------
1. DESCRIPTION OF BUSINESS
OpTel, Inc., a Delaware corporation, and subsidiaries (the "Company" or
"OpTel") is the successor of the cable television operations of Vanguard
Communications, L.P. ("Vanguard"). Vanguard commenced operations in April
1993. On December 20, 1994, Vanguard contributed its cable television
operations to its wholly owned subsidiary, OpTel. The contribution to OpTel
was recorded at Vanguard's historical cost.
OpTel is a developer, operator and owner of private cable television and
telecommunications systems that utilize advanced technologies to deliver
cable television and telecommunications service to customers in multiple
dwelling units ("MDU"). The Company negotiates long-term, generally
exclusive cable television service agreements and nonexclusive
telecommunications service agreements with owners and managers of MDUs,
generally for terms of up to 15 years. The company's primary markets are
major metropolitan areas in Arizona, California, Colorado, Florida, Illinois
and Texas.
During the period from April 20, 1993 (date of inception) to March 31, 1995,
the Company was wholly owned by Vanguard. On March 31, 1995, VPC Corporation
("VPC") (a wholly owned subsidiary of Le Groupe Videotron Ltee ("Videotron")
- a Quebec corporation), acquired a 66.75% interest in the Company. At August
31, 1997, VPC's interest in the Company was 74.62% (see Note 9).
In 1995, the Company elected to change its year-end to August 31 from
December 31 to conform to that of its new majority stockholder.
2. SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION - The consolidated financial statements include
the accounts of OpTel and its wholly owned and majority-owned subsidiaries
and limited partnerships. All significant intercompany accounts and
transactions have been eliminated. Amounts due to minority limited partners
are included in notes payable and long-term obligations.
CASH AND CASH EQUIVALENTS - Cash and cash equivalents of the Company are
composed of demand deposits with banks and short-term investments with
maturities of three months or less when purchased.
RESTRICTED INVESTMENTS - Restricted investments of the Company are composed
of U.S. Treasury securities restricted for payment of interest on the
Company's Senior Notes. These investments are classified as held to maturity
and are carried at amortized cost.
PROPERTY AND EQUIPMENT - Property and equipment are stated at cost, which
includes amounts for construction materials, direct labor and overhead, and
capitalized interest. When assets are disposed of, the costs and related
accumulated depreciation are removed, and any resulting gain or loss is
reflected in income for the period. Cost of maintenance and repairs is
charged to operations as incurred; significant renewals and betterments are
capitalized. Depreciation is calculated using the straight-line method over
the estimated useful lives of the various classes of property and equipment
as follows:
-6-
Headends 15 years
Telephone switches 10 years
Distribution systems and enhancements 15 years
Computer software and equipment 4 years
Other 5 to 10 years
Management routinely evaluates its recorded investments for impairment based
on projected undiscounted cash flows and other methods and believes the
investments to be recoverable.
INTANGIBLE ASSETS - Costs associated with licensing fees, commissions and
other direct costs incurred in connection with the execution of rights-of-
entry agreements to provide cable television and telecommunications service
to MDUs, the excess of purchase price over the fair value of tangible assets
acquired and other intangible assets are amortized using the straight-line
method over the following estimated useful lives:
Goodwill 20 years
Licensing fees and rights-of entry costs Life of contract
Deferred financing costs Terms of indebtedness
Other 1 to 5 years
Management routinely evaluates its recorded investments for impairment based
on projected undiscounted cash flows and other methods and believes the
investments to be recoverable.
FEDERAL AND STATE INCOME TAXES - Prior to August 2, 1996 the Company and its
corporate subsidiaries filed a consolidated federal income tax return.
Beginning August 2, 1996, in connection with VPC acquiring additional stock
from Vanguard, the Company was included in VPC's consolidated federal income
tax return. Effective February 14, 1997, as the result of issuing Class C
common stock (see Notes 6 and 9) the Company will again be required to file a
separate consolidated federal income tax return. During the period in which
the Company was consolidated with VPC, for purposes of financial reporting,
the Company has recorded federal and state income tax as if it were filing a
separate return. Deferred tax assets and liabilities are recorded based on
the difference between the tax bases of assets and liabilities and their
carrying amounts for financial reporting purposes, referred to as temporary
differences. Provision is made or benefit recognized for deferred taxes
relating to temporary differences in the recognition of expense and income
for financial reporting purposes. To the extent a deferred tax asset does not
meet the criterion of "more likely than not" for realization, a valuation
allowance is recorded.
REVENUE RECOGNITION AND DEFERRED REVENUE - The Company recognizes revenue
upon delivery of cable television programming and telecommunications service
to subscribers. OpTel typically bills customers in advance for monthly cable
television services, which results in the deferral of revenue until those
services are provided.
COST OF SERVICES - System operating costs include programming,
telecommunications service costs, revenue sharing with owners of MDUs for
which OpTel provides cable television and/or telecommunications service, and
franchise fees.
NET LOSS PER COMMON SHARE - The computation of net loss per common share is
based on the weighted average number of common shares outstanding during the
period (see Note 10). No loss per share information is presented for the
period the Company was organized as a partnership.
-7-
The net loss per common share, assuming full dilution, is considered to be
the same as primary since the effect of the convertible notes payable to
stockholder and common stock equivalents outstanding for each period
presented would be antidilutive.
ACQUISITIONS - Acquisitions accounted for using the purchase method of
accounting include results of operations of the acquired businesses in the
accompanying consolidated financial statements from the dates of acquisition.
Identifiable tangible and intangible assets acquired and liabilities assumed
are recorded at their estimated fair value at the date of acquisition. The
excess of the purchase price over the net assets acquired is recorded as
goodwill.
USE OF ESTIMATES - The preparation of financial statements in conformity with
generally accepted accounting principles requires management to make
estimates and assumptions that affect reporting amounts of certain assets,
liabilities, revenues and expenses. Actual results may differ from such
estimates. The Company is in the initial stages of entering new markets and
acquiring or constructing the infrastructure necessary to deliver cable
television and telephony services. The Company's network upgrades and
investment in centrally switched telephony require significant investment, a
portion of which will not be recovered unless the Company's customer base
increases from current levels, as to which there can be no assurance because
of possible changes due to competition, regulatory changes, technology
changes, the ability to finance future expenditures or other unforeseen
factors. The carrying value of property, equipment, and intangible assets
will be subject to ongoing assessment.
NEW ACCOUNTING PRONOUNCEMENTS - On September 1, 1996, the Company adopted
Statement of Financial Accounting Standards ("SFAS") No. 121, "Accounting for
the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed
Of", which did not have a significant impact on the Company's results of
operations or financial position.
In February 1997, the Financial Accounting Standards Board ("FASB") issued
SFAS No. 128, "Earnings per Share," which establishes new standards for
computing and presenting earnings per share and is effective for financial
statements issued for periods ending after December 15, 1997, including
interim periods; earlier application is not permitted. The Company does not
expect the adoption of SFAS No. 128 to have a significant impact upon the
Company's reported earnings per share.
The FASB issued, in February 1997, SFAS No. 129, "Disclosure of Information
about Capital Structure," which establishes standards for disclosing
information about an entity's capital structure and is effective for
financial statements for periods ending after December 15, 1997.
In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income,"
which establishes standards for reporting and display of comprehensive income
and its components in the financial statements. SFAS No. 130 is effective
for fiscal years beginning after December 15, 1997.
The FASB also issued, in June 1997, SFAS No. 131, "Disclosures about Segments
of an Enterprise and Related Information," which establishes standards for
the way public companies disclose information about operating segments,
products and services, geographic areas and major customers. SFAS No. 131 is
effective for financial statements for periods beginning after December 15,
1997.
-8-
RECLASSIFICATIONS - Certain reclassifications of prior year amounts have been
made to conform to the current year presentation.
3. ACQUISITIONS
On December 28, 1994, the Company acquired the stock of the operating
subsidiaries of International Richey Pacific Cablevision, Ltd. ("IRPC") by
assuming approximately $15,500,000 of liabilities, issuance of a note for
$1,000,000, payment of approximately $1,300,000 in cash and issuance of a
warrant for the right to purchase an ownership interest in Vanguard. IRPC
may exercise the warrant through December 28, 1997, at a price of $1,250,000.
Upon IRPC exercising the warrant, OpTel would be required to pay Vanguard
$1,000,000. Within the exercise period, Vanguard may call the warrant at a
price of $4,000,000. Upon Vanguard calling the warrant, OpTel would be
required to pay IRPC $1,000,000. If the warrant is neither exercised by IRPC
nor called by Vanguard, within 90 days of the expiration of the exercise
period, IRPC may put the warrant to OpTel at a price of $1,000,000. The
warrant is recorded by OpTel at its obligation under either situation of
$1,000,000 at August 31, 1997. The $1,000,000 secured note payable was due
to IRPC one year after closing and was subject to adjustment based on the
actual amount of assumed liabilities. No adjustments to the recorded note
payable have been agreed to with IRPC and the note has not been paid as of
August 31, 1997. The combined amounts due to IRPC are included on the
accompanying consolidated balance sheets in deferred acquisition liabilities.
The Company, as a result of the acquisition from IRPC, is a general partner
in limited partnership investments (the "Partnerships"). The operations of
these Partnerships have been consolidated with those of the Company. The
Company has the option to purchase the interest of each limited partner at
defined amounts ranging from 110% to 140% of each limited partner's initial
capital contribution for the first four years of the partnership agreements
and is required to purchase the interests at the end of the fifth year at
150% of the initial capital contribution. From the date of initial capital
contribution until the date the Company purchases the interest of a limited
partner, each limited partner receives a guaranteed return equal to 10% per
annum of their initial capital contribution paid quarterly. During the
periods ended August 31, 1997, 1996 and 1995 OpTel paid $0, $392,403 and
$2,114,431, respectively, to repurchase certain partnership obligations (see
Note 6). The operations of the acquired subsidiaries and the partnerships are
located in the San Diego, California, and Phoenix, Arizona areas.
On January 11, 1995, the Company purchased the assets of EagleVision, a
division of Nationwide Communications, Inc. ("NCI"). The purchase price
consisted of $15,200,000 in cash, the assumption of approximately $110,000 of
liabilities and a deferred payment due to NCI of not less than $6,000,000 and
not more than $10,000,000 based on the profitability of OpTel's assets in the
Houston, Texas market with certain adjustments. This deferred payment shall
be payable at NCI's option, either (a) following the sale of all or
substantially all of the EagleVision assets or the sale of a majority of the
outstanding voting capital of the OpTel subsidiary which acquired EagleVision
assets to a third party who is not an affiliate or (b) at the conclusion of
the fifth or sixth year following the acquisition. This deferred payment is
carried on the accompanying consolidated balance sheets in deferred
acquisition liabilities at the net present value of the estimated final
payment with an accretion of interest recorded to operations. As of the date
of acquisition and as of August 31, 1997, the estimated payment due was
$6,000,000 with a net present value at August 31, 1997 and 1996 of
$4,902,662 and $4,502,770, respectively. EagleVision's operations are
located in the Houston, Texas, area.
-9-
On June 30, 1995, the Company purchased the stock of Sunshine Television
Entertainment, Inc. ("Sunshine") for $5,500,000 in cash and the assumption of
approximately $350,000 of liabilities. Sunshine's operations are located in
the Miami, Florida, area.
On July 31, 1995, the Company purchased the assets of Interface
Communications Group, Inc. and certain related entities ("Interface") for
$8,900,000 in cash and the assumption of approximately $30,000 of
liabilities. The operations of Interface are located in the Denver,
Colorado, area.
On August 31, 1995, the Company purchased the general and limited partnership
interests of Triax Associates V, L.P. ("Triax"), for $15,200,000 in cash and
the assumption of approximately $100,000 of liabilities. The operations of
Triax are located in the Chicago, Illinois, area.
On January 30, 1996, the Company purchased the assets of Telecom Master L.P.
and Telecom Satellite Systems Corporation ("Telecom") for approximately
$5,700,000 in cash and the assumption of $100,000 of liabilities. The
operations of Telecom are located in the Dallas, Texas, area.
On August 2, 1996, the Company purchased certain assets of certain
subsidiaries of Wireless Holdings, Inc., and Videotron (Bay Area), Inc.,
companies that are 50% and 80% owned and controlled by Videotron,
respectively, for approximately $3,880,000. The amount paid represents the
sellers' historical cost which also approximates the acquired assets'
estimated fair market value. The operations of the acquired assets are
located in the San Francisco, California, and Tampa, Florida, areas.
On November 12, 1996, the Company purchased the assets of Malvey Cable
Company ("Nor-Cal") for approximately $2,500,000 in cash. The operations of
Nor-Cal are located in the San Francisco, California area.
On March 14, 1997, the Company purchased the stock of Tara Communication
Systems, Inc. ("Tara") for $2,450,000 in cash and the assumption of
approximately $65,000 of liabilities. The operations of Tara are located in
the Chicago, Illinois, area.
On August 1, 1997, the Company purchased certain assets of Northgate
Communications, Inc. ("Northgate") for approximately $1,700,000 in cash. The
operations of Northgate are located in the Los Angeles and San Diego,
California, areas.
The purchase price of certain of the above acquisitions are subject to final
adjustments for such items as actual liabilities assumed and number of
customers.
The pro forma effect of the 1997 and 1996 acquisitions would have an
insignificant impact on the consolidated results of operations of the Company
for the years ended August 31, 1997 and 1996.
-10-
4. PROPERTY AND EQUIPMENT
Property and equipment consisted of the following:
AUGUST 31
------------------------------------------------------
1997 1996
---- ----
Headends $ 53,087,587 $ 32,115,973
Telephone switches 9,347,147 4,976,699
Distribution systems and enhancements 68,537,677 36,372,848
Computer software and equipment 9,511,685 4,957,123
Other 8,761,635 5,813,345
Construction in progress 26,177,788 25,434,861
------------ ------------
175,423,519 109,670,849
Less accumulated depreciation (14,981,632) (5,871,199)
------------ ------------
$160,441,887 $103,799,650
============ ============
Interest expense of $2,256,503 and $1,849,541 was capitalized during 1997
and 1996 respectively.
5. INTANGIBLE ASSETS
Intangible assets consisted of the following:
AUGUST 31
-------------------------------------------------
1997 1996
---- ----
Goodwill $ 53,081,308 $47,344,322
Licensing fees and rights-of-entry costs 30,833,231 22,173,500
Deferred Financing costs 5,783,519 -
Other 3,243,433 1,649,989
------------ -----------
92,941,491 71,167,811
Less accumulated amortization (10,358,219) (5,291,808)
------------ -----------
$ 82,583,272 $65,876,003
============ ===========
-11-
6. NOTES PAYABLE AND LONG-TERM OBLIGATIONS
Notes payable and long-term obligations consisted of the following:
AUGUST 31
-------------------------------------------------------------------
1997 1996
---- ----
13% Senior Notes Due 2005, Series B
Net of unamortized discount of $6,526,042 $218,473,958 $ -
Installment notes payable bearing interest at rates
ranging from 7.75% to 13% per annum, substantially
all collateralized by certain transportation equipment
or private cable television systems 280,059 511,145
Limited partner obligations (see Note 3) 714,333 633,134
Obligations under capital leases, net of amounts
representing interest of $581,490 and $355,236 for
1997 and 1996, respectively 2,184,623 1,299,062
------------ ----------
$221,652,973 $2,443,341
============ ==========
On February 14, 1997, the Company issued $225.0 million of 13% Senior Notes
Due 2005 ("Senior Notes"). The Senior Notes require semiannual interest
payments due on August 15 and February 15 of each year until their maturity
on February 15, 2005. The Senior Notes are redeemable at the option of the
Company generally at a premium at any time after February 15, 2002 and can
be redeemed, in part, also at a premium, earlier upon the occurrence of
certain defined events. The Senior Notes are unsecured.
In connection with the issuance of the Senior Notes, the Company issued
225,000 shares of Class C Stock. The portion of the net proceeds allocated
to the Class C stock is $7 million. Such amount has been recorded as
stockholders' equity and as a discount to the Senior Notes. As a result of
issuing the Class C stock, the Company will no longer be included in VPC's
consolidated federal income tax return.
Concurrent with the issuance of the Senior Notes, the Company was required
to deposit in an escrow account $79.6 million in cash that, together with
the proceeds from such investment, will be sufficient to pay when due the
first six interest payments on the Senior Notes. Such amount is reflected as
restricted investments on the accompanying consolidated balance sheet.
-12-
Aggregate maturities of the Company's indebtedness are as follows as of
August 31, 1997:
NOTES PAYABLE CONVERTIBLE DEFERRED
AND NOTES PAYABLE ACQUISITION
LONG-TERM TO STOCKHOLDER LIABILITIES
OBLIGATIONS (NOTE 9) (NOTE 3) TOTAL
------------------------------------------------------------------------------------------
Fiscal year
ending:
1998 $ 1,586,966 $ - $2,017,252 $ 3,604,218
1999 810,836 - - 810,836
2000 530,213 - 4,902,662 5,432,875
2001 249,090 - - 249,090
2002 1,910 - - 1,910
Thereafter 218,473,958 129,603,875 - 348,077,833
------------ ------------ ---------- ------------
Totals $221,652,973 $129,603,875 $6,919,914 $358,176,762
============ ============ ========== ============
The Company leases office space and certain equipment under operating and
capital leases. The leases generally have initial terms of 3 to 20 years.
Equipment acquired under capital leases consists of the following:
AUGUST 31
-------------------------------------------
1997 1996
---- ----
Amount of equipment under capital leases $3,068,876 $1,717,161
Less accumulated amortization (470,124) (297,548)
---------- ----------
$2,598,752 $1,419,613
========== ==========
Minimum future obligations on operating leases at August 31, 1997, consist of
the following:
Fiscal year ending:
1998 $ 2,474,431
1999 2,284,813
2000 1,880,236
2001 1,546,499
2002 1,217,934
Thereafter 3,646,401
-----------
Total minimum lease payments $13,050,314
===========
Rental expense under operating leases for the periods ending August 31, 1997,
1996 and 1995 was $2,763,000, $2,158,000 and $616,000, respectively. The
company's rental expense under operating leases includes facility rentals as
well as rental of roof top space for distribution purposes.
-13-
7. COMMITMENTS AND CONTINGENCIES
EMPLOYMENT AND CONSULTING AGREEMENTS - Employment agreements with certain
executive employees provide for separation payments ranging from 3 to 24
months of the employee's annual salary if employment is terminated due to
change of control or without cause. However, stipulations for termination
payment and payment terms vary. The Company paid or accrued approximately
$277,500, $297,000 and $1,590,000 in severance during 1997, 1996 and 1995,
respectively, related to such employment agreements.
LEGAL - The Company is a defendant in certain lawsuits incurred in the
ordinary course of business. It is the opinion of the Company's management
that the outcome of the suits now pending will not have a material, adverse
effect on the operations, cash flows or the consolidated financial position
of the Company.
8. INCOME TAXES
The cumulative losses of Vanguard incurred prior to the transfer of its
assets to the Company on December 20, 1994, have been reported in the
individual income tax returns of Vanguard's partners. Upon transfer, the
Company recorded deferred taxes for the difference between the tax and book
basis of the assets, which was not material. Upon acquisition of the stock
of the IRPC subsidiaries, a deferred tax liability of $488,402 was recorded
to recognize the excess of the basis in the assets for financial reporting
purposes over the tax basis of the net assets acquired. During the period
from January 1, 1995, to August 31, 1995, the Company accumulated losses
sufficient to offset these deferred liabilities; accordingly, a tax benefit
was recorded in the statement of operations. Additionally, during the period
ended August 31, 1995, the Company incurred $18,900 of federal and state
income tax expense.
Income tax expense (benefit) consists of the following for the years ended
August 31, 1997 and 1996 and the period from January 1, 1995 to August 31,
1995:
Current:
Federal $ - $ - $ -
State - - 18,900
------------ ----------- -----------
Total current tax expense - - 18,900
Deferred tax expense (benefit) (13,212,890) (4,470,008) (3,451,805)
Change in deferred tax valuation allowance 13,212,890 4,470,008 2,963,343
------------ ----------- -----------
Total income tax expense (benefit) $ - $ - $ (469,562)
============ =========== ===========
-14-
A reconciliation of income taxes on reported pretax loss at statutory rates
to actual income tax expense (benefit) for the years ended August 31, 1997
and 1996 and the period from January 1, 1995 to August 31, 1995, is as
follows:
1997 RATE 1996 RATE 1995 RATE
-------------- ----- ------------- ----- ------------- -----
Income tax at statutory rates $(16,501,900) 34% $(6,266,127) 34% $(3,614,248) 34%
State income taxes, net of
federal tax benefit 8,502 0 (833) 0 12,474 0
Valuation allowance 13,212,890 27 4,470,008 24 2,963,343 28
Expenses (dedectible) not deductible
for tax purposes (842,204) (2) 1,796,952 10 168,869 2
Utilization of current loss by
parent company in
consolidated return 4,122,712 9 - - - -
------------ ----------- -----------
Total income tax benefit $ - 0% $ - 0% $ (469,562) (4)%
============ =========== ===========
The net deferred tax assets consist of the tax effects of temporary differences
related to the following:
AUGUST 31
---------------------------------------------
1997 1996
---- ----
Allowance for uncollectible accounts receivable $ 380,665 $ 184,326
Equipment, furniture and fixtures (10,694,096) (4,539,736)
Intangible assets 420,888 105,249
Accrued employee compensation 213,535 182,676
Net operating loss carryforwards 31,120,828 12,371,690
IRPC deferred tax liability (480,402) (488,402)
Other 58,841 (16,434)
------------ -----------
Deferred tax asset before valuation allowance 21,012,259 7,799,369
Valuation allowance (21,012,259) (7,799,369)
------------ -----------
Net deferred tax asset $ - $ -
============ ===========
Realization of deferred tax assets is dependent on generating sufficient
taxable income prior to expiration of the loss carryforwards. The Company is
unable to determine whether these accumulated losses will be utilized;
accordingly, a valuation allowance has been provided.
-15-
The following are the expiration dates and the approximate net operating loss
carryforwards at August 31, 1997:
Expiration Dates
Through:
2010 $ 1,346,252
2011 11,521,202
2012 26,160,832
2013 52,503,562
Certain of the Company's net operating losses were utilized by VPC while the
Company was included in VPC's consolidated tax return. Such losses will not
be available for future use by the Company, and, accordingly, the deferred
tax benefit and valuation allowance were reduced. In connection with the
revised shareholder agreement (see Note 9), subsequent to august 31, 1997,
the Company will be reimbursed for any tax benefit generated by the company
and utilized by VPC.
9. CONVERTIBLE NOTES PAYABLE TO STOCKHOLDER, STOCK ISSUANCE AND OTHER
TRANSACTIONS WITH STOCKHOLDERS
From December 22, 1994 through March 31, 1995, the Company borrowed
$60,000,000 from VPC under a Senior Secured Convertible Note Agreement. The
note, with an original maturity of June 30, 1996, and the accrued interest of
$792,115 for the period from December 22, 1994 until conversion on March 31,
1995, was converted to 1,120,985 shares of common stock of OpTel on March
31, 1995. Concurrently, VPC purchased 105,667 shares of OpTel's common stock
from Vanguard. Additionally, the Company incurred $1,587,142 of costs
related to this conversion of debt which was charged to additional paid-in
capital.
On July 26, 1995, VPC invested $24,999,504 in the Company, of which
$16,687,656 represented VPC's purchase of an additional 311,652 shares of
OpTel common stock, and $8,311,848 represented a convertible note payable
that bore interest at 15% and was convertible to 155,229 shares of common
stock at the option of VPC on November 15, 1995 (extended to January 29,
1996). In connection with the July 26, 1995, equity call, Vanguard had the
option to fund its portion to maintain its ownership interest at 33.25% by
November 15, 1995 (extended to January 29, 1996). The Company was required
to use the proceeds from any Vanguard contribution to repay the convertible
note. On January 29, 1996, Vanguard elected to let the option expire without
funding its portion of the equity call. On April 1, 1996, VPC converted the
$8,311,848 note and accrued interest of $853,957 into 155,229 shares of
common stock.
From August 1995 through August 1997, the Company issued a total of
$131,400,000 in convertible notes to VPC, all of which bear interest at 15%,
generally with principal and interest due on demand. Under the terms of the
notes, any accrued interest on which there is no demand for payment as of
each August 31, automatically converts to additional principal payable. As
of August 31, 1997, $106,678,233 was advanced to OpTel under these notes and
a total of $22,925,642 of interest on the notes has been converted to
principal to date.
The principal and interest on convertible notes may be converted, subject to
anti-dilution adjustments and other terms, into Class B Common Stock (see
Note 10) at the price at which common stock is first sold to the public in a
public offering ("IPO Date") or, after April 30, 1999, at
-16-
a price equal to the quotient of $225 million divided by the number of shares
of common stock outstanding at the conversion date.
In August 1997, in connection with a revised shareholder agreement, Capital
Communication C.D.P.Q., Inc. ("CDPQ"), a minority stockholder of Videotron,
acquired all of Vanguard's interest in OpTel, including an option to purchase
48,937 shares of Class B Common Stock at an exercise price of $53.55 per
share, subject to adjustment, that had been granted to Vanguard in August
1996. The option was exercised by CDPQ on August 15, 1997, resulting in the
Company receiving $2,620,392 in cash.
In September 1996, the Company entered into a consulting agreement with a
former director of the Company who is a limited partner of Vanguard. In
connection therewith, the Company granted him a warrant to purchase up to
24,992 shares of Class A Common Stock at an exercise price of $53.55 per
share, subject to adjustment, that is presently exercisable and expires on
August 31, 1999.
VPC and an affiliate of Vanguard had each agreed to provide consultant,
advisory and management services for $350,000 per annum (plus travel
expenses) per party. This arrangement terminated in August 1997 with the
sale of Vanguard's interest in the Company.
10. STOCKHOLDERS' EQUITY
At August 31, 1997, the Class A Common Stock ("Class A stock"), Class B
Common Stock ("Class B stock") and Class C Common Stock ("Class C stock") of
the Company are identical in all respects and have equal powers, preferences,
rights and privileges except that each holder of Class A stock is entitled to
one vote for each share of Class A stock held, each holder of Class B stock
is entitled to ten votes for each share of Class B stock held, and each
holder of Class C stock does not possess any voting privileges. VPC and CDPQ
(and their affiliates) are the only permitted holders of Class B stock. Any
Class B stock that is either sold or transferred to any party other than the
permitted holders automatically converts to a like number of shares of Class
A stock.
On February 7, 1997 the Company approved a stock split effected in the form
of a stock dividend. Each share of outstanding Class B stock received
17.3768 additional shares. The number of authorized shares of Class A stock
and Class B stock was increased to 8,000,000 and 6,000,000, respectively.
The financial statements have been restated to reflect the stock split as if
it had occurred on December 20, 1994, the date the Company reorganized as a
corporation. Additionally, the Company authorized the issuance of 300,000
shares of Class C Non-Voting Common Stock.
11. EMPLOYEE BENEFIT PLAN
401(K) PLAN - The OpTel 401(k) Plan (the "Plan"), established January 1,
1995, conforms to the provisions of the Employee Retirement Income Security
Act of 1974. It is a contributory tax deferred 401(k) plan. All employees
are eligible and may enter the Plan on the first day of the first full month
of employment, provided that they have attained the age of 21.
Each participant my elect to defer up to 15% of annual compensation up to the
annual contribution limit of the Internal Revenue Code. The Company matching
contribution is a discretionary amount to be annually determined by the Board
of Directors of the Company. The Company determined that, for the plan years
ended December 31, 1997, 1996 and 1995, it would match 50% of its employees'
elective contribution (to a maximum Company contribution of 3% of the
employees'
-17-
compensation). For the periods ended August 31, 1997, 1996 and 1995, the
Company's match of its employees' elective contributions was $288,731,
$187,577 and $80,886, respectively.
12. RESTRICTED INVESTMENTS
Concurrent with the issuance of the Senior Notes, the Company was required to
deposit in an escrow account $79.6 million in cash that was subsequently
invested in treasury securities. The securities are classified as held-to-
maturity and, at August 31, 1997, have an amortized cost basis of
$67,206,227, and aggregate fair value of $67,232,880, and gross unrealized
holding gains of $26,653. The contractual maturity of the securities
correspond to the semi-annual interest payments required under the Senior
Notes through February 15, 2000.
13. EMPLOYEE STOCK OPTIONS AND WARRANTS
During the year ended August 31, 1997 the Company adopted a stock option and
award plan for the benefit of officers and key employees. The plan is
administered by a committee of the Board of Directors. The plan authorizes
the Board to issue incentive stock options, as defined in Section 422A(b) of
the Internal Revenue Code of 1986, as amended (the "Code"), and stock options
which do not conform to the requirements of that Code section. The Board has
discretionary authority to determine the types of options to be granted, the
persons to whom options shall be granted, the number of shares to be subject
to each option granted and the terms of the stock option agreements. Unless
otherwise specifically provided in the option agreement, (i) the exercise
price of an option will not be less than the fair market value , as
determined by the Board, of the Class A stock on the date of grant and (ii)
the options vest in equal installments on each of the second, third, fourth
and fifth anniversaries of the date of grant. The options issued as of
August 31, 1997, expire ten years from the date of grant. In the event of a
"change in control," all options shall vest and become immediately
exercisable. The Board has authorized 95,137 shares to be issued under the
plan. Stock option activity under the plan and warrants issued (see Note 9)
for the year ended August 31, 1997, was as follows:
Number of Weighted Average
Shares Price Per Share Price Per Share
- - --------------------------------------------------------------------------------------------------------------
Options and warrants outstanding at August 31, 1996 -- -- --
Granted 112,115 $53.55 to $85.75 $76.70
Exercised -- -- --
Forfeited 22,078 $53.55 to $85.75 $80.92
- - --------------------------------------------------------------------------------------------------------------
Options and warrants outstanding at August 31, 1997 90,037 $53.55 to $85.75 $75.66
- - --------------------------------------------------------------------------------------------------------------
Options and warrants exercisable at August 31, 1997 27,095 $53.55 to $85.75 $56.05
Options available for grant at August 31, 1997 30,092
-18-
The weighted average remaining contractual life of the stock options
outstanding at August 31, 1997 is nine years.
At August 31, 1997, the Company has reserved a total of 65,045 shares of
Class A stock for exercise of stock options. The Company has also granted
stock warrants in connection with an agreement to provide consulting services
(see Note 9).
The Company applies APB Opinion No. 25, "Accounting for Stock Issued to
Employees" in accounting for its stock option and award plan and the stock
warrants. During 1997, the exercise price of each option granted was greater
than or equal to the market price of the Company's stock on the date of
grant. Accordingly, no compensation expense has been recognized under this
plan. For the year ended August 31, 1997, the difference between actual net
loss and loss per share and net loss and loss per share on a proforma basis
as if the Company had utilized the accounting methodology prescribed by SFAS
No. 123, "Accounting for Stock-Based Compensation," would have been $44,000
and $.02, respectively.
The estimated weighted average grant date fair value of options and warrants
granted during 1997 was $1.10 per share. For purposes of determining fair
value of each option, the Company used the minimum value method using the
following assumptions:
Risk-free interest rate 6.18% - 6.88%
Expected life 3 to 10 years
14. FINANCIAL INSTRUMENTS
The following disclosure of the estimated fair value of financial instruments
is made in accordance with the requirement of SFAS No. 107, "Disclosure About
Fair Value of Financial Instruments." The estimated fair value amounts have
been determined by the Company using available market information and
appropriate valuation methodologies. However, considerable judgment is
necessarily required to interpret market data to develop estimates of fair
value. Accordingly, the estimates presented herein are not necessarily
indicative of the amounts the Company could realize in a current market
exchange. The use of different market assumptions and/or estimation
methodologies may have a material effect on the estimated fair value amounts.
-19-
CARRYING ESTIMATED CARRYING ESTIMATED
AMOUNT FAIR VALUE AMOUNT FAIR VALUE
---------------- ------------------ --------------- ----------------
Assets:
Cash and cash equivalents $ 87,305,069 $ 87,305,069 $ 1,677,332 $ 1,677,332
Restricted investments 67,206,227 67,232,880 - -
Accounts receivable 4,044,145 4,044,145 3,063,719 3,063,719
Liabilities:
Accounts payable 7,926,879 7,926,879 5,647,024 5,647,024
Customer deposits and
deferred revenue 2,977,872 2,977,872 2,167,253 2,167,253
Convertible notes payable
to stockholder 129,603,875 129,605,000 89,414,364 89,415,000
Notes payable and long-term
obligations 221,652,973 228,650,000 2,443,341 2,445,000
Deferred acquisition liabilities 6,919,914 6,920,000 6,520,022 6,525,000
The carrying amount of cash and cash equivalents, accounts receivable,
accounts payable and customer deposits and deferred revenue approximates fair
value. The fair values of convertible notes payable to stockholder, certain
notes payable and long-term obligations and deferred acquisition liabilities
are estimated based on present values using applicable market discount rates
or rates that approximate what the Company could obtain from the open market.
The fair value of restricted investments and the Senior Notes are based on
quoted market prices. The fair value estimates presented herein are based on
pertinent information available to management as of August 31, 1997 and 1996.
Although management is not aware of any factors that would significantly
affect the estimated fair value amounts, such amounts have not been
comprehensively revalued for purposes of these financial statements since the
date presented, and therefore, current estimates of fair value may differ
significantly from the amounts presented herein.
-20-
15. QUARTERLY FINANCIAL DATA (UNAUDITED)
Year Ended August 31, 1997
--------------------------------------------------------------------------------------------------
First Quarter Second Quarter Third Quarter Fourth Quarter
- - ----------------------------------------------------------------------------------------------------------------------------------
Revenues $ 9,075,777 $ 9,545,940 $ 10,495,305 $ 10,720,298
Operating $12,692,826 $14,095,546 $ 17,003,399 $ 18,841,497
expenses
Other expense $ 3,277,015 $ 4,848,631 $ 8,867,448 $ 8,745,909
Net income $(6,894,064) $(9,398,237) $(15,375,542) $(16,867,108)
(loss)
Net loss per common share $ (2.99) $ (4.01) $ (6.08) $ (6.65)
Weighted average number
of shares outstanding 2,304,561 2,342,061 2,529,561 2,538,072
Year Ended August 31, 1996
--------------------------------------------------------------------------------------------------
First Quarter Second Quarter Third Quarter Fourth Quarter
- - ----------------------------------------------------------------------------------------------------------------------------------
Revenues $ 5,824,590 $ 6,463,522 $ 7,320,192 $ 7,996,543
Operating $ 7,999,598 $ 9,395,143 $ 10,320,214 $ 12,465,540
Expenses
Other Expense $ 613,789 $ 1,521,748 $ 1,572,981 $ 2,145,618
Net Income $(2,788,797) $(4,453,369) $ (4,573,003) $ (6,614,615)
(Loss)
Net loss per common share $ (1.30) $ (2.07) $ (2.02) $ (2.86)
Weighted average number
of shares outstanding 2,149,332 2,149,332 2,262,820 2,315,125
16. SUBSEQUENT EVENTS
On October 13, 1997, the Company received a commitment from a bank to provide
a $150 million senior secured credit facility (the "Senior Facility") which
will be used to provide capital to fund future development. The Senior
Facility will consist of a term loan and a revolving credit commitment both
of which will bear interest at interest rates customary for this type of
transaction and the credit position of the Company. The Senior Facility will
be secured by a first fixed and floating lien on substantially all of the
assets of the Company. Availability under the Senior Facility will be
subject to the Company meeting certain performance criteria. Management
expects that funds will become available under the Senior Facility in
December 1997. The funding of the Senior Facility is subject to customary no
material adverse changes clauses and terminates December 15, 1997, if not
closed.
* * * * * *
-21-
INDEPENDENT AUDITORS' REPORT
To the Board of Directors of
OpTel, Inc.:
We have audited the financial statements of OpTel, Inc. and subsidiaries as of
August 31, 1997 and 1996, and for each of the years ended August 31, 1997 and
1996, the period from January 1, 1995 to August 31, 1995, and the year ended
December 31, 1994; such financial statements and report are included herein. Our
audits also included the financial statement schedule of OpTel, Inc. listed in
Item 14. This financial statement schedule is the responsibility of the
Corporation's management. Our responsibility is to express an opinion based on
our audits. In our opinion, such financial statement schedule, when considered
in relation to the basic financial statements taken as a whole, presents fairly
in all material respects the information set forth therein.
DELOITTE & TOUCHE LLP
Dallas, Texas
October 14, 1997
-22-
SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS
- - ----------------------------------------------------------------------------------------------------------------------
Balance at Charged to costs Deductions - Balance at end of
beginning of and expenses write-offs and Period
period recoveries
- - ----------------------------------------------------------------------------------------------------------------------
ALLOWANCE FOR DOUBTFUL ACCOUNTS
Year ended August 31, 1997 $542,134 $1,787,709 $(1,204,620) $1,125,223
Year ended August 31, 1996 $473,218 $1,376,835 $(1,307,191) $ 542,134
Period ended August 31, 1995 $147,853 $ 372,339 $ (46,974) $ 473,218
Year ended December 31, 1994 $ 238 $ 147,615 $ (0) $ 147,853